Latest Uptier Decisions in Serta and Mitel Remind Contract Language Matters

The caselaw on “uptiers” as liability management exercises (LMEs) grew by two opinions on the last day of 2024. In Serta, the Fifth Circuit reversed the bankruptcy court’s blessing of the pre-bankruptcy uptier and post-reorganization indemnification of the parties thereto. The Fifth Circuit also remanded the case for further consideration of the excluded lenders’ breach of contract and implied covenant of good faith and fair dealing counterclaims, while suggesting that the merits of those counterclaims are strong.[1] In Mitel, the New York Appellate Division’s First Department dismissed left-out holders’ claims that had been permitted by the trial court to proceed.[2]

This alert will focus on Serta, as Mitel’s contract breach ruling was based on more permissive language than was at issue in Serta, and Mitel’s other dismissals, of claims for breach of the implied covenant of good faith and fair dealing and tortious interference, are in line with prior cases.

Takeaways discussed more fully below include the following:

• Contract language matters: the borrower’s ability in Mitel to “purchase [loans] by way of assignment” allowed a non-pro rata uptier, whereas ambiguity in the phrase “open market purchase” led the court in Serta to conclude that anything other than purchases on the secondary market for syndicated loans would not satisfy this exception to pro rata sharing.
• Serta will almost certainly reinforce a preexisting market trend away from LMEs involving only a select group of bare majority lenders, to LMEs designed to encourage participation by holders outside the initial group at worse economics rather than completely excluding such parties.
• The Fifth Circuit’s elimination of the Serta uptier lenders’ transaction-related indemnity from the chapter 11 plan may impact lender willingness to enter into non-pro rata transactions in contracts with Serta-like language or shift more attention to other forms of LMEs.

This alert assumes familiarity with the facts regarding Serta’s 2020 non-pro rata uptier transaction, as previously written about by MoFo here: Client Alert: Caveat Lendor: Serta Confirmation Opinion Permits Uptier with Finding of “Good Faith” and Provides Indemnity for Participating Lenders. The Fifth Circuit opinion also contains a fulsome factual background and procedural history.

Fifth Circuit’s Serta Opinion

The Serta opinion is wide-ranging; this alert discusses the court’s holdings on whether (i) the uptier transaction constituted an “open market purchase” such that it could be conducted on a non-pro rata basis without violating pro rata sharing provisions, and (ii) indemnification of the uptier lenders (the “Prevailing Lenders”)[3] could be incorporated into the company’s chapter 11 plan of reorganization. Beyond the scope of this client alert, the opinion contains extensive discussion of various important jurisdictional issues and pushes back against wide-ranging Circuit Court dismissals of bankruptcy appeals on “equitable mootness” grounds.

Open Market Purchase

Under the Serta credit agreement in place prior to the uptier (the “2016 Agreement”), there were exceptions from the general principle that payments be shared pro rata among lenders for (i) Dutch auctions, and (ii) “open market purchases.”[4] The bankruptcy court held that the uptier fit the “open market purchase” exception, focusing on the principle of competition; various lender groups had competed to provide the company financing.[5]

The Fifth Circuit reversed, finding that the phrase “open market” implies “a specific market . . . generally open to participation,” which requires defining the relevant market, in this case, for a syndicated loan, the secondary market for syndicated loans.[6] The Fifth Circuit refuted the bankruptcy court’s focus on competition, suggesting that the existence of competition “forget[s] the word ‘market.’”[7] “The point here is not whether the open market purchase . . . was open to anyone, but whether such a purchase took place on a market that was generally open to anyone.”[8]

After finding that the uptier violated the open market purchase exception to pro rata sharing, the Fifth Circuit noted that the excluded lenders (the “Excluded Lenders”) “have a strong case” that Serta and the Prevailing Lenders breached the 2016 Agreement.[9] However, rather than address that issue, the Fifth Circuit found there was insufficient discussion of the Excluded Lenders’ counterclaims for breach of contract in the appellate briefing, so the court simply vacated dismissal of the counterclaims and remanded the case to the bankruptcy court for reconsideration of the counterclaims.[10]

Indemnification

The Fifth Circuit also removed (“excised”) the Prevailing Lenders’ rights to indemnification by the company for liability related to the uptier, a provision that had been included in Serta’s confirmed chapter 11 plan.[11] The court noted that the plan’s indemnification provision was functionally equivalent to the indemnification the Prevailing Lenders received in connection with the pre-bankruptcy transaction. As such, this was an improper attempt to circumvent Bankruptcy Code section 502(e)(1)(B), which would have disallowed claims asserted under the pre-bankruptcy indemnity once Serta was in bankruptcy.[12]

