On December 31, 2024, the U.S Court of Appeals for the Fifth Circuit issued a unanimous decision reversing the bankruptcy court’s ruling that allowed an uptier transaction entered into by Serta Simmons Bedding, LLC (“Serta Simmons”) in 2020 (the “2020 Uptier”). The appellate court also held that plan provisions requiring the indemnification of the lenders who participated in the 2020 Uptier (“Prevailing Lenders”) were impermissible under the U.S. Bankruptcy Code and should be excised from the plan.

The use of uptier transactions by distressed borrowers has increased dramatically over recent years, spurred by the marked increase in distressed companies during the COVID-19 pandemic. The 2020 Uptier was one of the first major uptier transactions and was controversial from its inception because it resulted in the subordination of a majority of creditors’ interests. Typically, in an uptier transaction, a borrower will issue new superpriority debt under an existing credit facility, consented to by the majority of lenders, in exchange for giving those lenders’ debt superior status. Such transactions earned their name because new debt is “uptiered,” subordinating the existing debt of lenders who were not party to the uptier transaction. This is what occurred with the 2020 Uptier—the Prevailing Lenders were able to uptier their loan, with the remaining lenders (“Excluded Lenders”) recovering little on their claims in the restructuring.

Background

Serta Simmons is the world’s leading producer of mattresses and other bedding products. It entered into a 2016 credit agreement with certain lenders which provided it with a $1.95 billion first lien term loan credit facility (“2016 Agreement”). Among the various provisions, the 2016 Agreement mandated pro rata sharing among the lenders, a background norm in corporate finance that requires a borrower to proportionately allocate its repayments based on the lenders’ percentage interest in the outstanding debt. The 2016 Agreement included exceptions to the ratable sharing provision that “any lender may, at any time, assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender on a non-pro rata basis (A) through Dutch Auctions[1] open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) through open market purchases, in each case with respect to clauses (A) and (B), without the consent of the Administrative Agent.” The term “open market purchase” was not defined in the 2016 Agreement.

Later, facing liquidity issues during the COVID-19 pandemic, Serta Simmons entered into the 2020 Uptier with its Prevailing Lenders holding first-lien and second-lien debt. The 2020 Uptier: (i) provided Serta Simmons with $200 million in new financing in exchange for $200 million first-out superpriority debt; and (ii) traded $1.2 billion of first-lien and second-lien loans for $875 million in second-out superpriority debt. To facilitate the 2020 Uptier and to deal with anticipated future litigation, Serta Simmons amended the 2016 Agreement in order to allow it to issue new priming debt, labeled the 2020 Uptier an “open market purchase” within the meaning of section 9.05(g) of the 2016 Agreement, and agreed to indemnify the Prevailing Lenders for all losses, claims, damages, and liabilities in connection with their participation in the 2020 Uptier (“Prepetition Indemnity”).

Despite the 2020 Uptier, Serta Simmons’ financial condition continued to deteriorate. Subsequently, on January 23, 2024, Serta Simmons and 13 affiliated debtors (together, the “Debtors”) filed for chapter 11 protection in the Bankruptcy Court for the Southern District of Texas (“Bankruptcy Court”). The Bankruptcy Court entered an order confirming the Debtors’ Second Amended Joint Chapter 11 Plan (“Plan”) on June 14, 2023. The Plan was subject to a number of objections, including objections to an indemnity provision that baked the provisions of the Prepetition Indemnity into the plan (“Plan Indemnity”), but was ultimately confirmed and went effective on June 29, 2023.

