A Tale of 2 Rulings: Serta, Mitel Cases Remind Why Contract Language Matters in Debt Documents

A three-judge panel of the U.S. Court of Appeals for the Fifth Circuit on Dec. 31, 2024, unanimously held that the debt exchange undertaken by Serta Simmons Bedding (Serta) did not qualify as an "open market purchase" under the terms of Serta's 2016 credit agreement (2016 Credit Agreement). Therefore, the "uptier transaction" was not permitted, with the Fifth Circuit remanding certain aspects of the case back to the U.S. Bankruptcy Court for the Southern District of Texas (Bankruptcy Court) to determine if non-participating lenders should recover damages for breach of contract and related theories, claims that will no longer be subject to the indemnification previously offered the participating lenders under the confirmed Chapter 11 plan pursuant to the Fifth Circuit's ruling.¹

On the same day as the Fifth Circuit's decision, the New York Supreme Court's First Appellate Division issued a separate ruling ratifying an uptier transaction executed by Mitel Networks, which is summarized briefly at the end of this alert.

Possible Implications of the Serta Ruling

• Creative borrowers and market participants may advocate for new terms during the documentation stage to maintain flexibility. This may include defining open market purchases to align with the language contained in the Mitel loan documents (discussed below) and structuring future exchanges to appear as "open market" in form (i.e., offered to all) but not in substance (i.e., offering varied terms to different lenders, including different economics or deal sweeteners).
• Decreased borrower reliance on the open market exception as formulated in Serta to execute uptier transactions, even if they are located in a state outside of the Fifth Circuit's jurisdiction, because other courts could similarly adopt the Fifth Circuit's plain-meaning interpretation of the undefined term "open market purchase."
• Filing for Chapter 11 bankruptcy may not fully insulate liability management transaction (LMT) parties from exposure, with deal risk continuing after the bankruptcy plan is confirmed and consummated.
• Increased circumspection by market participants may be warranted before considering LMT transactions in light of the Fifth Circuit's broader message to the effect that attempts to circumvent established corporate lending principles – such as pro rata sharing and other sacred rights – will face close scrutiny at all stages, even after plan confirmation.

Background of the Serta Case

In 2020, Serta, together with lenders holding a majority of the first-lien and second-lien term loans (Participating Lenders), structured an uptier LMT transaction whereby Serta repurchased debt from the Participating Lenders on a non-pro rata basis by means of open-market purchases. While the 2016 Credit Agreement did require pro rata sharing of payments among lenders of the same class, it also contained an exception whereby "any Lender may, at any time, assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender on a non-pro rata basis ... (B) through open market purchases."

As part of the uptier LMT transaction, the Participating Lenders funded $200 million of new money in the form of superpriority "first-out" term loans under a new superpriority credit agreement (2020 Uptier Facility) and were given the opportunity to exchange, on a cashless basis and at a discount, $1.2 billion worth of first-lien and second-lien loans into $875 million of "second-out" term loans under the 2020 Uptier Facility. Pursuant to the terms of an intercreditor agreement, the 2020 Uptier Facility ranked ahead of the then existing first- and second-lien term loans held by the minority of lenders that were not part of the Participating Lenders group (such lenders, the Excluded Lenders).

To execute on the 2020 Uptier Facility, Serta, together with the Participating Lenders:

• amended the initial 2016 credit agreement to allow Serta to enter into the 2020 Uptier Facility (i.e., to issue super-priority debt), an amendment that required approval of only a simple majority of the outstanding first-lien indebtedness, controlled by the Participating Lenders
• took the position that the debt exchange for participation in the 2020 Uptier Facility was an "open market purchase" under the existing 2016 Credit Agreement, taking advantage of an exception to pro rata sharing under that agreement (discussed above), and
• agreed that Serta would indemnify the Participating Lenders for any and all losses, claims, damages and liabilities that the Participating Lenders might incur in connection with their participation in the 2020 Uptier Facility (Indemnity)

This 2020 Uptier Facility had an impact on the market, putting some lenders on the defensive but also initiating new LMT activity and in some cases, concomitant Chapter 11 cases filed to help mitigate liability resulting from that activity.²

The Excluded Lenders filed a lawsuit against Serta and the Participating Lenders in New York state court, urging that the 2020 Uptier Facility transaction was not permitted by the 2016 Credit Agreement. The New York court denied the defendants' motion to dismiss, stating that the term "open market purchase" was sufficiently ambiguous to justify a trial.

