LME New Year’s Update: Serta Appeals Court Decision May Put Open Market Exchanges To Bed

Summary

While 2024 saw skyrocketing volumes for liability management exercises (LMEs), the year took a turn as a result of the December 31 decision by the United States Court of Appeals for the Fifth Circuit in the Serta case.¹ The Fifth Circuit reversed a lower court decision that permitted a group of lenders to prime the other lenders under a credit agreement by exchanging their existing debt for a super senior position in reliance on the customary “open market purchase” exception to the ratable sharing requirements in Serta’s credit agreement.

Litigation over LMEs has become common, but so far, most cases have either settled or courts have adopted a narrow interpretation of credit documents that have favored the lender group that takes the priming position. Serta will not be the last of LMEs; in fact, on the same day as the Serta decision, the New York Supreme Court’s First Appellate Division upheld the Mitel Networks uptier transaction because, unlike Serta, the credit agreement in that case allowed the borrower to purchase loans at any time, without being limited to non-pro-rata purchases in open market transactions. Serta makes clear that the precise language of the credit agreement that allows non-pro-rata treatment of lenders must be very carefully analyzed in evaluating the structure of future LMEs.

Background: Uptiers and Drop-downs

An uptier transaction is a type of LME in which a group of lenders under a credit agreement (the “included lenders”) creates new secured debt that has a higher lien priority than the debt held by the other lenders (the “excluded lenders”). Uptiers are often achieved by amending the credit agreement to permit the new debt and its senior lien position. Lenders holding the requisite amount of debt and/or commitments can amend the credit agreement to permit the senior position (and strip covenants and other lender protections in order to ensure the new senior debt controls any future default scenarios) immediately prior to effecting the uptiering of the new senior debt. In some instances, the included lenders have issued new commitments to lend, for instance, through an incremental or accordion basket, so that their loans and unfunded commitments combine to form the requisite threshold needed to effect the amendments prior to the LME. While the uptier is not pro-rata to all lenders, many credit agreements have an exception that permits open market purchases of loans on a non-pro-rata basis. Most credit agreements include the pro rata provisions in the “sacred rights” of lenders, which requires a vote of all affected lenders to modify them. Thus, in order to effect the LME without a vote of all lenders, included lenders have relied on this open market exception to pro rata treatment by having the borrower purchase their existing loans with the new senior debt as the purchase consideration. As discussed below, the Serta opinion applies a narrow view as to what constitutes an open market for purposes of this exception.

Another common form of LME is a drop-down transaction which involves the transfer of material assets out of the existing lenders’ collateral package to an unrestricted subsidiary, or a subsidiary that is excluded from guaranty and collateral requirements. That subsidiary then pledges those assets to the group of lenders that are providing new, structurally senior, debt. While uptier transactions rely on contractual subordination of existing liens, drop-downs rely on the priming debt being structurally senior to existing debt by being issued by a subsidiary and supported by collateral that the existing lenders do not have a direct claim on. Drop-downs, such as done in the seminal J. Crew transaction, can be done without lender consent if there is enough room in the covenants for the investment of new assets in the unrestricted/excluded subsidiary. As a result, drop-downs can be done with third party lenders that are not part of the existing credit and thus avoid any non-pro-rata exchange issues with the existing debt. Drop-downs, however, can also be done with existing inside lenders, particularly if the credit agreement needs to be amended to permit it. In that case, the voting by, and the purchase of existing debt of, the included lenders are very similar to uptier LMEs. As a result, these types of drop-downs have often relied on the open market purchase exception to elevate the included lenders to the structurally senior position. Consequently, the Serta decision will likely limit this type of LME going forward.

Serta Decision

In Serta, the borrower entered into a non-pro-rata exchange pursuant to which the included lenders provided new money for a first-out, super-priority loan and exchanged existing loans for second-out, super priority debt, leaving the excluded lenders in effectively a third-out position. While the Serta credit agreement contained the customary ratable sharing provision that would have required all payments to be shared among lenders, it also contained an exception for “open market purchases” made by the loan parties. Thus, the transaction was structured to have the borrower purchase the debt of the included lenders using the new priority debt as the consideration. The ability to characterize the debt exchange as an open market purchase by the borrower, as opposed to a repayment, was crucial to avoiding pro rata treatment for the excluded lenders. The excluded lenders initially challenged the LME in a New York federal (non-bankruptcy) court where, in April 2022, the court concluded that whether the open market purchase exception provided the included lenders a complete defense could not be decided at the pleading stage.

