Fifth Circuit deals a blow to non-pro rata LMTs: Now what?

By now, the dust has begun to settle in the wake of the Fifth Circuit’s New Years Eve special—a 54-page decision that is certain to influence liability-management transaction (LMT) strategies and structures in the near term.

The Fifth Circuit reversed the 2023 rulings by the Houston bankruptcy court in the Serta Simmons chapter 11 case that, in effect, blessed Serta’s non-pro rata uptier exchange as a permissible “open market purchase” and dismissed breach claims and other challenges brought by a group of lenders that were “excluded” from participating in the transaction. 

The decision is notable for a number of reasons (including its disposition of some core chapter 11 practice issues not discussed at length in this alert, like equitable mootness, participating-lender indemnities, and equal treatment). First, the decision is binding precedent within the Fifth Circuit, which includes the Houston bankruptcy court, a “go to” venue for complex chapter 11 cases and post-LMT litigation (e.g. pending appeals on LMT-related issues in both the Robertshaw and Incora/Wesco Aircraft chapter 11 cases). Second, and perhaps more concerning for cash-strapped borrowers, is the unanimous panel’s analysis of the underlying credit agreement’s ratable-treatment protections and exceptions. 

The Fifth Circuit’s analysis conveyed a reading of the relevant documents and seeming skepticism of uptier LMTs that starkly differed from the bankruptcy court’s commercial-expectations perspective. Circuit Judge Oldham speculated in unmistakable terms:¹

“The 2020 Uptier was the first major uptier. But it was far from the last.  And while the loan market has seen an increase in contracts blocking uptiers (so-called ‘uptier blockers’) since 2020, there are doubtless still many contracts with open market purchase exceptions to ratable treatment. Though every contract should be taken on its own, today’s decision suggests that such exceptions will often not justify an uptier.”

Read the full text of the decision: In re Serta Simmons Bedding, LLC.

Before taking a closer look at the panel’s ruling and potential fallout, we recall Serta’s uptier LMT and the Houston bankruptcy court’s rulings that set the stage for the Fifth Circuit’s decision.

Serta’s uptier LMT

In 2020, Serta needed new capital and explored competing proposals from its existing lenders. Serta and a lender group holding majority positions in Serta’s first-lien and second-lien credit facilities (or the ‘participating lenders’) ultimately executed an uptier LMT that created more than US$1 billion in new super-priority debt through two transactions: 

• Step one, the participating lenders used their majority-lender status to amend the existing credit agreement to permit them to provide US$200 million in new money in exchange for US$200 million in first-out, super-priority debt; and

• Step two, the participating lenders sought to exploit the “open market purchase” provision in the existing credit agreement to execute a debt-for-debt exchange pursuant to which the participating lenders alone were allowed to trade in US$1.2 billion of their old first-lien and second-lien loans for approximately US$875 million in second-out, superpriority debt.

It was Serta’s use of the “open market purchase” provision to justify the non-pro rata exchange that excluded lenders argued violated the existing credit agreement’s terms.

Bankruptcy court dismisses excluded lenders’ challenges

After Serta filed for chapter 11 relief in Houston, the excluded lenders’ claims and challenges to the uptier exchange were quickly teed up through competing summary-judgement motions in the bankruptcy court. The excluded lenders argued that the uptier exchange didn’t qualify as an “open market purchase” and otherwise trampled on their sacred rights (e.g. their right to receive a pro rata share of payments and recoveries, and their senior lien priority and position in Serta’s capital structure). In March 2023, the bankruptcy court ruled in favor of Serta and the participating lenders on the excluded lenders’ breach claims, finding that the uptier “clearly” fell within the unambiguous terms of the “open market purchase” exception in the credit agreement. 

That decision paved the way for a confirmation trial where the remainder of the excluded lenders’ challenges were dismissed. The bankruptcy court confirmed Serta’s chapter 11 plan—including a participating-lender indemnity covering losses related to the uptier—disposed of certain other challenges to the uptier transaction and found that all parties (including excluded lenders) knew that Serta’s credit agreement was a “‘loose document’ and understood the implications of that looseness.” Because Serta had flexibility built into the agreement, the bankruptcy court found that the excluded lenders received “the bargain they struck—not the one they hoped to get.” 

Fifth Circuit rejects expansive “open market purchase" exception

The Fifth Circuit ostensibly applied the same law and interpretive tools that the Houston bankruptcy court did (or could have), but reached the opposite conclusion: that Serta’s 2020 uptier exchange violated the existing credit agreement’s unambiguous exceptions to ratable treatment. The outcome might be rooted, in part, in what seems like a dubious view of LMTs, and non-pro rata uptiers in particular, held by the Fifth Circuit. Indeed, Judge Oldham devotes the first pages in his opinion to explaining uptiers, their purported costs and benefits, and their impact on the “ratable treatment” of lenders, which he calls “a background norm of corporate finance,” and ends his opinion by suggesting that exceptions to that norm (or “sacred right”) “will often not justify an uptier.” 

