Serta - Fifth Circuit Decision

On December 31, 2024, the U.S. Court of Appeals for the Fifth Circuit issued its long-awaited decision regarding the permissibility of the Serta Simmons Bedding (Serta) uptier liability management exercise (the 2020 Uptier) and related issues arising from the confirmation of Serta’s chapter 11 plan of reorganization. The decision is a substantial victory for the excluded lenders challenging the 2020 Uptier, with the Fifth Circuit holding that Serta’s acquisition of loans from the participating lenders outside of the established secondary market for syndicated loans was not an “open market purchase” within the meaning of the applicable credit agreement. The Fifth Circuit also addressed challenges to an indemnity provision provided in the plan of reorganization for the benefit of the participating lenders, finding that the indemnity was improper, rejecting arguments that the appeal of the confirmation order was equitably moot, and excising the indemnity from the plan of reorganization.

The Fifth Circuit’s decision, along with the July 2024 ruling from Judge Marvin Isgur of the U.S. Bankruptcy Court for the Southern District of Texas (the Bankruptcy Court) in the Wesco/Incora adversary proceeding, may signal growing judicial skepticism of aggressive interpretations of funded debt contracts and liability management exercises (LMEs) more generally.¹ The Serta case is not over, however, with the Fifth Circuit remanding to the Bankruptcy Court the excluded lenders’ counterclaims for breach of contract. Thus, whether Serta and the participating lenders ultimately will face any liability relating to the 2020 Uptier, and perhaps more importantly, the remedy awarded in such a scenario, remains to be seen.

Overview of the Decision

In June 2020, Serta consummated the 2020 Uptier with a majority of its existing first lien and second lien lenders, creating two new tranches of debt, both of which jumped ahead of Serta’s then-existing first-lien loans: (i) a $200 million new-money financing; and (ii) an exchange tranche comprised of $875 million of loans created through an exchange of the participating lenders’ first- and second-lien loans. The applicable first lien credit agreement contained a “sacred right” prohibiting the assignment of loans to Serta (as well as other affiliated entities) on a non-pro rata basis unless accomplished via “Dutch Auctions open to all Lenders” (under procedures set forth in the credit agreement) or “through open market purchases.” Serta First Lien Term Loan Agreement, Section 9.05(g).

The 2020 Uptier became the subject to extensive litigation in both state and federal courts, but when Serta and certain of its affiliates (the Serta Debtors) filed chapter 11 petitions in the U.S. Bankruptcy Court for the Southern District of Texas in early 2023, the Serta Debtors and certain participating lenders filed an adversary proceeding in the Bankruptcy Court seeking a declaratory judgment that the 2020 Uptier did not violate the credit agreement. The excluded lenders asserted counterclaims for breach of contract and other causes of action. In support of their declaratory judgment claim, the Serta Debtors and the participating lenders principally argued that the transaction was proper because the exchanges of loans—which were negotiated in private between Serta and the participating lenders and not offered to the excluded lenders—were “open market purchases” under the credit agreement. In March 2023, the Bankruptcy Court agreed, granting summary judgment in favor of the Serta Debtors and the participating lenders that the loan exchanges in the 2020 Uptier were open market purchases and therefore permissible.

On a direct appeal from the Bankruptcy Court, the Fifth Circuit disagreed. The Fifth Circuit’s decision finds that the exchanges were not open market purchases because they did not occur on the “secondary market for syndicated loans.” In so holding, the Fifth Circuit noted that the more expansive reading of “open market purchase” advocated by the Serta Debtors and the participating lenders that an open market purchase is any acquisition of “something for value in competition among private parties” ignores the word “market” and also would include a Dutch auction. And if the definition of open market purchases is so broad that it includes Dutch auctions, it would make no sense for the credit agreement to separately provide that both Dutch actions and open market purchases are exceptions to the pro rata sacred right.

Having rejected the Serta Debtors’ and the participating lenders’ arguments, the Fifth Circuit reversed the Bankruptcy Court’s ruling that the exchanges of loans in the 2020 Uptier were open market purchases. In light of this ruling, the Fifth Circuit also held that the excluded lenders’ counterclaims for breach of contract against the Serta Debtors and the participating lenders may be viable and remanded such claims to the Bankruptcy Court for further consideration.

