On December 31, 2024, the United States Court of Appeals for the Fifth Circuit issued its long awaited opinion in the disputes arising from the controversial “uptier” transaction executed by Serta Simmons Bedding, L.L.C. (“Serta”) in 2020 and the confirmation of Serta’s chapter 11 plan by the Southern District of Texas Bankruptcy Court in 2023. The Fifth Circuit reversed former Bankruptcy Judge David Jones’ summary judgment ruling that the 2020 uptier transaction was permissible under Serta’s existing credit agreements. In addition, the Fifth Circuit reversed the portion of the order confirming Serta’s chapter 11 plan that required reorganized Serta to indemnify the holders of debt issued in the 2020 uptier transaction from claims made by the lenders excluded from the 2020 uptier transaction. The Fifth Circuit’s ruling has immediate and significant consequences for companies that have executed non-pro rata out-of-court liability management exercises (“LMEs”) and the lenders that have participated in such transactions in reliance on “open market exchange” exceptions to the customary credit agreement requirement of pro rata sharing of payments. In addition, the ruling may limit significantly non-pro rata LMEs going forward and effectively shifts the risks associated with any such transaction from borrowers and sponsors to participating lenders.
Background
Distressed borrowers have turned to LMEs with increasing frequency in recent years to refinance and restructure funded debt obligations. LMEs can be an attractive alternative to financial restructurings effectuated under chapter 11 of the United States Bankruptcy Code, particularly for equity sponsors that do not want investments in portfolio companies wiped out, or significantly diluted, in a chapter 11 a bankruptcy. LMEs are also attractive for opportunistic lenders that participate, as they are often structured to enhance the value of their claims at the expense of lenders that do not participate in the LME. LMEs have generated significant litigation and controversy as well as myriad contractual “blockers” in newly issued credit agreements that are designed to limit the ability of borrowers to effectuate LMEs that prejudice excluded lenders.
Among the common LME transaction structures is the “uptier” transaction. In an uptier transaction, a borrower enters into a transaction with a group of existing lenders through which the borrower issues new debt and provides existing lenders participating in that new debt with claims and liens that are contractually senior to the claims and liens securing existing indebtedness. The new contractually senior debt is issued in exchange for (and customarily at a discount to) existing debt held by the participating existing lenders. Uptier transactions almost always require the participating existing lenders to agree to amendments of existing loan documents in order to allow for the issuance of new debt with senior claims and liens. Serta’s uptier transaction is perhaps the most well-known. Like most uptier transactions, Serta relied on the open market purchase exception to the requirement or “sacred right” of pro rata sharing in its credit agreement to effectuate the exchange of existing debt into new contractually senior debt.
The Serta Uptier Exchange
In 2016, Serta issued $1.95 billion in first lien loans under a syndicated credit agreement (the “2016 First Lien Credit Agreement”) and $450 million in second lien loans under a separate syndicated credit agreement (the “2016 Second Lien Credit Agreement” and, with the 2016 First Lien Credit Agreement, the “2016 Credit Agreements”). Section 2.18 of the 2016 First Lien Credit Agreement included the standard “sacred right” of pro rata sharing among lenders. This section, a form of which is included in nearly all syndicated credit agreements, requires that any payment of principal or interest or other fees by Serta be made pro rata among the lenders in accordance with their respective ownership percentage of outstanding loan claims. In contrast to the many covenants and other provisions in the 2016 First Lien Credit Agreement that could be amended, waived, or modified with the consent of lenders holding a majority of the outstanding loan claims, Section 2.18 could not be amended, waived, or modified without the consent of any affected lender.
One of the exceptions to the requirement of pro rata sharing among lenders in Serta’s 2016 First Lien Credit Agreement was the provision allowing for any lender to assign all or a portion of its claims on a non-pro rata basis to Serta “through open market purchases.” For Serta and its lenders, any transaction that fits within this open market purchase exception does not require any amendment, waiver, or modification to the sacred right of pro rata sharing set forth in Section 2.18 of the 2016 First Lien Credit Agreement or the consent of any excluded lender.
