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Opinion Private credit
Accountability may finally be catching up with ‘legal innovation’ in LMEs
by Dagmara Michalczuk
Dagmara Michalczuk
Co-chief investment officer
Tetragon Credit Partners
The Serta judgment shows that being in the majority no longer guarantees protection
For years, market consensus was that in liability management exercises (LMEs), controlling the majority of the debt meant controlling the outcome. But the Serta litigation may have finally changed that.
In July, the US Bankruptcy Court for the Southern District of Texas ordered the remaining, non-settled participating lenders in Serta’s disputed 2020 uptier LME to pay USD 161.5m in damages and pre-judgment interest to certain excluded minority lenders. Whether the decision survives further appeals remains uncertain, but the message for the market is clear: majority control does not offer immunity from liability.
In many respects, the decision represents a rare David-versus-Goliath moment. Until now, the common view was that the largest lenders dictated restructuring outcomes, while minority creditors had little choice but to accept the outcome. Instead, a group of excluded lenders successfully challenged one of the market’s most controversial LMEs and secured substantial damages against the participating majority lenders.
Someone must bear the cost
Justice, however, raises another complicated question: who actually pays? Some CLOs that participated in the Serta uptier have since materially amortised and have little remaining asset value. Others have been fully liquidated. Recovering damages from CLOs whose assets have been distributed raises practical and legal questions that have received little attention to date. The industry has spent years debating creditor-on-creditor violence. It will now need to confront who ultimately bears the cost of these liabilities and how that risk should be disclosed to CLO investors.
The Serta ruling may also change the litigation calculus for CLO managers. Legal action is expensive, in terms of actual costs, time and management resources, with no guarantee of success. When litigation succeeds, however, those costs look less like an expense and more like a recovery-preservation investment. CLO managers must therefore weigh whether pursuing claims serves their equity investors’ long-term interests. Some managers may prefer to preserve equity cashflows rather than engage in lengthy lawsuits.
Others may conclude that failing to challenge aggressive LMEs invites future value transfers from their CLO portfolios and presents an existential threat. CLO equity and debt investors would be wise to evaluate not only how managers select credits, but also how they analyse restructurings, weigh litigation risks and manage legal costs.
A question of transparency also deserves attention. Potential litigation liabilities have generally been absent from standard CLO trustee reports. Investors receive extensive disclosure on portfolio composition, trading activity and structural metrics, yet there is no standardised reporting of legal costs and contingent liabilities arising from LME disputes. As litigation becomes a fixture of the loan market, this reporting gap demands urgent attention.
Liability may reshape future restructurings
Ultimately, Serta’s greatest impact may not be the damages judgement itself, but the precedent it sets: inequitable LMEs carry real financial costs for those who participate in them. If lenders recognise that extracting value today can create liability tomorrow, future restructurings may become more balanced. Sponsors, borrowers and majority lenders may think twice before pursuing non-pro rata restructurings that leave minority creditors out of negotiated outcomes. Even a credible threat of litigation can now strengthen a minority lender’s negotiating position.
The philosopher St Augustine noted that “punishment is justice for the unjust”. Credit markets, I believe, function best when well-established rules are respected and investors have full transparency into the risks they bear. In recent years, many have questioned whether that held true in the ‘Wild West’ of leveraged finance. The Serta decision suggests that accountability may finally be catching up with ‘legal innovation’, restoring at least some negotiating leverage to minority lenders and reinforcing the importance of contractual protections and market integrity.