Serta – The Fifth Circuit’s Year-End Gift to Non-Consenting Lenders

In the face of financial distress, in recent years numerous companies have engaged in complex financial restructuring transactions intended to de-lever, generate additional liquidity, prolong maturity dates or otherwise create a runway to manage upcoming debt maturities. While market participants politely refer to such transactions as “liability management transactions” (LMT) or “liability management exercises,” the end-result is that non-participating lenders, often caught unaware¹, are stripped of valuable collateral or subordinated to superpriority indebtedness. Clever borrowers (and their private equity sponsors) have utilized flexibilities in syndicated credit agreements to implement such transactions with the blessing of consenting lenders engaging in, as the Wall Street Journal aptly calls it, “creditor on creditor” violence.²

Serta Simmons is eponymous with “uptiering” transactions. On Dec. 31, 2024, the United States Court of Appeals for the Fifth Circuit issued an opinion in the disputes related to the LMT executed by Serta Simmons Bedding LLC and a group of consenting lenders³. In providing a year-end gift to the non-consenting lenders, the Fifth Circuit reversed a bankruptcy court ruling that a 2020 uptiering transaction was permissible under Serta’s existing credit agreements and reversed the portion of the order confirming Serta’s Chapter 11 plan that required reorganized Serta to indemnify the holders of debt issued under the 2020 uptiering transaction from claims made by non-consenting lenders. Those rulings will have immediate consequences for companies (and their consenting lenders) that have engaged in non-pro rata LMTs utilizing flexibilities in credit agreements allowing for “open market purchases” of loans.

This alert focuses on the Fifth Circuit’s resolution of certain claims related to the Serta LMT transactions described below.

What is an Uptier LMT?

In an uptier LMT, a borrower issues new debt in which consenting lenders receive a claim and lien contractually senior to the claims and liens of non-consenting lenders. Such new debt is often exchanged for existing debt held by the consenting lenders and coupled with an amendment to the existing credit agreement to permit the issuance thereof. Effectuating amendments to syndicated credit agreements generally require an affirmative vote of a majority of the holders of the debt. However, amendments or modifications of certain “sacred rights,” including amendments that implicate pro rata sharing of payments⁴ , are subject to the vote of “all lenders” or “all affected lenders.” Market participants like Serta have utilized a flexibility under syndicated credit agreements allowing lenders to assign all or a portion of their claims on a non-pro rata basis to borrowers “through open-market purchases,” thus bypassing the “sacred right” related to pro rata sharing.

What happened in Serta?

In 2016, Serta entered into a first lien credit agreement, (the “Serta first lien agreement”), incurring $1.95 billion of first lien loans and a second lien credit agreement, incurring $450 million of second lien loans. Section 2.18 of the Serta First Lien Agreement included the “sacred right” relating to pro rata sharing of payments. However, Section 9.05(g) of the Serta first lien agreement included a path for non-pro rata payment of loans through either “Dutch auctions” open to all lenders⁵ or “open market purchases.”⁶

Faced with financial difficulties, on June 8, 2020, Serta announced it had entered into an agreement with a majority of its first lien and second lien lenders (the consenting lenders) to amend the existing credit agreements to allow the incurrence of $200 million of new-money superpriority “first out” debt (the new money financing) and $875 million of superpriority “second out” debt in the form of exchange indebtedness, thus allowing for additional liquidity of $200 million and reducing overall debt by $400 million (the uptier exchange financing). Concurrently, the liens and claims of non-consenting lenders would be contractually subordinated to the new money financing and uptier exchange financing. Serta and the consenting lenders claimed that the uptier exchange financing would be accomplished by utilizing the “open market purchases” exception stated in Section 9.05(g) of the Serta first lien agreement and labelled the transaction document the “Open Market Purchase and Cashless Exchange Agreement.” The non-consenting lenders were not allowed to participate in the new facilities, and promptly sought an injunction and temporary restraining order prohibiting Serta from proceeding with the LMT.

Like so many borrowers that have engaged in LMTs, Serta subsequently filed for protection under Chapter 11 of the Bankruptcy Code.