The 2020 Uptier Was Not a Valid Open Market Purchase

The 2020 Uptier was met with resistance from Excluded Lenders and other creditors. In response, the Debtors and Prevailing Lenders filed an action for declaratory relief on January 24, 2023, seeking the Bankruptcy Court’s approval of the 2020 Uptier through a declaration that it did not violate the pro-rata sharing provisions in the 2016 Agreement and did not violate the implied covenant of good faith and fair dealing.[2] On February 24, 2023, the Debtors and Prevailing Lenders each filed a motion for summary judgment, arguing inter alia that: (i) the term “open market purchase” under the 2016 Agreement included debt exchanges in which not all lenders are invited to participate; (ii) the inclusion of “non-pro rata” in section 5.09(g) of the 2016 Agreement reflects an intention that open market purchases need not be open to all; (iii) the Debtors undertook a robust marketing process to obtain the best price possible; and (iv) therefore, the 2020 Uptier was a valid open market purchase under the 2016 Agreement.[3]

Former Bankruptcy Judge David Jones granted partial summary judgment in favor of the Debtors and the Prevailing Lenders, finding that the 2020 Uptier was an open market purchase and permitted under the 2016 Agreement. In so finding, Judge Jones found that there was no ambiguity in the meaning of “open market purchase” in section 9.05(g) of the 2016 Agreement, and that the 2020 Uptier fit within the definition because there was no evidence of any coercion or manipulation in the transaction.

On appeal, the Fifth Circuit reversed the Bankruptcy Court’s decision, finding that the 2020 Uptier was not a permitted open market purchase under the 2016 Agreement. The appellate court rejected the expansive definition of “open market purchase” proffered by the Debtors, because its application would mean that short of coercing one of the lenders, the Debtors could call any arms-length transaction an open market purchase.[4] Additionally, according to the Fifth Circuit, an open market is “a specific market that is generally open to participation by various buyers and sellers.”[5] This means that an open market purchase takes place on the market relevant to the purchased product, in this case being the secondary market for syndicated loans.[6] Instead of purchasing the loans on the secondary market, Serta Simmons privately engaged individual lenders outside of the secondary market, taking the 2020 Uptier outside the protection of section 9.05(g).[7]

The Bankruptcy Code Does Not Permit the Indemnification of Prevailing Lenders

The Excluded Lenders and a creditor, Citadel Equity Fund Ltd. (“Citadel”), objected to the Plan Indemnity, arguing that it allowed the Prepetition Indemnity to pass through the Plan in violation of sections 502(e)(1)(B) and 509(c) of the Bankruptcy Code.[8] Together, they argued, these provisions were enacted to ensure that a non-debtor co-obligor’s reimbursement claim could not be recovered prior to the full payment of the primary claim.[9] The Debtors’ Plan ran afoul of this legislative intention by allowing the contingent claims of co-obligors to pass through bankruptcy at the expense of the Excluded Lenders’ claims that would be discharged for almost no value.[10]

However, Judge Jones found that the Plan Indemnity was given to the Prevailing Lenders as part of a “basket of consideration” in exchange for the equitization of almost $1 billion in secured claims and the provision of DIP Financing.[11] According to Judge Jones, because the Plan Indemnity dealt with potential liability connected to participation in the 2020 Uptier, it was unsurprising that the Plan Indemnity’s language was virtually identical to that of the Prepetition Indemnity.[12] Therefore, the Plan Indemnity was valid as part of a plan settlement pursuant to section 1123(b)(3) of the Bankruptcy Code.

The Fifth Circuit reversed Judge Jones’ ruling, holding that the plan provisions that required the Debtors to indemnify the Prevailing Lenders were impermissible under the Bankruptcy Code. Initially, the court found that the issue was not equitably moot since the Plan Indemnity could simply be excised from the Plan without threatening the success of the Debtors’ reorganization.[13] Additionally, it was unclear which third parties would be harmed by excision, and while the Excluded Lenders and Citadel had been denied a stay of the confirmation order, such failure did not mandate finding an appeal equitably moot.[14]

Turning next to the merits, the Fifth Circuit found that the Plan Indemnity was “an impermissible end-run” around the Bankruptcy Code.[15] The court began its analysis with section 502(e)(1)(B) of the Bankruptcy Code, which requires bankruptcy courts to disallow contingent prepetition indemnification claims.[16] The Debtors attempted to avoid the section 502(e)(1)(B) ban by characterizing the Plan Indemnity as a valid settlement indemnity under section 1123(b)(3)(A). The Fifth Circuit rejected this argument because section 1123(b)(3)(A) only allows for a plan to settle or adjust certain claims or interests and does not expressly allow for “the back-end resurrection of claims already disallowed on the front end.”[17] The Plan Indemnity mirrored the terms of the Prepetition Indemnity and sought to protect the same group of lenders. On this basis, the Bankruptcy Court’s acceptance of the validity of the resurrected Prepetition Indemnity in the form of the Plan Indemnity was a “mistake.”[18]

