The United States Court of Appeals for the Fifth Circuit issued a decision in Serta Simmons on 31 December that reverses in part and remands in part the prior decision issued by the bankruptcy court.

Mattress manufacturer, Serta Simmons, has come to be known as the seminal liability management uptier case. It was the first case where a court issued a decision, and importantly, a favorable one for the company. After filing for bankruptcy in January 2023 in the United States Bankruptcy Court for the Southern District of Texas, the company filed an adversary proceeding to resolve the dispute over a 2020 uptier transaction.

Ultimately, former Judge David Jones ruled in favor of the company and participating lenders, allowing the uptier transaction — a decision the excluded lenders appealed. Since this ruling, other companies and lenders have engaged in uptier transactions that left certain holders behind, before ultimately filing for bankruptcy in Texas including Incora and Robertshaw.

Now, a year and a half later, the United States Court of Appeals for the Fifth Circuit has issued a decision reversing the bankruptcy court’s decision on the validity of Serta’s 2020 uptier transaction and excising the plan’s indemnity provisions that benefit the participants of the transaction, as well as vacating and remanding the decision on the excluded lenders breach of contract counterclaims.

Background and credit agreement language

Prior to Serta’s 2020 uptier transaction, the company completed a refinancing transaction in 2016 through a series of syndicated loans including $1.95bn in first-lien syndicated loans and $450m in second-lien syndicated loans which each had a credit agreement.

The first lien term loan agreement included two provisions that protected pro-rata sharing rights. The first provision was in section 2.18 which stated:

“[E]ach Borrowing, each payment or prepayment of principal of any Borrowing, each payment of interest in respect of the Loans of a given Class and each conversion of any Borrowing . . . shall be allocated pro rata among the Lenders in accordance with their respective Applicable Percentages of the applicable Class.”

The second provision was section 9.02(b)(A) which “generally requires unanimous consent of any affected lender to waive, amend, or modify section 2.18 in any way that would “alter the pro rata sharing of payments required thereby.”

The court acknowledges that there were exceptions to these provisions, the notable exception came from section 9.05(g), which stated:

“[A]ny 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 open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) through open market purchases . . . .”

The credit agreement does not define the term “open market”.

The uptier transaction mechanics

In 2020, when Serta was again facing financial difficulties, the company decided to engage in an uptier transaction with some of its first and second lien lenders (the “prevailing lenders”), who provided the company with $200m in new financing in exchange for $200 million in first-out, super-priority debt, and traded in $1.2bn of their first and second lien loans for approximately $875m in second-out, super-priority debt.

To accomplish this transaction, Serta and the prevailing lenders, which included a majority of first lien loans, amended the 2016 credit agreement. Then, the company and prevailing lenders labeled the uptier as an “open market purchase,” and finally, the company agreed to indemnify the prevailing lenders “for any and all losses, claims, damages and liabilities which they might incur in connection with their participation.”

Bankruptcy and adversary proceeding

Serta filed for bankruptcy in January 2023 and with the support of their prevailing lenders, filed an adversary proceeding against the lenders excluded from the transaction, seeking a declaration that the 2020 uptier transaction (1) was permitted under the terms of the 2016 agreement and (2) did not violate the implied covenant of good faith and fair dealing.

Judge Jones granted partial summary judgment in favor of the Serta and its prevailing lenders and held that the term “open market purchase” was “clear and unambiguous,” and the 2020 uptier was a valid “open market purchase” under the exception to pro rata sharing.

After a final judgment was entered in the adversary proceeding, the court certified its decision for appeal, the parties jointly agreed to certify the post-trial final judgment to the court of appeals.

In the main bankruptcy case, Serta filed a plan that included a provision that provided an indemnity to all creditors holding Class 3 and Class 4 claims in the bankruptcy, as of the effective date of the Plan, which was approved as a fair and equitable component of a section 1123(b)(3) settlement. The confirmation order was similarly appealed to the court of appeals.

Open market purchases refers to a specific market

The court agreed with the excluded lenders and held that the 2020 uptier was not a permissible open market purchase within the meaning of the 2016 agreement.

