Bankruptcy Court Finds Open Market Purchase Faulty Under Credit Agreement

In In re Serta Simmons Bedding, L.L.C., No. 23-20181, 2024 WL 5250365 (5th Cir. Jan. 21, 2025), as revised (Jan. 21, 2025), the Fifth Circuit Court of Appeals held that the controversial "uptier transaction" undertaken by Serta Simmons Bedding and affiliates in 2020 did not qualify as an "open market purchase" under the terms of its credit agreement, and thus was not permitted. The Fifth Circuit remanded certain aspects of the case back to the U.S. Bankruptcy Court for the Southern District of Texas.

Background

In 2016, Serta borrowed $1.95 million under a first-lien credit agreement and $450 million under a second-lien credit agreement. In 2020, prior to filing for bankruptcy relief, Serta engaged in a transaction with a bare majority of its first-lien lenders and a subset of second-lien lenders that allowed these participating lenders to "jump the creditor line" and gain super priority over the debt of nonparticipating, excluded lenders without their consent.

More specifically, the participating lenders advanced $200 million of new, first-out, super-priority debt to Serta and also exchanged $1.2 billion of their existing first-lien and second-lien debt for approximately $875 million in new second-out, super-priority debt. The excluded lenders, holding the balance of existing first-lien and second-lien debt, did not participate in either the new debt or exchanged debt transactions.

To execute on these two debt transactions, Serta and the participating lenders (1) amended the 2016 credit agreement to allow Serta to issue super-priority debt with approval of only a simple majority of the outstanding first-lien indebtedness and (2) labeled the exchanged debt transaction as an "open market purchase" to take advantage of an exception to the "sacred right" ofpro ratasharing among lenders under the 2016 agreement. Serta also agreed to apply an uptier indemnification for the participating lenders for any liabilities in connection with participation in the new debt and exchanged debt transactions.

In January 2023, Serta filed for bankruptcy relief under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court for the Southern District of Texas. Serta immediately filed a proposed Chapter 11 plan that was pre-negotiated with the participating lenders, that provided for, among other things, a reduction of Serta's debt from $1.9 billion to $315 million by means of a debt-for-equity swap available to the participating lenders and new exit financing to be provided by these participating lenders in exchange for retention of the uptier indemnification. The plan was subsequently amended to provide that the uptier indemnification was not available to all participating lenders, but instead to the current holders of the new and exchanged debt after accounting for any subsequent assignments.

Serta and the participating lenders then filed an adversary proceeding, seeking a declaratory judgment that the new debt and exchanged debt transactions were permitted under the 2016 credit agreement, and that the participating lenders did not violate the implied covenant of good faith and fair dealing by entering into the new debt and exchanged debt transactions. The excluded lenders counterclaimed, arguing that the new debt and exchanged debt transactions breached the 2016 agreement.

In March 2023, the Bankruptcy Court entered partial summary judgment in favor of the participating lenders, stating that: "The parties could have easily avoided this entire situation with the addition of a sentence or two to the 2016 Credit Agreement. They did not."

The Fifth Circuit granted the excluded lenders' motion for a direct appeal. While the appeal was pending, the Bankruptcy Court confirmed Serta's Chapter 11 plan on June 6, 2023. In ruling in favor of Serta's Chapter 11 plan, the Bankruptcy Court concluded that the relevant "market" was limited to the holders of Serta's first-lien debt under the 2016 credit agreement.

The excluded lenders appealed the confirmation of Serta's Chapter 11 plan. On September 18, 2023, the Fifth Circuit agreed to hear direct appeals of the confirmation of Serta's Chapter 11 plan, as well as the March 2023 summary judgment order, on a consolidated basis.

The Fifth Circuit's Ruling

On December 31, 2024, the Fifth Circuit reversed the Bankruptcy Court, holding that the exchanged debt transaction did not qualify as an "open market purchase" as that term is used in the 2016 credit agreement.

The Fifth Circuit noted the importance of the "sacred right" of ratable treatment of all lenders of the same class in a syndicated loan transaction. The court observed that the 2016 credit agreement specifically required pro rata sharing among lenders, but allowed for limited exceptions in buyback and related transactions involving a "dutch auction" or "open market purchases." While "dutch auction" was well defined, the phrase "open market purchase" was not defined in the 2016 credit agreement.

In interpreting the meaning of "open market purchase" the Fifth Circuit ultimately rejected the definition proposed by Serta and the participating lenders, and adopted by the Bankruptcy Court. The court found that Serta's definition overlooked the significance of the word "market" and erroneously suggested that an open market purchase simply means acquiring something for value in competition among private parties. Instead, the court held that an open market purchase must be tied to a specific market for what is being bought. Here, it was first-lien debt under the 2016 credit agreement, which is traded on the secondary market for syndicated loans. Since Serta engaged private lenders outside of the secondary market, it failed to act in an "open market purchase."

Thus, the Fifth Circuit concluded that the exchanged debt transaction did not constitute a permitted "open market purchase" as the Bankruptcy Court had erroneously held.

Further Industry Developments

As the Fifth Circuit stated, "Though every contract should be taken on its own, [this] decision suggests that such exceptions [e.g., the "open market purchase" exception] will often not justify an uptier." This statement holds true, as recent uptier transactions have been treated differently across jurisdictions.

On the same day as the Serta decision, the New York Supreme Court, Appellate Division, ruled on a similarly structured uptier transaction undertaken by Mitel Networks.¹ In contrast toSerta, wherein the Fifth Circuit focused on the interpretation of the "open market" transaction qualifier, the Mitel credit agreement provided that Mitel was permitted to "purchase" loans "at any time" as an exception to the prohibition on non- pro rata payments among lenders of the same class. Ultimately, and conversely to the Fifth Circuit in Serta, the court held that there was nothing in the Mitel credit agreement to suggest a refinancing could not be interpreted as a "purchase," and thus the debt exchange involving some but not all lenders was permitted.

The Mitel court also found that the debt exchange did not violate the "sacred rights" of the nonparticipating lenders because the credit agreement required consent of only those lenders "directly adversely affected" by a modification to the Mitel credit agreement. The debt exchange by the participating lenders subordinated the nonparticipating lenders, but did not modify any loan terms. In Mitel, the court found that nonparticipating lenders were affected only "indirectly."

Prior to the Serta and Mitel decisions, on July 10, 2024, the U.S. Bankruptcy Court for the Southern District of Texas ruled on a dispute over an uptier transaction between Wesco Aircraft Hardware Corp., dba Incora, and a group of its noteholders.² In Incora, the court held that the debtor and participating lenders violated an indenture provision by purporting to approve amendments that released collateral securing the debt without the requisite supermajority consent. In addition, the Incora court held that while the applicable indenture provisions permitted the issuer and its affiliates to purchase notes, it required any such purchase to be pro rata if the purchase was for less than all outstanding notes. Because the sponsor's purchase was for a subset of notes, it violated the pro rata requirement under the indenture.

Although these recent decisions involve differing uptier transactions across jurisdictions, market participants should exercise caution in light of the Serta and Incora decisions and the underlying message that circumventing "sacred rights" and commercial norms will face scrutiny.

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Footnotes

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