Takeaways

The Fifth Circuit’s decision may potentially chill the market for uptier transactions as it takes a swing at a once-reliable option for struggling companies which relied on the general acceptance of open market purchase provisions. As for the rejected plan indemnities, interested lenders may be discouraged by the increased risks associated with uptier transactions. Litigation risk will now shift from debtors to lenders because equitable mootness under these circumstances will no longer provide an effective back-stop to litigation, and at least in the Fifth Circuit, the use of settlement indemnities containing terms identical or substantially similar to prepetition indemnities provided in uptier transactions will not be approved.

On the other hand, however, the market for uptier transactions may not be so strongly impacted because the decision is only binding in the Fifth Circuit, and it is unknown whether other jurisdictions will follow suit. Distressed companies and interested lenders may also get creative with the language in credit agreements moving forward to allow for such transactions. For example, in the Ocean Trails CLO VII v. MLN Topco Ltd. decision that was also handed down on December 31, 2024, the New York Appellate Court blessed an uptier transaction because it found that the terms of the credit agreement allowed for the purchase of loans on a non-pro-rata basis.[19] While the Fifth Circuit put the 2020 Uptier to bed, it remains to be seen whether other courts will follow suit.

[1] A Dutch auction is an auction in which property is initially offered at an excessive price that is gradually lowered until the property is sold. See Dutch Auction, Black’s Law Dictionary (12th ed. 2024).

[2] See Adversary Complaint(ECF No. 1), Serta Simmons Bedding, LLC, et al. v. AG Centre Street Partnership L.P. (In re Serta Simmons Bedding, LLC), Case No. 23-09001, (Bankr. S.D. Tex. Jan. 24, 2023).

[3] See Serta Simmons Bedding, LLC’s Motion for Summary Judgment(ECF No. 69), p. 18, Serta Simmons Bedding, LLC, et al. v. AG Centre Street Partnership L.P. (In re Serta Simmons Bedding, LLC), Case No. 23-09001, (Bankr. S.D. Tex. Feb. 24, 2023); Lender Plaintiffs’ Motion for Summary Judgment (ECF No. 73), pp. 3-4, Serta Simmons Bedding, LLC, et al. v. AG Centre Street Partnership L.P. (In re Serta Simmons Bedding, LLC), Case No. 23-09001, (Bankr. S.D. Tex. Feb. 24, 2023).

[4] Opinion (ECF No. 233), p. 33, Excluded Lenders v. Serta Simmons Bedding, LLC, (In re Serta Simmons Bedding, LLC), Case No. 23-20181, (5th Cir. Dec. 31, 2024)(“Opinion”).

[5] Id. at 29.

[6] Id.

[7] Id. at 32.

[8] In re Serta Simmons Bedding, LLC, Case No. 23-90020, 2023 WL 3855820, at *10 (Bankr. S.D. Tex. Jun. 6, 2023).

[9] Objection of the Ad Hoc Group of First Lien Lenders to the First Amended Joint Chapter 11 Plan of Serta Simmons Bedding, LLC and Its Affiliated Debtors(ECF No. 824), pp. 2, 13-16, In re Serta Simmons Bedding, LLC, Case No. 23-90020, (Bankr. S.D. Tex. May 11, 2023).

[10] Id.

[11] Id.

[12] Id.

[13] Opinion, at 40, 42-43.

[14] Id. at 41-42.

[15] Id. at 46.

[16] Id.

[17] Id. at 48.

[18] Id. at 47.

[19] Case No. 2024-00169 (N.Y. App. Div., 1st Dept., Dec. 31, 2024).