Specifically, the court found that “an open market purchase is a purchase of corporate debt that occurs on the secondary market for syndicated loans,” rendering the uptier not an open market purchase.

The court explained that an “open market” is a specific market that is generally open to participation by various buyers and sellers, and “takes place on such a market as is relevant to the purchased product—here, the secondary market for syndicated loans.”

The court analyzed a number of sources before coming to this definition including three dictionaries, all of which contemplated a specific market in which various parties may participate and the prices are set by competition.

The court also analyzed various New York precedents, which all supported the idea that as a matter of financial industry custom or usage the term “open market” refers to a specific market.

Serta and the prevailing lenders argued that “an open market purchase means to acquire something for value in competition among private parties.” However, the court believes that the word “market” proves this theory incorrect, and the debtor and prevailing lenders reading would only be supported if the agreement read “open purchase” not “open market purchase.”

Specifically the court believes open market is tied to and must take place in a specific market — the existence of competition is not enough. Accordingly, when Serta chose to privately engage individual lenders outside of the secondary market, Serta lost the protection of section 9.05(g).

Serta and the prevailing lenders suggested definition would also render the Dutch auction definition and exception as “surplusage,” writes the court.

The court’s understanding leaves room for both of the exceptions to take place: a Dutch auction may be conducted off market, where all lenders must be notified and an open market purchase must be done in the secondary market, whereas if an open market purchase can be done off-market, it overlaps with the Dutch auction.

The court similarly negated a number of other arguments Serta and the prevailing lenders put forth, including that a guide published by the Loan Syndications and Trading Association (“LSTA”) supports their definition.

The LSTA in its discussion of “buyback methodologies” writes: “In the category of open market purchases, a borrower is allowed to negotiate one-on-one with individual lenders to repurchase loans up to a pre-agreed dollar amount.”

The court, however, noted that the LSTA is not binding authority and even if it was, the definition seems to only cover open market purchases to retire outstanding debt and “not to swap old debt for new debt (as the 2020 uptier did).”

Accordingly, the court reversed the bankruptcy courts ruling on the validity of the uptier transaction as an open market purchase.

Breach of contract counterclaims require more substantive discussion

The court included very little discussion on the excluded lenders’ appeal of their denied counterclaims for breach of contract, explaining that the bankruptcy courts denial was “largely based on its analysis of the open market purchase issue” and there was little substantive discussion before this court. Accordingly, the court vacated in part and remanded for consideration the excluded lenders breach of contract counterclaims.

Plan indemnities to be excised — equitable mootness cannot save sophisticated lenders from the consequences of their own actions.

The court once again agreed with the excluded lenders and held that the plan improperly included indemnities relating to the 2020 uptier.

In reaching this decision the court includes a four-part discussion which includes:

1. Why equitable mootness does not bar our review of the plan’s confirmation order;
2. Why inclusion of the indemnity was an impermissible end-run around the Bankruptcy Code
3. How the indemnity violated the Code’s requirement of equal treatment; and
4. Why the appropriate remedy is excision.

As mentioned above, the plan provided an indemnity to all creditors holding first and second-out super-priority debt issued in the 2020 uptier as of the effective date of the plan. The court explained that there is a difference between an “inability to alter the outcome (real mootness)” and “unwillingness to alter the outcome (‘equitable mootness’),” and describes equitable mootness as “a judicial anomaly,” or “a judge-created doctrine of pseudo-abstention that favors the finality of reorganizations” limiting the appellate courts review of plan confirmation orders.

Equitable mootness analysis

In analyzing equitable mootness the court considers three factors: (1) whether a stay has been obtained, (2) whether the plan has been “substantially consummated,” and (3) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.

Although the court acknowledges that the excluded lenders and Citadel failed to obtain a stay of confirmation (though one was requested multiple times), and the plan has been substantially consummated, “the requested relief of excision would not affect either the rights of parties not before the court or the success of the Plan,” and therefore based on this third factor the issue is not equitably moot.