Serta then brought the dispute to a head in a more centralized forum, commencing a Chapter 11 case with the Bankruptcy Court in January 2023. Serta immediately filed a proposed Chapter 11 plan that had been pre-negotiated with the Participating Lenders, as later amended, that provided for, among other provisions, reduction of Serta's debt from $1.9 billion to $315 million by means of a debt-for-equity swap available to the Participating Lenders and new exit financing to be provided by the Participating Lenders in exchange for indemnification by the reorganized Serta against any liability resulting from the 2020 Uptier Facility pursuant to the Indemnity.

Serta and the Participating Lenders also initiated an adversary proceeding before the Bankruptcy Court (Litigation) seeking a declaratory judgment that the 2020 Uptier Facility and the exchange transaction were permitted under the existing 2016 Credit Agreement, and that the Participating Lenders did not violate the implied covenant of good faith and fair dealing by entering into the 2020 Uptier Facility. The Excluded Lenders counterclaimed, arguing that the 2020 Uptier Facility breached the 2016 Credit Agreement and sought money damages.

In March 2023, the Bankruptcy Court entered partial summary judgment in favor of the Participating Lenders in the Litigation, characterizing the 2016 Credit Agreement as a "loose" document that unambiguously provided a great deal of flexibility to Serta to engage in liability management transactions under the "open market purchase" provisions. The Bankruptcy Court admonished that: "[t]he parties could have easily avoided this entire situation with the addition of a sentence or two to the 2016 Credit Agreement. They did not. And this litigation ends with each party receiving the bargain they struck—not the one they hoped to get."³

The Fifth Circuit granted the Excluded Lenders' motion for a direct appeal of that order granting summary judgment in favor of Serta.⁴ While the appeal was pending, the Bankruptcy Court confirmed Serta's Chapter 11 plan over objection of the Excluded Lenders. In doing so, the Bankruptcy Court held that "based on the overwhelming evidence adduced at trial, the [Uptier] Transaction was the result of good-faith, arm's length negotiations by economic actors acting in accordance with the duties owed to their respective creditors, investors and owners."⁵ In fully resolving the Litigation in favor of the Participating Lenders, the Bankruptcy Court determined that "the 2020 [Uptier] Transaction is binding and enforceable in all respects"⁶, and entered an order confirming the Chapter 11 plan on June 6, 2023. (Confirmation Order).⁷ As part of this holding, the Bankruptcy Court concluded that the relevant "market" was limited to the holders of Serta's first-lien debt under the 2016 Credit Agreement itself:

The 2016 Credit Agreement defines the scope of the market as it limits buyers to existing holders of the Debtors' loans. The process utilized by Evercore to solicit interest from these existing lenders, the receipt and negotiation of multiple offers by the Debtors to achieve the greatest benefit for the Debtors, the attempts by various lenders to "outmaneuver" one other with an ultimate winner announced, and the Objecting Lenders subsequent attempts to undermine the announced winning deal is the quintessential "Wall Street" open market purchase.⁸

The Objecting Lenders also appealed the Confirmation Order to the U.S. District Court for the Southern District of Texas (District Court) and were unsuccessful in obtaining an order of the Bankruptcy Court and District Court staying the effectiveness of the Chapter 11 plan and Confirmation Order. On Sept. 18, 2023, the Fifth Circuit agreed to hear direct appeals of the Confirmation Order, as well as the Summary Judgment Order, on a consolidated basis.⁹

Fifth Circuit's Interpretation of "Open Market Purchase" Provisions

On Dec. 31, 2024, the Fifth Circuit issued its long-awaited Opinion on appeal, reversing the prior rulings of the Bankruptcy Court, holding that the exchange executed by Serta as part of the 2020 Uptier Facility did not qualify as an "open market" purchase as that term is used in the 2016 Credit Agreement under well-settled contract interpretation principles.¹⁰

Before engaging in a detailed analysis on how to discern the meaning of the provision at issue, the Fifth Circuit noted the importance of the "sacred right" of ratable treatment of all participating lenders of the same class in a syndicated loan transaction.¹¹ The Court observed that the 2016 Credit Agreement did in fact contain protection around pro rata sharing but allowed for limited exceptions in transactions involving open market purchases or a "Dutch Auction." However, unlike the latter term, the phrase "open market purchase" was not defined in the 2016 Credit Agreement.¹²

After determining that it held the appropriate appellate jurisdiction, ¹³ the Fifth Circuit considered whether the Bankruptcy Court's ruling in favor of Serta was sound based on the meaning of "open market purchases." In interpreting this provision, the Fifth Circuit noted that although courts often look to dictionaries to discern meaning, in the context of a particular industry, courts will also interpret contractual language based on industry customs and usage. See Opinion at 29-31. In its interpretation exercise, the Fifth Circuit resorted to multiple sources, including Black's Law Dictionary, the Oxford English Dictionary, Webster's Dictionary, other caselaw precedent, the Federal Reserve's open market operations and third-party industry sources such as the Loan Syndications and Trading Association (LSTA). See Id.

