On December 31, 2024, the U.S. Court of Appeals for the Fifth Circuit released its long-awaited ruling in the Serta Simmons bankruptcy case, a ruling that could have important implications for the viability of uptiering and similar liability management transactions in the lending markets, including the ever-pressing need for open negotiation and clean and careful drafting.
The Fifth Circuit found that Serta’s 2020 uptier transaction did not constitute an “open market purchase” and therefore was a violation of the credit agreement’s provisions protecting the pro rata treatment of lenders, reversing the decision by the Bankruptcy Court for the Southern District of Texas. In addition to the Fifth Circuit’s ruling on the “open market purchase” issue, the Court addressed, among other things, whether Serta’s granting of an indemnity that was more valuable to some lenders than others violated the requirement in section 1123(a)(4) of the Bankruptcy Code to treat similarly situated creditors equally and the degree to which the doctrine of equitable mootness limited the Court’s ability to modify the confirmed plan. While important and interesting, those other issues are not the subject of this article, which instead focuses on the case’s potential impact on uptiering transactions and related issues.
Background: Uptier Transactions and the Bankruptcy Court's Decision
In 2016, Serta entered into a new $1.95 billion first lien term loan credit agreement. Of note, the 2016 credit agreement contained customary provisions ensuring pro rata treatment of similarly situated lenders and prohibiting amendments to the pro rata treatment of lenders without the consent of all affected lenders. The prohibition included an exception for “(A) … Dutch Auctions open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) … open market purchases.” Without going into detail on Dutch auctions, both types of transactions permit a borrower to purchase loans from one or more lenders who choose to sell their loans to the borrower; in other words, lenders receive payments on a non-pro rata basis. As is typical in corporate loan agreements that include this concept, the term “open market purchase” is not defined in the 2016 credit agreement.
In 2020, Serta consummated an uptier transaction with a majority of its lenders, relying on this exception for open market purchases. An uptier transaction is one in which a borrower amends the terms of a credit facility to allow the issuance of new, super-priority debt in exchange for existing lower-priority obligations, typically on more favorable pricing terms for the participating lenders. A majority of the facility’s lenders must consent to the amendment, after which the borrower purchases the existing debt of those majority lenders in exchange for the issuance of new debt senior in priority to the existing debt, leaving the minority lenders who did not participate in the exchange in a subordinated position. In the Serta uptier, the majority lenders provided $200 million of new first-out super-priority debt and exchanged $1.2 billion of their first-lien and second-lien loans for approximately $875 million in second-out, super-priority debt.
Serta struggled over the intervening years and ultimately filed for Chapter 11 on January 23, 2023. Key to the Chapter 11 proceeding was whether the 2020 uptier transaction was permissible, with the nonparticipating minority lenders objecting to the transaction on the basis of, among other things, (i) a violation of the implied covenant of good faith and fair dealing in New York law-governed contracts and (ii) a breach of the pro rata sharing provisions contained in the 2016 credit agreement. In a March 28, 2023, ruling, the Bankruptcy Court determined that the uptier transaction constituted a valid open market purchase and, in a later ruling, that consummation of the uptier transaction did not violate the implied covenant of good faith and fair dealing.
Fifth Circuit Holdings
In a unanimous ruling from a three-judge panel, the Fifth Circuit reversed the Bankruptcy Court, holding that the Serta uptier transaction did not constitute an open market purchase and therefore violated the credit agreement’s pro rata sharing requirements. More specifically, the court held that an open market purchase requires parties to purchase the debt on the specific market relevant to the purchased product — in this case, the secondary market for broadly syndicated loans — in a transaction that was open to participation by various buyers and sellers. It reached this conclusion through a review of dictionary definitions of the component terms, New York State precedent case law, Loan Syndications and Trading Association (LSTA) publications, and even usage by the Federal Reserve of the term “open market operations,” which is used to denote the purchase and sale of securities on the open securities market. These definitions led the Court to conclude that the counterarguments of Serta and the majority lenders failed to properly account for the word “market,” given that the uptier was conducted as a private negotiation, stating that “an open market is a designated market, not merely the background concept of free competition that characterizes much of American commerce.” Additionally, the Court reasoned that a Dutch auction and an open market purchase must be mutually exclusive constructs (to avoid surplusage — a central principle of New York contract interpretation); a Dutch auction may be open to all lenders, but an open market purchase must be open to the entire market in question.