The requested excision of the plan would only affect Serta, who would no longer be on the hook for liability related to the 2020 uptier, and the prevailing lenders, states the court, and Serta would actually benefit from this excision — though the prevailing lenders would not.

Similarly, the success of the plan, which was intended to position Serta for long term success, would not be threatened since removing this indemnity would position Serta for “an easier future without a massive liability hanging over its head.”

Serta and the prevailing lenders argue the court “cannot excise the indemnity without unwinding the entire Plan and triggering a whole new confirmation proceeding,” but the court believes that the remedy of excision would not require this and in fact would have the opposite effect since Serta would be released of “a controversial indemnity potentially worth tens of millions of dollars.”

Serta and the prevailing lenders also argue that this would lead to an unfair result since these lenders “agreed to support the Plan only because of the settlement indemnity. If they had known it would be excised later, they would not have given their agreement; rather, they would have exacted some other consideration from [Serta],” and therefore the court cannot excise the indemnity without letting them go back to the drawing board which requires upending the Plan.

The court strongly disagrees with this argument and believes agreeing with it would “effectively abolish appellate review of even clearly unlawful provisions in bankruptcy plans,” and this would effectively strip appellate courts of their jurisdiction over bankruptcy appeals.

The court acknowledges that there may be adverse consequences to these lenders that should have been foreseeable “[f]rom the moment the Prevailing Lender plaintiffs agreed to a controversial indemnity arising out of a contentious transaction.”

Further the court writes “We will not save such sophisticated parties from the consequences of their actions, and we decline to dismiss these appeals as equitably moot.”

End run around the bankruptcy code

Pursuant to Bankruptcy Code section 502(e)(1)(B), the bankruptcy court must disallow any contingent claim for reimbursement where the claiming entity is co-liable with the debtor. Although the bankruptcy court found that the indemnity was allowed, not as a proof of claim, but as a settlement, the appellate court found that section 1123(b)(3)(A) does not offer a “back-end resurrection of claims already disallowed on the front end.”

Specifically, everyone agreed that the proofs of claims for indemnification related to the prevailing lenders participation in the 2020 uptier, would be disallowed under section 502 as claims are contingent claims for reimbursement where the claiming entity is co-liable with the debtor since Serta was a contractual partner with the prevailing lenders in the deal, so the prevailing lenders cannot recharacterize this as a settlement to get around this.

The court notes that even if the indemnity was justified under section 1123(b)(3)(A), it still fails under the Code’s requirement of equal treatment.

Equal treatment

Under Bankruptcy Code section 1123(a)(4), a plan must “provide the same treatment for each claim or interest of a particular class, unless the holder of a particular claim or interest agrees to a less favorable treatment of such particular claim or interest.”

The court believes that although all members of Classes 3 and 4 received the settlement indemnity, the expected value of the indemnity varied dramatically depending on whether members had participated in the 2020 uptier. The court specifically noted that to the class members involve the indemnity was “potentially worth millions or even tens of millions of dollars,” but for class members that “had no involvement with the uptier, the indemnity was worth little or even nothing,” effectively providing “some class members received settlements with higher effective values than their co-class members.”

Although Serta and the prevailing lenders argued that disparate value is sometimes permissible, the court noted that in those cases the disparate value flowed from corporate law, not from intentional actions of the parties through participation in a controversial transaction.

Appropriate remedy

The court explains that when choosing a remedy, it can “‘fashion whatever relief is practicable’ for the benefit of appellants,” and here it chooses to excise the offending indemnity.

Accordingly, the court reversed the bankruptcy courts final order confirming the Plan insofar as it approved the Plan’s indemnity relating to the 2020 uptier.

What to expect in 2025 — Consequences of the decision

The court notes in the decision that Serta may have been the first major uptier but it is far from the last and that when considering open market purchase exceptions to ratable treatment, although “every contract should be taken on its own, today’s decision suggests that such exceptions will often not justify an uptier.”

In light of this decision, we can expect that the excluded lenders will commence litigation against the prevailing lenders involved. Additionally looking at the market more broadly, we can expect to see fewer uptiers and more drop downs in the coming year.