The court recounted in detail how the plan originally proposed to simply reinstate the pre-bankruptcy indemnification until objecting parties pointed out that the claims were not allowable under the Bankruptcy Code, in response to which the company changed the indemnification in the plan such that it would only take effect upon emergence from bankruptcy and be granted not only to parties who participated in the uptier, but to any subsequent holders of those loans at the time of emergence.[13] This “new” provision was part of a global plan settlement with the Prevailing Lenders, the company argued, but the Fifth Circuit found it was just an attempt to repackage the non-allowable claims that would arise under the pre-bankruptcy indemnity.[14] The court rejected the argument that “the Prevailing Lenders [would not have] agreed to support the Plan [absent] the settlement indemnity” and that it would thus be unfair to remove that term, as such rationale would, in theory, permit approval of plan provisions that were otherwise illegal under the Bankruptcy Code.[15]

Interestingly, the court also concluded that Serta’s attempt to create the “new” post-emergence indemnity by defining the scope to include holders of the uptier loans who were not transaction participants violated the Bankruptcy Code’s requirement that claims within a particular class receive same treatment.[16] The court reasoned that the value of the indemnity was zero for the sub-class of holders of the uptier loans who had not participated in the original transaction, yet highly valuable for the uptier participants.[17] Such disparate recovery on account of the same pre-bankruptcy claims—the uptier loans—violated the requirement that all holders receive roughly the same consideration because the “effective value” of the indemnity to lenders who participated in the uptier and those who didn’t differed so materially.[18]

Takeaways

Perhaps the most impactful element of the Serta decision is the elimination of the upteir participants’ post-bankruptcy indemnity. Although Serta was an uptier, transaction-related indemnification has been a feature of LMEs generally, and the Fifth Circuit’s post hoc elimination of this protection may impact lenders’ willingness to engage in non-pro rata deals where there is material litigation risk and a likelihood of a future bankruptcy, absent development of methods to avoid this pitfall. The relative willingness of courts in different Circuits to use excision as a remedy may also impact the jurisdiction of future post-LME bankruptcy filings.

Serta likely will also accelerate the existing market trend toward more inclusive LMEs (both uptiers and non-pro rata drop-downs) designed to provide various lenders with differing treatments, while also undercutting the disfavored lenders’ economic incentives to litigate.

Analysis begins with the language of the contract; this is the key takeaway from Mitel. The Fifth Circuit concluded by acknowledging that “every contract should be taken on its own,” but where some prior decisions have left it at that (e.g., Judge Christopher Lopez—who was assigned Serta after Judge Jones’ departure from the bench and will now consider the matters on remand—in Robertshaw[19]), the Fifth Circuit added that “today’s decision suggests that [open market purchase] exceptions [to pro rata sharing] will often not justify an uptier.”[20] However, not all documents are created equal, and the variations on exceptions to pro rata treatment include options that can more expressly bless transactions like the uptier in Serta. To wit—this is Mitel. In Mitel, the borrower had the right to “purchase [loans] by way of assignment,”[21] and the court found that this more permissible assignment provision was not violated by a non-pro rata uptier in that case.[22] A material subset of credit agreements in the market provide borrowers and their affiliates with even broader non-pro rata repurchase rights than those found in the Mitel opinion. According to a recent article by Covenant Review, 20 percent of the deals reviewed by Covenant Review in 2024 “explicitly referenced privately negotiated transactions in addition to or as an alternative to open market purchases.”[23]

Serta may push borrowers to think more intently about third-party drop-down transactions to raise needed capital and extend liquidity runway. Both non-pro rata uptiers and drop-down transactions with existing lenders are reliant upon the borrower’s ability to purchase or exchange the loans held by a subset of its lenders, making both options questionable following Serta. As companies grapple with the appropriate LME for their situation, they will be forced to consider the litigation risk (and likely outcome) of a non-pro rata uptier or drop-down transaction; they may therefore feel constrained to consider more carefully the possibility of engaging in transactions (e.g., drop-down transactions) with financing from third-party financing sources.

