Excluded Lenders v. Serta Simmons Bedding, L.L.C. (In re Serta Simmons Bedding, L.L.C.), 2024 U.S. App. LEXIS 32969 (5th Cir. Dec. 31, 2024)
The Fifth Circuit addressed the validity of Serta’s controversial use of an uptier exchange (Uptier Exchange) – arguably, one of the first in the market – to facilitate a material refinancing. Simply put, an uptier exchange is a transaction that permits a subset of lenders constituting a majority of an existing lender group to leapfrog the minority, leaving the minority with an instrument that is junior to the new debt provided by the majority subset. Uptier exchanges have caused great controversy, with many criticizing them as violating a “sacred right” of syndicated loan agreements, that is, the ratable treatment of all lenders by “subordinating” the interests of the nonparticipating minority lenders.
Prior to entering bankruptcy, Serta engaged in a transaction with a majority of its existing first-lien and second-lien lenders wherein they created new superpriority tranches of debt (New Debt) consisting of: (1) a $200 million “first out” financing (new money); (2) an $875 million “second out” tranche (issued through a debt exchange, at a discount, for certain portions of outstanding first-lien and second-lien term loans); and (3) other additional amounts of superpriority “third-out” debt that could be used for future debt exchanges. To accomplish this, Serta and the majority lenders took advantage of a purported loophole in Serta’s credit agreement (Credit Agreement) that allowed Serta to make certain “open market purchases” involving its existing debt without the consent of all lenders (therefore indicating that the lenders’ sacred rights were unaffected).
Importantly, the New Debt was to rank ahead of Serta’s existing/un-refinanced debt. As such, certain minority existing lenders, who were not offered the opportunity to participate in the Uptier Exchange, found themselves subordinated to the New Debt. These minority lenders argued that the Uptier Exchange breached their “sacred right” to receive a pro rata share of payments under the Credit Agreement and that Serta (and the majority lenders) violated the implied covenant of good faith and fair dealing under New York law by depriving them of their senior secured position in Serta’s capital structure. The dispute first led to litigation in New York state and federal courts. Then, after the New York federal court entered a ruling that allowed the minority lenders’ challenge of the Uptier Exchange to proceed, Serta commenced a case before the United States Bankruptcy Court for the Southern District of Texas (Bankruptcy Court).
The Bankruptcy Court ratified the Uptier Exchange, finding that the transaction constituted an “open market purchase” (as defined in the Credit Agreement), and the Uptier Exchange did not breach the implied covenant of good faith and fair dealing under New York law. The Bankruptcy Court also confirmed Serta’s Chapter 11 plan, which contained a settlement that provided, in part, that Serta would indemnify, among others, the majority lenders for any losses resulting from the Uptier Exchange (Indemnity). The minority lenders appealed the validity of the Uptier Exchange and the Indemnity to the Fifth Circuit.
The Fifth Circuit overruled the Bankruptcy Court for several reasons. First, the Fifth Circuit invalidated the Uptier Exchange because it was not a permissible “open market purchase” under the Credit Agreement. Although Serta and the majority lenders offered several arguments in support of the Uptier Exchange, the Fifth Circuit was unconvinced by those arguments (and the Bankruptcy Court’s holding). Instead, the Fifth Circuit found that the presence of competition among private parties did not absolve Serta and the majority lenders of their duty to market the Uptier Exchange in the secondary syndicated loan market, which they did not do. As the Fifth Circuit noted, “[t]he market is generally open to all buyers and sellers, and its prices are set by competition. So[,] if [Serta] wished to make a[n] … open market purchase and thereby circumvent the sacred right of ratable treatment, it should have purchased its loans on the secondary market. Having chosen to privately engage individual lenders outside this market, [Serta] lost the protection [of the open market purchase exception].” In re Serta Simmons Bedding, L.L.C., 2024 U.S. App. LEXIS 32969, at *40. Because the Uptier Exchange was done in contravention of the Credit Agreement, the Fifth Circuit concluded that the Uptier Exchange violated the minority lenders’ sacred right to a ratable distribution.