Serta subsequently filed for chapter 11 bankruptcy in January 2023 in Houston and immediately sought a declaratory judgment that its uptier transaction did not violate the credit agreement. The Bankruptcy Court upheld the uptier transaction, holding that the non-pro-rata uptier fell within the “open market purchase” exception as a matter of law. The decision was certified to the U.S. Court of Appeals for the Fifth Circuit for direct appeal.

On December 31, the Fifth Circuit reversed the Bankruptcy Court. The Fifth Circuit ruled the exchange between Serta and the participating lenders was not within the scope of an “open market purchase.” As the term “open market purchase” was not defined in the credit agreement (most credit agreements do not define this, but rely on the plain meaning of this term), the Court consulted a number of sources, including dictionaries, case law, the Federal Reserve market procedures, the Loan Syndications and Trading Association publications, and others, to determine the meaning of this term. The Court concluded that the term “open market” must refer to a specific existing market, like the stock market or other exchanges, and not the more expansive interpretation of the included lenders that it referred to as the general concept of competition for buying and selling. As the Serta purchase was essentially a privately negotiated sale among the included lenders and the borrower, and not a purchase of distressed loans on the regular bank syndication market, the open market exception did not apply to the non-pro-rata treatment of the excluded lenders. The Court further determined that to accept the more expansive interpretation that “open market” means any competitive bid process, would render the term meaningless or superfluous, as “open market” could then be taken to refer to any arms-length transaction.

LMEs at their core are contract interpretation exercises. Of course, no two credit agreements are perfectly alike, so the precise wording of each credit document needs to be parsed to determine if an uptier transaction is possible and/or how to structure a priming position. Just like LMEs have come onto the scene as a result of creative contract drafting and interpretation, Serta may lead to new innovations in how LMEs are implemented. Going forward, lenders, distressed companies and their respective advisors will need to structure future LME transactions (and perhaps their credit agreements on the front end) in light of these rulings.

Key LME Takeaways Heading into 2025

• The Serta ruling deals directly with an uptier transaction, but the analysis applies equally to non-pro-rata drop downs by lenders. Classic drop downs, particularly those where there is no debt exchange or the new money comes from a third party lender, are still viable LME options.
• There are credit agreements in the market that—unlike the Serta agreement at issue—expressly permit privately negotiated “open market purchases” or non-pro-rata purchases of loans (which was the case with Mitel Networks). As of now, these credit terms are the exception to the general pro-rata rule, but we can expect borrowers to start requesting non-pro-rata language in the future in order to maintain the flexibility for LMEs. We would equally expect many lenders will push back on these efforts.
• Lender response to increased LME activity includes cooperation agreements, traditional LME protections (J. Crew, Chewy and Serta blockers), next generation LME protections (Envision, Pluralsight, At Home and Wesco / Incora blockers) and a general blocker for any LME. We expect these efforts to limit LME flexibility will continue to evolve.
• Examples of some tweaks to LME blockers that are being discussed include deleting the open market exception, permitting the exception only if it is offered to all lenders, and/or requiring that open market purchases be for cash only. It is too early to predict what will emerge as the generally accepted syndication market response to Serta.
• Limitations on “Sacred Rights”: Lenders should be aware that negative covenant baskets that permit (or restrict) debt, liens, asset sales and investments; LME Blockers; and collateral releases; often can be amended with only majority lender consent, raising the potential for LMEs regardless of whether an open market purchase is authorized.
• Further, courts have previously held that while subordination of payment is a sacred right, the subordination of a lien is not. Thus, included lenders that hold the requisite voting threshold can still adjust lien priority on the debt of excluded lenders to help effect an LME, leaving a useful LME tool intact.

¹ See In re Serta Simmons Bedding, LLC, Case No. 23-20181 (5th Dec. 31, 2024).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Peter Friedman, an O’Melveny partner licensed to practice law in the District of Columbia; Jeff Norton, an O’Melveny partner licensed to practice law in New York; Ike Chidi, an O’Melveny partner licensed to practice law in California; Matthew P. Kremer, an O’Melveny partner licensed to practice law in New York; Glen K. Lim, an O’Melveny partner licensed to practice law in California and New York; Brian S. Stern, an O’Melveny partner licensed to practice law in California; Jennifer Taylor, an O’Melveny partner licensed to practice law in California; Daniel C. Tola, an O’Melveny partner licensed to practice law in California; and James A. Midkiff, an O’Melveny associate licensed to practice law in California and Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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