The panel then turned to the text of the existing credit agreement, which generally required pro rata sharing among all lenders. The credit agreement contained two exceptions to the ratable-sharing provisions, but only the “open market purchase” exception was relevant. Thus, the panel had to determine whether the 2020 uptier was a permissible “open market purchase” under the 2016 credit agreement.

While the bankruptcy court’s analysis was preoccupied with the “[s]ophisticated financial titans” in both lender groups and their commercial expectations, the Fifth Circuit focused on the construction and definition of the phrase “open market purchase.” Or better said, the lack of a definition—after all, the linchpin to the participating lenders’ argument was the fact that “open market purchase” was not defined—allowing them to propose the broadest possible meaning.

Serta and the participating lenders argued the term “means to acquire something for value in competition among private parties,” but that definition, according to the Fifth Circuit, describes only an “open purchase” and therefore “forget[s] the word ‘market.’” The panel found that an “open market” means a “designated market, not merely the background concept of free competition that characterizes much of modern American commerce.” In Serta’s case, that meant that “the relevant product is first-lien debt issued under” an existing credit agreement, “and the market for [purchasing] that product is the ‘secondary market’ for syndicated loans.” As a result, Serta “lost the protection of [the ‘open market purchase’ exception]” by choosing to engage with the participating lenders outside of the designated market. 

The panel bolstered its conclusion with an examination of the “Dutch auction” exception, which contemplated an off-market transaction like the one Serta used in the 2020 uptier. The panel reasoned that, “[i]f an open market purchase is merely an acquisition of ‘something for value in competition among private parties,’ the Dutch auction exception does no work,” because “[Serta] could call any arms-length transaction—including a Dutch auction—an open market purchase.” The “expansive definitions” favored by Serta and the participating lenders violated interpretive canons that advise against interpretation that “render [contractual provisions] surplusage.”

The panel then remanded the excluded lenders’ breach claims to the Houston bankruptcy court, which weren’t considered in its initial summary judgment decision. In doing so, the panel observed that the excluded lenders had a “strong case” that Serta and the participating lenders breached the credit agreement. In light of the panel’s conclusion, it also reversed the bankruptcy court’s approval of, and excised from Serta’s chapter 11 plan, certain provisions that required reorganized Serta to indemnify participating lenders for any damages that might be awarded to the excluded lenders on their breach claims.

Where will the market go from here?

The outcome in Serta looks like a rare “sweep” by excluded lenders in LMT litigation.  Early industry speculation is that the decision could chill the uptier market. At a minimum, the decision may force distressed companies entrenched in non-pro rata LMT litigation to avoid restructuring through Fifth Circuit courts. Such companies may favor restructuring in jurisdictions unburdened by a circuit-level skepticism of uptier transactions. Although some will argue that Serta should be confined to uptiers that rely on “open market purchase” exceptions, if you read between the lines, the Fifth Circuit’s decision makes clear that courts should take dim view of LMTs that erode the “sacred right” of ratable treatment. 

That said, the LMT marketplace is nothing if not flexible. Serta may be a new arrow in the excluded-lender quiver, but all market participants and advisors are certain to keep the decision front of mind when drafting their next deal, or drawing up their next LMT playbook. Here are a few things that our distressed debt advisory and restructuring groups will be watching in the next year:

• More Fifth Circuit precedent coming? Houston’s bankruptcy court has been a hotbed of post-LMT litigation in recent years, with borrowers and their participating lenders enjoying more success than their excluded rivals (e.g. until recently in Serta, but also in the Robertshaw chapter 11). A recent decision by Judge Marvin Isgur in Incora/Wesco Aircraft, however, signaled that the court could invoke an analysis that, like the Fifth Circuit, strengthened excluded lenders’ “sacred rights” under existing credit agreements. With plenty more LMT litigation on the Fifth Circuit’s docket, 2025 could see the court re-visit Serta issues and provide market participants with more grist for the LMT mill.