Serta Bankruptcy

After filing, Serta and the consenting lenders filed a complaint seeking a declaratory judgment that the uptier exchange financing was an “open market purchase” under the Serta First Lien Agreement. In a bench ruling, Former Judge David R. Jones of the United States Bankruptcy Court for the Southern District of Texas concluded that the uptier exchange financing complied with the open market purchase clause.

The plan of reorganization, which has been appealed, included repayment in full of new money financing through a refinancing transaction and distribution of almost all of the equity of Serta to the holders of the uptier exchange financing, leaving practically no recovery for the non-consenting lenders.

Appeal

On appeal, in a unanimous decision handed down on New Year’s Eve, a three-judge panel of the Fifth Circuit reversed Judge Jones’ decision. The panel determined that the uptier exchange financing did not qualify as an “open market purchase.” The panel noted that the “market” for syndicated loans is the “secondary market.” The panel remarked “[h]aving chosen to privately engage individual lenders outside of this market” Serta “lost the protection of § 9.05(g).”⁷ Additionally, in looking at language from the Loan Syndication and Trading Association (LSTA) guidebook, the panel concluded that the guidance provided by the LSTA (even if viewed as dispositive) did not support the uptier exchange financing.⁸ The panel remanded the case for further consideration of the non-consenting lenders’ breach of contract and implied covenant of good faith and fair dealing counterclaims, while suggesting that the merits of those counterclaims are strong. When coupled with the removal of the consenting lender’s rights to indemnification by Serta for liability related to the uptier exchange financing, the Fifth Circuit truly gave the non-consenting lenders a year-end gift.

Key Takeaways

1. Looking backward: An “open market purchase” occurs on the specific market for the product being purchased.⁹ In the case of corporate loans, that market is the secondary market for syndicated loans. An “open market purchase” does not generally refer to non-coercive private transactions between willing parties. Although the Fifth Circuit opinion is not binding on state and federal courts in New York, it supports the position taken by Judge Katherine Failla of the United States District Court for the Southern District of New York, in 2022 in which she stated “[o]n a plain reading of the term, the Transaction depicted in the Complaint did not take place in what is conventionally understood as an ‘open market.’”¹⁰ LMTs that have been effectuated through non-pro rata payment of loans merit careful review.
2. Looking forward:
   1. Market participants may elect to remove the word “market” and re-characterize the mechanism as “open purchases” and/or include language permitting "privately negotiated transactions." Alternatively, market participants may develop a defined framework for what constitutes an “open purchase” in a manner similar to Dutch auctions.
   2. The presence of a so-called “Serta blocker” may not be sufficient to prevent future LMTs structured as a non-pro rata uptier transaction. “Serta blockers” are often drafted with numerous exceptions that can be utilized to eviscerate the purported lender protection.¹¹

What Comes Next?

On the same day that the Fifth Circuit issued its ruling in Serta, the New York Appellate Division’s First Department ruled on a similar uptiering transaction completed by Mitel Networks. Based on some distinguishing facts, including the absence of the words “open market,” the First Department dismissed non-consenting lenders’ claims that had been permitted by a trial court to proceed.¹² The industry will be closely monitoring the non-pro rata LMT announced by Better Health on Dec. 20, 2024, and Del Monte Foods’ LMT announced in August 2024 (which is already being challenged in the Delaware courts). The LMT space is constantly evolving and it is recommended that lenders evaluate their credit agreements for the following issues that are implicated in uptiering transactions: (1) the inclusion of a “Serta blocker” with limited, if any, exceptions, (2) prohibitions on the incurrence of priming debt, (3) prohibitions on changes to the application of payments (and not only the enumerated section with the post-default waterfall) and the pro rata application of payments (and not only the enumerated section related to pro rata application), (4) inclusion of debt buyback and debt purchase provisions in the “sacred rights” provisions and (5) elimination of language in the “sacred rights” provisions that would permit “transactions otherwise permitted under the [credit documents]” as such language permits manipulation of credit documents by majority lender consent in a manner that eviscerates the protections afforded by the “sacred rights.”

For more information, please contact Steven Greene, Dev Ghose and Taylor Skaggs.