Serta’s financial performance declined following the 2016 financing transactions. In 2020, because of further business declines caused by the pandemic, Serta received competing LME proposals from groups of lenders holding 2016 First Lien Credit Agreement and 2016 Second Lien Credit Agreement claims. Serta ultimately entered into a transaction with a group of lenders that held a majority of the claims under the 2016 First Lien Credit Agreement (the “Prevailing Lenders”). Under the transaction, Serta incurred $200 million in new first-out, super priority financing and effectuated a non-pro rata, debt for debt exchange, whereby $1.2 billion in existing claims under the 2016 First Lien Credit Agreement and 2016 Second Lien Credit Agreement were exchanged (the “Uptier Exchange”) for $875 million in new second-out, super priority debt (the “Uptier Exchange Debt”). Immediately prior to consummating these transactions, the Prevailing Lenders agreed to amend the 2016 First Lien Credit Agreement and 2016 Second Lien Credit Agreement to permit Serta to incur the $200 million in new first-out, super priority financing and to permit the issuance of the Uptier Exchange Debt. Under these amendments, the over $800 million of remaining 2016 First Lien Credit Agreement and 2016 Second Lien Credit Agreement claims (and liens securing such claims) were expressly subordinated to the $200 million in new first-out, super priority financing and Uptier Exchange Debt. What these amendments could not accomplish, however, was any deviation from the requirement of pro rata sharing of payments set forth in Section 2.18 of the 2016 First Lien Credit Agreement. Aware of this fact, Serta and the Prevailing Lenders took the position that the exchange of $1.2 billion in claims under the 2016 Credit Agreements for Uptier Exchange Debt was an “open market purchase” and therefore excepted from the pro rata sharing requirement by, among other things, titling their exchange agreement the “Open Market Purchase and Cashless Exchange Agreement”.
The Uptier Exchange resulted in immediate litigation in state and federal court in New York. On March 29, 2022, United States District Judge Katherine Failla of the Southern District of New York denied Serta and the Prevailing Lenders’ motion to dismiss claims challenging the Uptier Exchange. In doing so, Judge Failla stated that “on a plain reading of the term, the [Uptier Exchange] depicted in the Complaint did not take place in what is conventionally understood as an ‘open market.’” Judge Failla’s refusal to dismiss claims challenging the Uptier Exchange was consistent with rulings by New York state courts refusing to dismiss claims challenging the uptier transactions executed by TriMark and Boardriders in 2020 that were asserted by lenders excluded from those transactions.
In January, 2023, Serta filed for protection under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Texas. Upon commencing its bankruptcy cases, Serta and the Prevailing Lenders filed a complaint seeking a declaratory judgment that, among other things, the Uptier Exchange was an “open market purchase” under the terms of the 2016 First Lien Credit Agreement. Former Bankruptcy Judge David Jones determined, on a summary judgment basis and without a full evidentiary trial, that the Uptier Exchange was an open market purchase. While aware of Judge Failla’s statement to the contrary, Judge Jones stated that it was “very easy for me” to find that the Uptier Exchange was an open market purchase.
As a result of the issuance of $200 million in new first-out, super priority financing and Uptier Exchange Debt, the remaining indebtedness under the 2016 Credit Agreements was deeply subordinated. In the chapter 11 plan confirmed in Serta’s Chapter 11 case (the “Serta Chapter 11 Plan”), nearly all equity value in reorganized Serta was distributed to holders of Uptier Exchange Debt, while the $200 million in first-out claims were paid in full under the Serta Chapter 11 Plan through a refinancing. Holders of claims that remained under the 2016 Credit Agreements received essentially no recovery under the Serta Chapter 11 Plan.
Fifth Circuit’s Rulings
The Fifth Circuit found that the Uptier Exchange did not qualify as a transaction within the “open market purchase” exception to the pro rata sharing requirement in Serta’s 2016 First Lien Credit Agreement. In doing so, the Fifth Circuit reversed the contrary ruling by former Bankruptcy Judge Jones. The Fifth Circuit found that “an open market purchase occurs on the specific market for the product that is being purchased. In this case, the relevant product is first-lien debt issued under the [Serta 2016 First Lien Credit Agreement], and the market for that product is the “secondary market” for syndicated loans . . . So if [Serta Simmons] wished to make a Section 9.05(g) open market purchase and thereby circumvent the sacred right of ratable treatment, it should have purchased its loans on the secondary market.”