• When one door closes, another opens. While the Fifth Circuit’s decision may have pulled out the welcome mat for companies seeking to have their LMT transactions blessed, let’s not forget that courts in other jurisdictions outside of the Fifth Circuit have observed, despite the “‘all for one, one for all’ spirit of a syndicated loan, . . . nothing in the law [ ] requires holders of syndicated debt to behave as Musketeers.”² Although the Serta court applied New York law in its analysis, its ruling does not bind New York courts or federal courts in other jurisdictions.  To wit, also on December 31, just a few short hours after the Fifth Circuit revived the Serta excluded lenders’ breach claims, a five-judge panel of the New York Supreme Court’s Appellate Division (First Department) paved the way for distressed borrowers and their lenders to structure non-pro rata exchanges.
  • The New York Appellate Division unanimously reversed a trial court’s December 2023 decision denying motions to dismiss challenges to a 2022 non-pro rata uptier exchange. Although that transaction effectively subordinated excluded lenders to US$857 million in new priming debt, the appellate panel found no breach of the underlying credit agreement and deemed the related amendments and new agreements “valid and enforceable contracts.” 
  • In a short, but unequivocal decision, the New York panel was unconcerned with the “violence” allegedly done to excluded lenders’ sacred rights. The result, however, can be attributed to a crucial difference in the underlying agreement’s ratable-treatment exceptions: the Serta documents allowed for “open market purchase” while the documents before the New York panel allowed the company to “purchase” loans at any time, i.e., without reference to a “designated market,” which was a material consideration for the Fifth Circuit. 
  • In light of the unqualified “purchase” exception, the appellate panel found “no indication in the agreements that a refinancing or exchange cannot include a purchase, nor [ ] any indication that a purchase requires payment in full, upfront, in cash, or that debt cannot constitute payment.” Read the full text of the New York Appellate Division opinion.

The New York Appellate Division’s decision comes at an interesting moment. If market participants look back in time, they will see that many trailblazing LMTs, that found refuge in federal bankruptcy courts, actually began their journey in litigation filed in New York Supreme Court.  Like Serta, many of these companies pivoted to chapter 11 only after a trial court denied motions to dismiss, creating unsustainable uncertainty for them and their participating lenders (e.g. including chapter 11 cases filed after uptiers by Trimark USA, Boardriders, and TPC Group, and cases filed after other LMTs by J. Crew, Neiman Marcus, Revlon, Envision, and others).

Only time will tell whether LMT participants will return to New York, continue to dip their toes in the shores of New Jersey, tempt the Fifth Circuit again, or seek some other “safer” jurisdiction.  But has the Fifth Circuit put an end to the non-pro rata uptier LMT?  Not likely.

• Fifth Circuit adds insight on bedrock bankruptcy issues. As mentioned, the Serta decision is also noteworthy for its discussion of other bankruptcy issues. While these rulings won’t have the knock-on effects that the Serta LMT ruling might, they provide useful insight for chapter 11 practitioners in the Fifth Circuit and elsewhere.
  • “Equitable mootness,” a judge-made doctrine that counsels appellate courts to abstain from deciding matters that might alter the outcome in a chapter 11 case, has been questioned by courts in recent years. Although the Fifth Circuit didn’t entirely disavow the doctrine, it noted that, “to the extent equitable mootness exists at all, we affirm that it cannot be ‘a shield for sharp or unauthorized practices.’” Thus, Serta adds to the growing body of law that pushes reviewing courts to avoid dismissing an appeal on equitable grounds and instead consider whether it can fashion appropriate relief without scrambling a confirmed chapter 11 plan.
  • In addition, the Fifth Circuit panel reversed the bankruptcy court’s ruling that an provision in Serta’s chapter 11 plan that required the company to indemnify the participating lenders for damages awarded in post-bankruptcy litigation. The panel saw the indemnity as an “end-run” around Bankruptcy Code section 502(e)(1)(B), which disallows contingent prepetition indemnification claims, and rejected Serta’s argument that the provision was nevertheless permissible under Bankruptcy Code section 1123(b)(3)(A) as a plan settlement. Accordingly, Debtors cannot use a plan settlement under section 1123 to resurrect a claim that would otherwise be disallowed under other Bankruptcy Code provisions. 
  • The Fifth Circuit then considered, “even if the settlement indemnity was justified,” whether the indemnity violated the Bankruptcy Code’s “equal treatment” requirement. The panel found that it did.  While the Bankruptcy Code requires that plans provide the “same treatment for” each claim in a particular class, the Fifth Circuit found that the “differences in the expected value of the indemnity meant that distributions to the members of Classes 3 and 4 were not equal.” The panel stopped short of “delimit[ing] the exact scope of [the equal-treatment requirement in Bankruptcy Code section 1123(a)(4)],” but the ruling made plain that the equal-treatment analysis requires courts to look beyond a plan’s plain language to evaluate whether “some class members received settlements with higher effective values than their co-class members.”

Norton Rose Fulbright’s distressed debt advisory group regularly leads clients through complex, high-stakes transactions by combing deep experience and top-ranked talent across industries and major jurisdictions worldwide to help clients execute sophisticated solutions aligned with strategic goals at every stage of a company’s financial lifecycle.

In addition, Norton Rose Fulbright’s restructuring group is widely recognized for providing high-quality counsel to major constituents in many of the largest, most significant and complex bankruptcy cases filed nationwide over the past decade. We have strong restructuring experience in all key industry sectors—particularly energy, healthcare, transportation/shipping, and telecommunications—which have been subject to many notable Chapter 11 filings over the past few years.