Fifth Circuit Reverses Bankruptcy Court’s Ruling on Lenders’ Sacred Right of Pro Rata Repayment in Uptiering Transaction

January 23, 2025

On December 31, 2024, the Fifth Circuit Court of Appeals overturned the Bankruptcy Court for the Southern District of Texas’ (the “Bankruptcy Court”) decision that the exchange by certain lenders of Serta Simmons Bedding, LLC (“Serta”) holding $1.2 billion of first lien term loans for super priority term loans constituted an open-market purchase exempt from the pro rata payment provisions of the credit agreement.

Background

In November 2016, Serta entered into credit facilities providing for $1.95 billion in first lien term loans and $450 million in second lien term loans. Importantly, the Credit Agreement generally required pro rata treatment among lenders, except for purchases of loans by Serta or its affiliates in “open market purchases” or Dutch Auctions open to all lenders.i

Facing liquidity and other financial headwinds, Serta and certain lenders (the “Participating Lenders”) holding a narrow majority of loans under the first lien and second lien credit facilities launched a transaction to stabilize the business. In 2020, the Participating Lenders and Serta entered into a super priority term loan credit agreement wherein the Participating Lenders (i) provided Serta with a $200 million first-out super priority term loan, and (ii) exchanged $1.2 billion of their existing first lien term loans for approximately $875 million of second-out super priority term loans (collectively, the “Uptier Transaction”).ii

The first and second lien lenders that were not invited to participate in the Uptier Transaction (the “Excluded Lenders”) initiated a lawsuit against Serta and the Participating Lenders in the United States District Court for the Southern District of New York alleging that the Uptier Transaction violated the terms of the existing credit facilities. Subsequently, in 2023, Serta filed chapter 11 bankruptcy protection and sought a declaratory ruling from the Bankruptcy Court that the Uptier Transaction was valid under the existing credit facilities. The Bankruptcy Court determined that the purchase that effectuated the exchange of first and second lien loans for second out super priority loans was valid under the open market purchase exception in the existing credit agreement.  The Bankruptcy Court defined an open market purchase as “something obtained for value in competition among private parties”. The Bankruptcy Court then confirmed Serta’s chapter 11 plan of reorganization (the “Plan”), which affirmed the validity of the Uptier Transaction and provided the Participating Lenders with an indemnity (the “Indemnity”), including against liability from the Excluded Lenders. Shortly after, an appeal was certified to the United States Court of Appeals for the Fifth Circuit (the “Fifth Circuit”).

The Fifth Circuit’s Ruling

The Fifth Circuit disagreed with the Bankruptcy Court and held that the Exchange was not an open market purchase under the existing Credit Agreement.iii The Fifth circuit highlighted that ratable treatment in corporate finance transactions is “such an important norm that it is often described as a lender’s “sacred right” under syndicated loan agreements.”

Considering the importance of ratable treatment, the Fifth Circuit narrowly interpreted the term “open market purchase” holding that an open market purchase must relate to a specific market. The Fifth Circuit rejected the Bankruptcy Court’s broad reading of open market purchase under the First Lien Credit Agreement, stating that an “open market” was “not merely a general context where private parties engage in non-coercive transactions with each other” and that an “open market is a designated market”, which in this case was the secondary syndicated loan market. iv

The Fifth Circuit also held that the doctrine of equitable mootness did not prevent the Court from reviewing and striking the Indemnity from the Plan. In support of its holding, the Fifth Circuit made a distinction between “inability to alter the outcome (real mootness) and unwillingness to alter the outcome (equitable mootness)”.v The Fifth Circuit noted that although the Excluded Lenders failed to obtain a stay of confirmation and that though the Plan had been substantially consummated, the excision of such provisions would not affect either the rights of parties not before the Court or the success of the Plan. Consequently, the Fifth Circuit “excised” the Indemnity from the Plan.

Implications

Liability management transactions have become increasingly common in the growing syndicated loan market. However, market participants have utilized non-pro rata uptier transactions much less over the past few years. Instead borrowers and ad hoc lender groups have been focused on less contentious restructuring alternatives departing with the older approach of true lender-on-lender violence. For example, cooperation agreements have become more prevalent lately as creditors begin to realize the shift in bargaining power obtained through an effective cooperation agreement which also reduces the risk of a deal-away. Also, drop-down transactions have provided an interesting alternative to non-pro rata uptier transactions, permitting all asset drop downs to an unrestricted subsidiary via the use of an investment carve-out.

Irrespective of these alternatives, non-pro rata uptier transactions will likely still be in play for borrowers and creditors that have credit agreements containing open market purchase provisions different than the one addressed in Serta. It is also important to remember that the Fifth Circuit’s ruling applied only in the context of a non-pro rata uptier. Borrowers that invite all lenders to participate in the uptier transaction, or borrowers that conduct open market purchases on the secondary market instead of through private arrangements with specific lenders, will not run afoul of the Fifth Circuit’s holding, creating a safer and more inclusive uptier alternative.

Ultimately, borrowers and creditors that decide to embark on non-pro rata uptier transactions will need to be mindful of the exact language in their credit agreements governing open market purchases and those lenders that participate in the uptier transaction will need to be aware of the exposure risk from excluded lenders. This remains true in the context of a bankruptcy filing where a plan of reorganization may have otherwise been able to provide some measure of protection to those participating lenders. The Fifth Circuit’s decision in Serta will also undoubtedly re-focus deal parties’ attention at origination of the transaction to making sure open market purchase provisions in the applicable credit agreement are tightly drafted to either lend support to or limit non-pro rata uptier transactions.

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i Memorandum Opinion, In re Serta Simmons Bedding, LLC, No. 23‑90020 (Bankr. S.D. Tex. June 6, 2023), ECF No. 1045; see also N. Star Debt Holdings L.P. v. Serta Simmons Bedding LLC, No. 652243/2020, 2020 WL3411267 (N.Y. Sup. Ct. June 19, 2020).

ii Debtor v. Bedding, L.L.C. (In re Bedding), Nos. 23-20181, 23-20450, 23-20363, 23-20451, 2024 U.S. App. LEXIS 32969 (5th Cir. Dec. 31, 2024.

iii  Id. at 38.

iv  Id. at 31.

v  Id. at 39-40.