Ultimately, the Fifth Circuit rejected the definitions of "open market purchase" proposed by Serta and the Participating Lenders, as adopted by the Bankruptcy Court, concluding that Serta's definition overlooked the significance of the word "market" and noted that Serta's definition suggests that an open market purchase simply means acquiring something for value in competition among private parties. The Fifth Circuit emphasized that the term "open market" refers to a specific market, such as the stock market, commodities market or securities market, rather than a general context where private parties engage in non-coercive transactions with each other.

Similarly, according to the Fifth Circuit, the Participating Lenders' definition was also flawed as it suggests that an open market exists wherever there is competition, but the Fifth Circuit rejected that definition, finding instead that an open market is tied to a designated market, not merely "the background concept of free competition that characterizes much of modern American commerce."¹⁴

The Fifth Circuit rejected the expansive definition proposed by Serta and the Participating Lenders as being contrary to the well-settled contract interpretation principle that a term should not be assigned a meaning that would render other provisions superfluous or meaningless, and the definition proposed by Serta and the Participating Lenders would, according to the Fifth Circuit, do just that as it would mean that "open market purchase" encompasses any arm's length transaction, including by way of a "Dutch Auction," thus rendering the explicit Dutch Auction exception set forth in Section 9.05(g) of the 2016 Credit Agreement superfluous or meaningless.¹⁵

Accordingly, the Fifth Circuit concluded that "an open market purchase occurs on the specific market for the product that is being purchased" and because the product at issue was "first-lien debt issued under the 2016 Credit Agreement," the "market for that product is the 'secondary market' for syndicated loans." In addition, that "market is generally open to buyers and sellers, and its prices are set by competition."¹⁶ The First Circuit held that if Serta wished to make an open market purchase and circumvent the "sacred right" of ratable treatment, it should have purchased its loans on the secondary securities market. In choosing not to do so, the debt exchange at the heart of the 2020 Uptier Facility could not constitute a permitted "open market purchase" as the Bankruptcy Court had held, in error.¹⁷

Mitel Networks Decision

On the same day as issuance of the Serta decision, the New York Supreme Court's First Appellate Division (Mitel Court) ruled on a similarly structured uptier transaction undertaken by Mitel Networks (Mitel), reaching a different conclusion based on some distinguishing facts.¹⁸ In contrast to the 2016 Credit Agreement entered into by Serta, which hinged on the phrase "open market purchase" without further definition, the Mitel credit agreement provided that Mitel was permitted to "purchase" loans "at any time" as an exception to the prohibition on non-pro rata payments among lenders of the same class. The Mitel credit agreement did not have the "open market" qualifier, the importance of which was highlighted by the Fifth Circuit in Serta.

Ultimately, the Mitel Court held that there was nothing in the Mitel credit agreement to suggest a refinancing or exchange could not be a "purchase" and thus the cashless debt exchange involving some, but not all, of the lenders was permitted under the terms of the Mitel credit agreement. One could question whether the outcome would have been different had the Mitel credit agreement used the words "open market."

The Mitel Court also found that the debt exchange did not violate the "sacred rights" of the non-participating lenders because the Mitel credit agreement required consent of only those lenders "directly adversely affected" by a modification to the Mitel credit agreement and, according to the Mitel Court, the debt exchange by the participating lenders into superpriority debt, which subordinated the non-participating lenders, only "indirectly" affected the non-participating lenders.

More importantly, the Mitel Court found that, in any event, the debt exchange (i.e., participating lenders assigning their loans to the borrower, with loans were then canceled and replaced with new loans without any amendment to the Mitel credit agreement) was not in fact an agreement to waive, amend or modify the Mitel credit agreement, and thus the amendment rules around the sacred rights were not even implicated.