Second, the Fifth Circuit found that the doctrine of equitable mootness did not bar its review of Serta’s confirmed plan, and, particularly, the Indemnity. Equitable mootness is a judicially created bankruptcy doctrine whereby an appellate court expresses an unwillingness to upset the finality of a bankruptcy reorganization, and, thus abstains from doing so. To determine if equitable mootness applied, the Fifth Circuit underwent a three-factor test: “(i) whether a stay has been obtained, (ii) whether the plan has been ‘substantially consummated,’ and (iii) whether the relief requested would affect either the rights of parties not before the court or the success of the plan.” Id., at *51 (citing In re Highland Cap. Mgmt. LP, 48 F.4th 419, 429 (5th Cir. 2022)). Specifically, the Fifth Circuit found that the first two factors favored Serta and the majority lenders because the minority lenders failed to obtain a stay of confirmation (despite their continued attempts to do so) and the plan was substantially consummated. However, the Fifth Circuit concluded that the third factor, whether the relief requested would affect either a party not before it or the success of the plan, favored the minority lenders. Because of this, the Fifth Circuit declined to apply the doctrine of equitable mootness. Importantly, the Fifth Circuit recognized that all those that could be impacted by the appeal were present before it and that Serta’s and the majority lender’s primary argument – unfairness – was unavailing. The Fifth Circuit explained that accepting their argument effectively abolished appellate review of clearly unlawful provisions in bankruptcy plans. Ending its analysis, the Fifth Circuit explained that equitable mootness cannot be used as a shield for “sharp or unauthorized practices.”
Finally, the Fifth Circuit examined Serta’s confirmed, substantially consummated plan and determined that excision of the Indemnity was warranted. Serta and the majority lenders argued that the Indemnity was permitted because it was a settlement permitted under Section 1123(b)(3)(A) of the Bankruptcy Code, which provides that “a plan may … provide for the settlement or adjustment of any claim or interest belonging to the debtor or to the estate.” 11 U.S.C. § 1123(b)(3)(A). The Bankruptcy Court agreed with this argument. But the Fifth Circuit declined to do so, instead finding that inclusion of the Indemnity as a settlement was merely an impermissible end run around Section 502(e)(1)(B)’s requirement of disallowance. Section 502(e)(1)(B) of the Bankruptcy Code provides for the disallowance of a contingent claim for reimbursement where the claiming entity is co-liable with the debtor. 11 U.S.C. § 502(e)(1)(B). The Fifth Circuit found that the Indemnity and the resulting claims were, in effect, the same indemnity claims the majority lenders had prior to Serta’s bankruptcy, and that these had been disallowed under Section 502(e)(1)(B). Thus, Serta and the majority lenders could not resurrect claims that were disallowed on the front end.
The Fifth Circuit also found that inclusion of the Indemnity violated Section 1123(a)(4) of the Bankruptcy Code, which requires a plan to provide “the same treatment for each claim or interest in a particular class,” unless such creditor agrees to less favorable treatment. 11 U.S.C. § 1123(a)(4). The Indemnity was facially valid because all members of Classes 3 and 4 of Serta’s Chapter 11 plan were entitled to receive it. But the Fifth Circuit found that the Indemnity only provided value to those who participated in the Uptier Exchange, which did not include all members of Classes 3 and 4. Thus, the Fifth Circuit concluded that the Indemnity constituted impermissible unequal treatment in violation of Section 1123(a)(4) of the Bankruptcy Code.
As the Fifth Circuit stated, while we have yet to see them, the consequences of this case could be far-reaching. At a minimum, the case reveals an unwillingness by the Fifth Circuit to apply equitable mootness. It puts parties on notice that plan provisions that plainly violate the Bankruptcy Code may not be safe, no matter how long a plan is substantially consummated. With respect to uptier exchanges, it is important to note that the Fifth Circuit did not address the issue of the implied covenant of good faith and fair dealing. But what can be gleaned from this decision is that borrowers “must respect the sacred right of pro rata sharing and engage with its lenders on equal footing.” Indeed, “though every contract should be taken on its own, [this case] suggests that such exceptions [(e.g., the “open market purchase” exception)] will often not justify an uptier.”