As a result of its ruling that the Uptier Exchange was not an open market purchase, the Fifth Circuit reinstated the breach of contract claims made by lenders excluded from the Uptier Exchange (the “Excluded Lenders”) against the Prevailing Lenders. And significantly, the Fifth Circuit also found that the provision in the Serta Chapter 11 Plan obligating reorganized Serta to indemnify holders of Uptier Exchange Debt from claims by the Excluded Lenders relating to the Uptier Exchange was impermissible under the Bankruptcy Code and ordered that the indemnity be excised from the confirmed Serta Chapter 11 Plan. The Fifth Circuit based its holding that the indemnity violated the Bankruptcy Code on Section 502(e)(1)(B)’s disallowance of contingent claims for reimbursement. The Fifth Circuit expressly rejected the argument by Serta and the Prevailing Lenders that Section 1123(b)(3)(A) allowed the indemnity as a settlement of a claim included in a chapter 11 plan as an “impermissible end run around 502(e)(1)(B).”[1] The Fifth Circuit also rejected the argument by Serta and the Prevailing Lenders that any review of the confirmation order should be denied on grounds of “equitable mootness,” holding that the indemnity provision could be excised from the Serta Chapter 11 Plan without adversely affecting the rights of parties not before the court or the success of the plan.
Implications:
While the terms of specific credit agreements vary,[2] many LMEs (whether they are uptier transactions or otherwise) that are executed on a non-pro rata or exclusionary basis rely on an open market purchase exception to the customary requirement of pro rata sharing of payments to exchange existing debt for new structurally or contractually senior debt at a discount.[3] As a result of the Fifth Circuit’s ruling, reliance on a standard open market purchase exception to effectuate a non-pro rata exchange exposes borrowers and participating lenders to heightened risk of legal challenges. While the Fifth Circuit’s ruling is not binding on state and federal courts in New York, it supports the position taken by S.D.N.Y. District Judge Failla that the Uptier Exchange “did not take place in what is conventionally understood as an ‘open market.’” Courts tasked with evaluating claims challenging recent non-pro rata LMEs executed in reliance on open market purchase exceptions similar to that included in the 2016 Credit Agreements are likely to find the Fifth Circuit’s analysis of the Serta transaction to be highly persuasive.
In addition to its express finding on the contours of the open market purchase exception, the Fifth Circuit cast aside appeals to equitable mootness and shifted all of the risk associated with the Uptier Exchange from reorganized Serta to the Prevailing Lenders. By ruling that the provision in the Serta Chapter 11 Plan that obligated reorganized Serta to indemnify holders of the Uptier Exchange Debt violated the Bankruptcy Code, reorganized Serta is now “free and clear” from any taint related to the Uptier Exchange. The Participating Lenders, therefore, will have to fund all defense costs arising from litigation with the Excluded Lenders and bear any related damages themselves. In a statement that circulated in press reports on January 3rd, reorganized Serta stated that the Fifth Circuit’s ruling left only a dispute between the Prevailing Lenders and Excluded Lenders, and that “Serta Simmons Bedding’s business and its restructuring are unaffected by the Fifth Circuit’s decision and the Company continues business as usual.” Unless overturned on appeal, bankruptcy courts within the Fifth Circuit are now precluded from approving LME related indemnities as plan settlements under Section 1123(b)(3)(A) in chapter 11 plans. While borrowers and sponsors will continue to pursue creative transaction structures to effectuate LMEs, opportunistic lenders that participate in non-pro rata LMEs should no longer expect to “cleanse” the transaction through settlement indemnities under the borrower’s future chapter 11 plan.
[1] Serta and the Prevailing Lenders did not dispute that the indemnities by Serta in favor of the Prevailing Lenders included in the transaction documents executed at the time of the Uptier Exchange were contingent claims for reimbursement by the Prevailing Lenders that were disallowed under Section 502(e)(1)(B) in Serta’s chapter 11 case.
[2] In fact, on the same day the Fifth Circuit issued its Serta opinion, the New York Supreme Court’s First Appellate Division reversed a trial court order and granted motions to dismiss challenges to an uptier transaction executed by Mitel Networks. There, unlike Serta, the applicable credit agreement did not limit Mitel’s ability to repurchase loans on a non-pro rata basis to Dutch auctions and open market purchases.
[3] Following the execution of the Uptier Exchange and other controversial LMEs, many newly executed syndicated credit agreements (or older credit agreements amended following the Uptier Exchange) have included so-called “Serta blockers” in one form or another in an attempt to minimize the risks of an uptier transaction. Other transactions that have given rise to eponymous “blockers” include Chewy, J Crew, Envision, Pluralsight, At-Home, and Wesco. And, recently Spirit Airlines has proposed to include an “omni” blocker in secured notes to be issued on Spirit Airlines’ eventual exit from bankruptcy. The omni blocker purports to bar reorganized Spirit from executing any LME without first offering all holders of the notes a bona fide offer to participate in the transaction.