Non-Exhaustive List of Drafting Considerations for Uptier Protection

The widely varied outcomes on LTM cases, including the Serta and Mitel decisions, highlight the importance for minority lenders in ensuring that the facilities in which they participate have adequate protections that could include, depending on the nuances of the deal structure, the following in respect to uptier LMTs:

• Serta Protection: Push for broad "Serta protection" with as few qualifiers as possible.
• Priming Debt Restrictions: Limit to the extent possible the ability of the credit parties to incur debt senior in right of payment and/or lien except that which is specifically permitted under the credit agreement by the parties at closing.
• Waterfall Protection: Restrict changes to ratable treatment, order of payments, application of payments or any waterfall or similar provision to the extent possible.
• Buy-Back Mechanics: Include rules around buy-back mechanics (open market or "Dutch Auctions") and assignments to Loan Parties and their Subsidiaries to the extent possible. Some options might include:
  • lock it down as in effect on the closing date and make changes sacred
  • block usage during an Event of Default (EoD) unless waived by all lenders
  • require buyback or assignments to be in cash, not a debt exchange
  • offer buyback to all lenders with similar economics
  • prohibit transactions that subordinate some lenders in right of payment or security without their prior consent
  • prohibit assignments to loan parties and their subsidiaries and make this a sacred right
• Value Stripping Protection: If possible, include value stripping protections to backstop the above, as moving assets outside the credit group increases the likelihood of engineering LMTs with fewer restrictions.
• Market Acceptability: One or more of these protections might be acceptable, but circumstances vary, and it might be difficult to secure some or all of these protections in any particular transaction.

For more information on the above rulings or questions about a specific matter pertaining to your organization, please contact the authors.

Notes

¹ In re Serta Simmons Bedding, LLC, No. 23-20181, ___ F.4th, 2024 WL 5250365 (5th Cir. Dec. 31, 2024) (Opinion) (hereinafter cited as "Opinion at __").

² See, e.g., In re Robertshaw US Holding Corp., Case No. 24-90052 (CL) (S.D.T.X. Bankr. June 20, 2024) [Dkt. No. 351]; In re Wesco Aircraft Holdings, Inc., Case No. 23-90611 (MI) (S.D.T.X. Bankr. June 1, 2023), Adv. Proc. No. 23-03091.

³ Serta Simmons, 2023 WL 3855820, at **13-14.

⁴ See Excluded Lenders v. Serta Simmons Bedding, L.L.C., No. 23-90012 (5th Cir. April 26, 2023).

⁵ 2023 WL 3855820, at *14.

⁶ 2023 WL 3855820, at *12

⁷ The Objecting Lenders argued that the Chapter 11 plan could not be confirmed as by allowing the Participating Lenders' claim arising under the Indemnity contrary to sections 502(e)(1)(B) and 509(c) of the Bankruptcy Code. See In re Serta Simmons Bedding, LLC, 2023 WL 3855820 *10 (Bankr. S.D. Tex. June 6, 2023).The Objecting Lenders also argued that the plan violated the "absolute priority" rule embodied in Section 1129 of the Bankruptcy Code by providing for a $1.5 million payment to holders of equity interests while the Objecting Lenders' claims were not being paid in full. Id. The Bankruptcy Court ruled that the distribution to existing equity holders did not violate the absolute priority rule because Serta agreed to make the payment in exchange for "new value" in the form of a $54 million tax benefit held by equity. 2023 WL 3855820 , *11

⁸ Id. at *11.

⁹ See In re Serta Simmons Bedding, LLC, 2023 WL 3855820 (Bankr. S.D. Tex. June 6, 2023), notice of appeal filed, No. 23-90020 (Bankr. S.D. Tex. June 6, 2023), stay pending appeal denied, No. 23-90020 (Bankr. S.D. Tex. June 21, 2023), stay pending appeal denied, No. 4:23-cv-2173 (S.D. Tex. June 29, 2023), direct appeals certified, No. 23-90026 (5th Cir. Sept. 18, 2023).

¹⁰ The full Opinion is available on the Fifth Circuit's website.

¹¹ See Opinion at pp. 4-7.

¹² See Opinion at 9-1.

¹³This Holland & Knight alert focuses primarily on the Fifth Circuit's consideration of the merits of the parties' arguments before the Bankruptcy Court relating to the 2020 transaction. There are other aspects of the Opinion of importance to bankruptcy practitioners, generally, such as relating to the jurisdiction of the Bankruptcy Court to enter final orders in the Litigation as well as the appellate jurisdiction of the Fifth Circuit, and the claims relating to the indemnity that are beyond the scope of this alert.

¹⁴ See Opinion at 31-32.

¹⁵ See Opinion at 33.

¹⁶ See Opinion at 38.

¹⁷ See Opinion at 29-32

¹⁸ Ocean Trails CLO VII v. MLN Topco Ltd., Case No. 2024-00169 (N.Y. App. Div., 1st Dep't, Dec. 31, 2024).

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.