The Fifth Circuit rejected the counterarguments made by Serta and the majority lenders. In the first instance, those parties noted that the 2016 credit agreement provides that a Dutch auction must be “open to all Lenders” but that the same language does not apply to open market purchases, reasoning that an open market purchase did not therefore need be open to all lenders. The Court rejected this argument on the grounds that “open market” does the work to require that all lenders be able to participate, and so the missing language would have been superfluous.
Serta and the majority lenders also argued that the minority lenders’ course of performance demonstrated their implied consent. Specifically, Serta presented evidence that some of the minority lenders had made an alternative recapitalization proposal involving a similar kind of debt swap for their own benefit, so the parties understood the open market purchase exception to allow uptiers. The Fifth Circuit disagreed, noting that under New York law, course of performance requires something to occur over a considerable period of time, not on a single occasion. The Fifth Circuit also reasoned that not all of the minority lenders submitted a debt swap proposal, further cutting against the argument that all of the minority lenders viewed an uptier as a permissible open market purchase.
Finally, Serta and the majority lenders argued that industry usage supported their view, pointing the court to a guide published by the LSTA. While the cited sections of the LSTA guide do support the idea of non–pro rata open market purchases, the court dismissed the LSTA as being nonbinding and not directly on point for the Serta facts.
Takeaways
Courts interpreting New York law–governed credit agreements, whether sitting in New York, Texas, or elsewhere, give great importance to the words on the page (i.e., what is within the “four corners” of the agreement) in an attempt to discern the intent of the parties. The Fifth Circuit decision, like the lower Bankruptcy Court decision before it, was an exercise in interpreting the meanings of the words “open,” “market,” and “purchase” in the absence of specific defining language. This implies that had the parties been more explicit in their drafting, the court may have come to a different conclusion. In light of the focus on contract language, certain market participants and commentators have already suggested that revisions to existing credit agreement definitions or provisions may be prudent or desirable and both borrowers and lenders should carefully review their existing language and consult with counsel to determine whether changes should be made to their existing loan documents.
It is worth considering as well the thin majority represented by the Serta lenders who approved, and were given the opportunity to participate in, the uptier. Query whether had Serta offered the uptier to all of its lenders or even a more significant majority, the Fifth Circuit would have been more sympathetic. Or was the Serta uptier doomed from the start because it was a transaction that did not result in equality of outcome for all of the similarly situated lenders? It would be instructional to see what the Fifth Circuit would do with an uptier that was, in fact, offered to all lenders but consummated by only some lesser percentage, or if the outcome would have been different had the credit agreement contained some variant of “Serta” language in the voting provisions explicitly permitting an uptier with the consent of the majority lenders so long as it is offered to all lenders. Would fairness of process sway the court even if some lenders were ultimately left behind and pro rata treatment not maintained?
In addition, we will learn over time what implications this ruling may have for various related issues. For instance, outside of the uptier context, can borrowers in the Fifth Circuit that are relying on the “open market purchase” exception to retire debt do so through privately negotiated non–pro rata transactions without amending their agreements to permit that explicitly? The impact on collateralized loan obligations (CLOs) and their willingness to participate in deals that permit uptiers is another open question. CLOs can often find themselves in the minority of a lender group due to their hold size and potential inability to contribute new capital after the end of the fund’s investment period. Do CLO managers gain greater comfort from this ruling that they will remain pari passu with other syndicate members even where loan agreement language allows such transactions?
What is also unclear is how this decision may affect uptiers or other liability management transactions conducted in the context of loans that are not broadly syndicated, including club deals or other direct lending deals. These loans do not trade on an “open market,” and any borrower purchases may need to be negotiated privately by necessity.
The open market purchase point has been remanded to the Bankruptcy Court, and the Chapter 11 case more generally continues to be contested on appeal. As such, this is a continually developing situation, and both borrowers and lenders are encouraged to consult with their counsel to determine the effects this important ruling may have on their transactions.
- Stephen E. Hessler, shessler@sidley.com
- Matthew A. Clemente, mclemente@sidley.com
- Rakhee V. Patel, rpatel@sidley.com
- Dennis M. Twomey, dtwomey@sidley.com
- Genevieve G. Weiner, gweiner@sidley.com
- Leslie A. Plaskon, lplaskon@sidley.com
- Nicholas M. Schwartz, nschwartz@sidley.com
- Angela Fontana, angela.fontana@sidley.com
- Kelly M. Dybala, kdybala@sidley.com
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