Serta may color the analysis in other situations involving non-pro rata treatment, e.g., interpreting weak-form “Serta blocker” language or carve-outs to pro rata treatment in other contexts such as DIP financing or cooperation agreements. Less-than-absolute Serta blockers may allow particular types of financing, or forms of economics, to be given on a non-pro rata basis. In the DIP context, an informative dispute was seen in December in the American Tire Distributors bankruptcy,[24] where a minority group of lenders left out of the DIP financing, which included new money and a 3:1 rollup, objected that the rollup—only of the majority participating lenders’ loans—violated the pro rata treatment provisions in the pre-bankruptcy credit agreement. The company and majority lender group argued that a carve-out from Serta protection permitted “any” DIP financing, and therefore, “any” meant literally any term, including the roll-up. Judge Craig Goldblatt said he thought the minority lender group would win on its pro rata sharing argument, if there were to be a trial on the merits; that was enough to get the debtors and the majority lender group to drop the roll-up entirely (and therefore, no official ruling was needed).[25]

In other contexts, cooperation agreements (“Coops”) that provide flexibility for non-pro rata economics to a subset of signatories, such as a steering committee, may raise similar issues. The Fifth Circuit’s strong enforcement of pro rata treatment may impact the decision calculus for lenders who find themselves in a position to sign a Coop and miss out on the preferential steering committee economics. In a situation with Serta-like language, is the backstop of the Fifth Circuit’s enforcement of pro rata rights sufficient protection from a non-pro rata deal, such that it makes more sense to not sign a Coop, which would entail consenting upfront to receiving inferior treatment in a future transaction?

Watch to see whether other Circuits find Serta persuasive. This ruling is binding only in the Fifth Circuit. It contains a thorough discussion of the relevant issues and may be considered persuasive by courts in other Circuits, such as those bankruptcy stalwarts, the Second and Third Circuits, and may lead to more filings in those jurisdictions as borrowers test the persuasiveness of Serta in other courts.

Watch the remand to the bankruptcy court for consideration of the excluded lenders’ counterclaims and discussion of remedies. As noted above, after finding the uptier did not fall within the open market purchase exception to pro rata treatment, the Fifth Circuit said that the Excluded Lenders “have a strong case” that Serta and the Prevailing Lenders breached the 2016 Agreement, while remanding back to the bankruptcy court to reconsider those counterclaims and potential remedies. In the Robertshaw case, Judge Lopez found money damages to be the appropriate remedy for a breach of a credit agreement.[26] Unfortunately for the damaged lender in that case, the breach was only by the debtor/borrower and such money damages were held by the court to be an unsecured claim subject to recovery from a de minimis cash pool. In Serta, the Prevailing Lenders were named as counterclaim defendants, so the focus of the remedies analysis on remand may be shifted to those lenders.

[1] In re Serta Simmons Bedding, L.L.C., Nos. 23-20181, 23-20450, 23-20363, 23-20451, 2024 WL 5250365 (5th Cir. Dec. 31, 2024) (the “Serta Opinion”).

[2] Ocean Trails Co., et al. v. MLN Topco Ltd., et al., No. 2024-00169, 2024 WL 5248898 (N.Y. App. Div. Dec. 31, 2024) (the “Mitel Opinion”).

[3] This alert will attempt to use the defined terms from the Fifth Circuit opinion.

[4] See the Serta Opinion at 9 (quoting § 9.05(g) of the 2016 Agreement).

[5] See the Serta Opinion at 13.

[6] See id. at 29.

[7] See id. at 31.

[8] Id. at 29–30 n.12 (emphasis in original).

[9] See id. at 38.

[10] See id.

[11] See id. at 54.

[12] See id. at 47.

[13] See id.

[14] See id. at 49.

[15] See id. at 44.

[16] 11 U.S.C. 1123(a)(4).

[17] See id. at 51.

[18] See id. at 52.

[19] Robertshaw U.S. Holding Corp. v. Invesco Senior Secured Management Inc., Adv. No. 24-03024 [Dkt. No. 351] (Bankr. S.D. Tex. June 20, 2024) (addressing pre-bankruptcy non-pro rata financing disputes: “[t]his decision is limited to the facts of this case”).

[20] See the Serta Opinion at 54.

[21] See the Mitel Opinion at 3.

[22] See id.

[23] Serta: Implications of the Fifth Circuit’s “Open Market Purchase” Holding in In re Serta, Covenant Review, Jan. 2, 2025.

[24] At the time of publication, Morrison Foerster represents the official committee of unsecured creditors in the American Tire Distributors chapter 11 cases.

[25] In re American Tire Distributors, Inc., et al., No. 24-12391 (Bankr. D. Del. Nov. 19, 2024), Hr’g Tr. 111:10–21, 115:8–116:25, 122:10–123:6.

[26] In re Robertshaw U.S. Holding Corp., 663 B.R. 65 (Bankr. S.D. Tex. 2024); see also In re Robertshaw U.S. Holding Corp., 662 B.R. 146 (Bankr. S.D. Tex. 2024) (regarding the breach).