Addressing a separate appeal of the confirmation order, the Fifth Circuit also found that an indemnity for the participating lenders in the confirmed plan of reorganization was improper and excised it from the plan. The participating lenders had obtained a similar indemnity in the 2020 Uptier, but, recognizing that this prepetition indemnity would be disallowed by section 502(e)(1)(B) of section 11 of title 11 of the United States Code (the Bankruptcy Code), the Serta Debtors granted the participating lenders (and other members of the same creditor classes) a substantially similar indemnity in the plan of reorganization, but framed it as a settlement between the Serta Debtors and the participating lenders permitted under section 1123(b)(3)(A) of the Bankruptcy Code. The Fifth Circuit, however, disagreed that the indemnity was permissible under section 1123(b)(3)(A). While the Fifth Circuit recognized that a plan of reorganization ordinarily may include a settlement of any claim or interest of the debtor, it found that the plan indemnity was an impermissible end-run around section 502(e)(1)(B)’s disallowance of contingent claims for reimbursement. According to the Fifth Circuit, because section 502(e)(1)(B) disallowed the prepetition indemnity claims arising from the 2020 Uptier on the front end, such claims could not be resurrected on the back end by section 1123(b)(3)(A).

In excising the plan indemnity, the Fifth Circuit also found that, even if the indemnity were permitted by section 1123(b)(3)(A) of the Bankruptcy Code, it still was impermissible under section 1123(a)(4) because it violated the Bankruptcy Code’s requirement of equal treatment for members of the same creditor classes. According to the Fifth Circuit, because the indemnity was worth millions of dollars to participating lenders but worthless to members of the same creditor classes who did not participate in the 2020 Uptier (and instead purchased 2020 Uptier debt on the secondary market), participating lenders received “settlements with higher effective values than their co-class members” in violation of section 1123(a)(4).

Finally, the Fifth Circuit also rejected arguments from the Serta Debtors and participating lenders that the appeal of the indemnity provision was equitably moot.² Specifically, the Fifth Circuit rejected the argument that it would be unfair to excise the indemnity from the plan of reorganization because the participating lenders only agreed to support the plan in exchange for the now-excised indemnity. According to the Fifth Circuit, adopting the Serta Debtors’ and participating lenders’ arguments would “effectively abolish appellate review of even clearly unlawful provisions in bankruptcy plans.” And quoting one of its prior decisions—In re Pacific Lumber Co., 584 F.3d 229, 244 (5th Cir. 2009)—the court noted that “adverse appellate consequences were foreseeable to [the participating lenders] as sophisticated investors who opted to press the limits of bankruptcy confirmation.”

Impact on LMEs

Although the Fifth Circuit’s decision focuses on specific provisions of the applicable credit agreement related to pro rata sharing and the term “open market purchases,” the decision likely will have a broader impact on the structuring of future LMEs, including both “pure uptier” transactions (like Serta) and other transaction structures such as drop-downs, pari-plus loans and double-dips where debt exchanges are contemplated.

While LME structures will continue to be highly dependent on the specific provisions of the applicable debt documents, a significant portion of broadly syndicated term loan credit agreements include pro rata sharing provisions as a “sacred right” and include the “open market purchase” mechanic similar or identical to the Serta credit agreement—analyzing the risks associated with LMEs under such agreements therefore will be impacted by the Fifth Circuit’s decision. And while it is unclear how the decision will implicate credit agreements or other debt instruments with differing provisions, minority lenders may be more willing to challenge aggressive “lender-on-lender violence” LMEs absent further creative structuring by companies and their majority lenders.

The Serta decision also could alter the dynamics between existing lenders and potential third-party financing sources. Recently, sponsors engaging in LMEs have threatened financings with third parties, but in the end consummated LMEs with existing lenders and maximized discount capture. Going forward, however, third-party financing sources may be able to offer more appealing transactions, as structuring exchanges with existing lenders may become more difficult.

Lastly, although a significant portion of credit agreements include the “open market purchase” language, others contain different terms altogether, such as “non-pro rata purchases,” or additional specific language noting that open market purchases can include privately negotiated exchanges. It remains to be seen the extent to which sponsors will push for broader language in their newly issued debt documents, and whether the credit markets will accept such changes.

¹ The same day as the Fifth Circuit’s decision, the Appellate Division of the New York Supreme Court dismissed a challenge to an uptier LME in Ocean Trails CLO VII, et al. v. MLN TopCo Ltd., et al., No. 2024-00169 (N.Y. App. Div. 1st Dep’t Dec. 31, 2024) (Mitel), finding, among other things, that the LME in that case complied with the applicable credit agreement. The Mitel case, however, involved substantially different facts, including that the applicable credit agreement did not contain a pro rata exception for “open market purchases” and instead permitted the borrower to “purchase by way of assignment” loans at any time.

² The Fifth Circuit’s discussion of equitable mootness is notable in its skepticism of the doctrine. Indeed, in dicta, the Fifth Circuit appeared to question whether “equitable mootness exists at all.”