ConvergeOne Ruling Gives Teeth to Bankruptcy Class Equality Rule

Minority lenders’ success in reversing part of ConvergeOne Holdings Inc.'s bankruptcy plan over their exclusion from a lucrative investment opportunity serves as the latest deterrent to debtors’ ability to structure similar insider-focused deals.

The cloud computing provider’s pre-packaged Chapter 11 plan gave unequal treatment to some lenders within the same creditor class, violating the US bankruptcy code, Judge Andrew Hanen of the US District Court for the Southern District of Texas said last week.

The reversal is the first time a court has agreed with a minority lender challenge that the right to participate in valuable backstop financing must be offered to similarly situated creditors within a Chapter 11 reorganization, and it could affect similar liability management transaction deals, according to University of Chicago Law School professor Vincent Buccola.

The ruling applies the reasoning in the Fifth Circuit’s December 2024 decision rejecting Serta Simmons Bedding LLC’s pre-bankruptcy liability management deal.

“It’s going to be a major on curb on debtors’ ability to approximate the results non-pro rata LME dealing through the bankruptcy process,” Buccola said.

Significance

Hanen held that offering exclusive, nonmarket-tested participation rights and backstop economics to a subset of creditors within a class—yielding materially higher recoveries—violates bankruptcy law.

The ConvergeOne decision in many ways is an outgrowth of the Serta opinion, said Sean A. O’Neal, a partner at Cleary Gottlieb Steen & Hamilton LLP.

The Fifth Circuit interpreted the contract language that governed the uptier transaction and held that Serta should have gone to the secondary market for syndicated loans instead of privately tapping individual, existing lenders under an “open market purchase” provision of its debt contract.

While the Serta reversal was based on contract interpretation—which parties could subsequently draft around—the ConvergeOne decision is rooted in the bankruptcy code itself and can’t be altered by a private contract. That could make it a formidable obstacle to structuring similar deals in Chapter 11 down the road.

Like in Serta, the opinion shows that courts view equal treatment of creditors as a bedrock of bankruptcy law and that they’ll closely examine the facts through a lens of fairness and equal treatment, O’Neal said.

The ConvergeOne deal included a unit of equity holder and senior secured lender, CVC Capital Partners.

“The court was highly influenced by the fact that one of the majority lenders was an affiliate of the private equity sponsor,” O’Neal said.

Serta was about priming through contract interpretation outside of bankruptcy and the lens to assess functional inequality, but parties can draft around parts of Serta in future deals, said Josh Clark, a senior director of leveraged finance at Fitch Group. ConvergeOne squarely applies the bankruptcy code’s equal treatment requirement to the plan economics, he said.

“That constraint is not contractable,” Clark said.

While significant, Hanen’s decision may have limited reach.

The judge’s order isn’t precedential in other circuits and it’s not clear whether courts outside of the Fifth Circuit will take a similar approach, so it’s too early to say there’s a trend, O’Neal said. The decision could also be appealed by the majority lenders.

Nonetheless, Hanen’s decision is important for distressed businesses, lenders, and practitioners, especially because it reversed the Southern District of Texas bankruptcy court—the country’s second most popular venue for large Chapter 11 cases.

“This is a significant decision that boards should consider when engaging with lenders in liability management transactions,” O’Neal said. “Even so, it’s just one district court decision, by a court located in the Fifth Circuit where Serta was decided.”

Backstop Fees

The decision focused on the use of exit financing “backstop fees,” which are payments for deal participants that agree to purchase shares that aren’t bought by other investors. Companies and their advisers in recent years have used the backstop deals to achieve liability management exercises within Chapter 11.

Proskauer Rose LLP, which represented the excluded lenders, said after the ruling that the decision “has potentially far-reaching implications for corporate restructurings.”

Debtors shouldn’t assume giving exclusive backstop rights to favored creditors will withstand judicial tests, the firm said.

Debtors have often structured plans where a subset of lenders—typically a majority coalition holding the required 67% voting power—receive substantial fees for committing to backstop a new securities offering.

Until the ConvergeOne decision, courts generally accepted that those fees didn’t violate the bankruptcy code’s equal treatment rule because they were for new financing commitments, not treatment for their claims, Buccola said.

An Eighth Circuit decision from 2019 came to a different conclusion in the Peabody Energy Corp. bankruptcy, but Hanen distinguished it.

The ConvergeOne decision held that the opportunity to participate in the backstop deal is a form of value that must either be offered equally to all class members or be subject to a competitive market process.

“In general, the issue is that in a lot of these deals, it appears that the debtor is using this as a fig leaf to funnel money to favored lenders,” Buccola said.

The idea behind allowing a 67% vote to bind a dissenting minority is the assumption that all members within a creditor class are “similarly situated” and receiving the same treatment, Buccola said. But that grounding of the code falls away if the majority that votes “yes” under a bankruptcy plan gets something materially different than others in their class, he said.

By treating the backstop opportunity as part of the overall “blended return,” Hanen’s decision aims to ensure the vote is a legitimate gauge of fairness for the entire class, Buccola said.

The decision, Buccola said, may alter the strategies used by debtors and majority lender groups in Chapter 11 by giving “teeth to the requirement that parties be treated the same way.”