Serta Simmons Uptier: Implications

We now have the first major Court of Appeals decision on a liability management transaction. On the last day of 2024, Judge Andy Oldham of the 5th Circuit issued a very thoughtful and thorough opinion regarding the Serta Simmons uptier transaction and subsequent bankruptcy plan. (I have fond memories of Andy looking like a deer in the headlights on the 1st day of 1L Contracts when he was asked "What's an assumpsit?" by a certain former co-blogger...) Although the opinion is an important punctuation point, I don't think it will itself fundamentally change the use of liability management transactions; there's really little downside from pursuing them and potentially plenty of upside.

 

The tl;dr story is that in 2020 Serta undertook a non-pro-rata uptier exchange transactions:  Serta teamed up with a subset of the lenders under its 2016 Financing Agreements to undertake an exchange offer:  the favored lenders amended the covenants on their holdings of 1st and 2nd lien debt under the 2016 Financing Agreements and then exchanged their holdings for new super-priority debt (enabled by the covenant amendments) that jumped ahead of the other lenders under the 2016 Financing Agreements, who were not even offered the exchange. The 2016 Financing Agreements had ratable sharing provisions, but the exchange was supposedly authorized by an “open market purchase” exception.  Serta and the favored lenders ended up in litigation with the excluded lenders and a bankruptcy followed. In the bankruptcy Judge David R. Jones (yes, that one) of Bankr. SDTX ruled that the exchange was authorized as an “open market purchase,” and he confirmed Serta’s reorganization plan that was premised on the validity of the exchange. The 5th Circuit, taking the case on direct appeal, reversed, sensibly holding that the transaction was not an “open market purchase.” 

The decision is the first Court of Appeals ruling on a LMT. Although the 5th Circuit slapped down the Serta up tier, I don’t think the opinion itself marks the end of liability management transactions.  The opinion is based on the contractual language of the financing agreements, namely what an “open market purchase” means.  It is not an opinion holding that the transaction violated the implied covenant of good faith and fair dealing or that it was a fraudulent transfer.  That’s a narrower opinion that could have resulted; it is cabined to the specific contractual language at issue, namely whether an exchange that is not offered to all holders is an “open market” exchange.  The 5th Circuit probably killed off “open-market purchase” uptier exchanges, but that’s only one flavor of LMT.  The opinion does not affect all of the other types of LMTs we’ve seen:  drop-downs (like JCrew or Chewy), Sale-Leasebacks (Windstream), Double Dips/Pari Plus (like At Home or Wheel Pros or Sabre), and uptiers that do not hinge on “open market repurchase” language (e.g., Robertshaw, Wesco/Incora, TriMark).  We’re going to continue to see fights over those types of transactions.  

The more interesting part of the 5th Circuit’s ruling—and the one that I think actually has the more far-reaching implications—is the ruling on the indemnification of the participating lenders.  Serta originally indemnified the lenders that participated in the uptier. In the face of objections in bankruptcy, it altered the indemnity, so that it indemnified all members of classes 3 and 4, regardless of whether they were participating lenders.  Some excluded lenders objected on the basis of this constituting unequal treatment in violation of section 1123(a)(4)—the indemnity was only of value to some class members, not to all, so there was really a greater payment made to class members who were participating lenders.  The 5th Circuit agreed, holding that what mattered was equality of result, not equality of opportunity.  That’s a ruling that will complication any indemnification of participating lenders in uptiers. It’s also a ruling that has much broader implications. Consider, for example, whether it is permissible to pay something extra to RSA signatories now in the 5th Circuit. Perhaps if the extra is small enough, but otherwise they will need to be separately classified to get different treatment (and that could raise both classification issues and 1129(b)(1) unfair discrimination issues).  More broadly, the 5th Circuit’s ruling on equal treatment strongly signals that it is willing to look to the economic reality underlying transactions and that it has gotten the message from the Supreme Court in Jevic, and is not going to tolerate transactions that have the effect of end-running the Code’s priority provisions.  That’s the part of the ruling that should be causing some concern for the LMT business.  

 

But the truth is that other than for open market purchase transactions, there’s still really no reason not to do an LMT. The debtor might get some more runway (although with some distraction) and any participating lenders (if an uptier) get a jump up on the others. There's no real downside. In this regard, LMTs have the same calculus as any fraudulent transfer:  grab the value and then let the other guy litigate. Worst case scenario is generally that you settle and return just part of the value.  You might not be able to grab 100%, but if you can grab 70%, why wouldn’t you do so? The problem here is a failure of remedies:  when the remedy is rescission or even contract expectancy damages, there just isn't an incentive against undertaking aggressive transactions. Until the remedy for fraudulent transfers is reformed, we're going to continue to see LMTs and other aggressive transactions.