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Welcome to the 111th Pari Passu newsletter.

Today, we are talking about a name that nearly everyone knows in restructuring: Serta Simmons. This company paved the way for companies to pursue a new avenue of restructuring via liability management restructuring, namely, uptiers. In a revolutionary move in 2020, a group of Serta’s lenders (the participating lenders) engaged in this uptier maneuver. This move was heavily contested by the group of lenders (known as the non-participating lenders) who were not offered the opportunity to participate in this restructuring. 

In 2023, Serta Simmons filed for Chapter 11 bankruptcy, where the approved plan of reorganization had features that benefited the participating lenders while hurting the non-participating lenders (i.e., the plan of reorganization upheld the 2020 tier as a valid transaction). However, at the start of 2025, the United States Court of Appeals for the 5th Circuit held that the uptier transaction was a violation of the credit agreement (i.e., the 2020 uptier was not a valid transaction), sending shockwaves through the restructuring community as this case sets a precedent for many companies who have engaged in uptier transactions in recent years.

Note: This paper is not meant to dive into the history of Serta Simmons / the 2020 Uptier, given the widespread discussion of the case already available in the media. Rather, we are looking at the recent ruling and the implications on liability management transactions.

Table of Contents

• The 2020 Transaction

• Permissibility and Litigation

• Indemnification of Uptier Litigation

• 5th Circuit Review

• Credit Language and LME Implications

The 2020 Transaction

To fully understand the uptier transaction, we have to go back to 2016 where the first and second lien debt tranches were created. In 2016, Serta Simmons refinanced their debt, where the company issued $1.95bn of 1L debt and $450mm of 2L debt (by the time of the transaction, these amounts decreased to approximately $1.8bn and $420mm as they were paid down). Serta Simmons's financials deteriorated over the next four years after the refinancing. As the effects of the COVID-19 pandemic were beginning to set in, the company needed to engage in a restructuring. The company chose an uptier transaction involving the participating lenders from the first and second lien tranches [1].

As a brief review, a few key elements allow an uptier to be effectuated. Fundamentally, an uptier transaction occurs when a company incurs additional, super senior secured debt that sits senior to any pre-existing secured debt in the capital structure. Most credit documents restrict a company's ability to raise debt, often requiring its lenders' unanimous consent to permit the capital raise. This makes it very difficult for a company, especially a distressed company, to raise new capital, as lenders only want to provide capital if they can come in at the top of the capital structure. Thus, in an uptier transaction, a company will amend the underlying credit documents to permit the incurrence of new super senior debt (this amendment only requires majority consent of lenders) [6]. As seen in Figure 1, an uptier transaction features at least two tranches. The first is a new money tranche, which will sit at the top of the capital structure. The second is the existing debt tranche. The participating lenders typically exchange their debt at a discount for new debt. In exchange for this, participating lenders now sit right below the new money tranche of debt [6]. For the non-participating lenders, they are effectively pushed down to the bottom of the capital structure. Thus, it is very lucrative for creditors to be a part of the participating group (which, as we will discuss with Serta, is not always an option) [6]. 

Looking at Serta, Figure 2 below depicts the capital structure before and after the uptier transaction. The uptier saw the creation of three new tranches of debt: a First Out Tranche, a Second Out Tranche, and a Third Out Tranche (this tranche is not depicted as it was unused at the time of filing, i.e, no debt outstanding). The Participating Lenders consisted of Eaton and Invesco, among other creditors, and the Non-Participating Lenders consisted of Apollo and Angelo Gordon, among other creditors. Under the proposed uptier, Eaton would provide $200mm in new money for the First Out tranche. The Second Out tranche consisted of exchanged debt, where the 1L debt for participating lenders would be exchanged at 74 cents, while the 2L debt for participating lenders would be exchanged at 39 cents [1],[2]. 

Permissibility and Litigation Surrounding the Uptier Transaction

A key concept surrounding uptier transactions is the concept of pro-rata sharing. If a company were to offer an uptier that was available to all lenders (i.e, the non-participating lenders were non-participating by choice), there would be no issues with the transaction. Pro-Rata Sharing means that all recoveries / payments should be made available and equal to all lenders in a class of debt. While Pro-Rata uptiers exist (an example is Shuttefly’s pro-rata uptier in May 2023), it is less common because of the difficulties in getting the required voting class. To effectuate an uptier, a majority of creditors (who are offered the uptier) have to consent / participate in the transaction. Thus, it is easier to get a majority of votes if you can control who is voting (i.e., non pro-rata).

Per Section 2.18 of the 2016 Credit Agreement [1], 

In addition to this section, the credit document required that any changes to the pro-rata sharing provisions would require unanimous approval. What this means for non pro-rata uptiers is that, for a company to only offer the uptier to select lenders, they would first need all lenders to agree to remove the pro-rata sharing provision that would require all creditors to be treated equal. 

However, in Section 9.05(g), the 2016 Credit Agreement outlined two exceptions for the pro-rata sharing provisions [1].

As seen from the excerpt above, the two exceptions are 1) Dutch Auctions and 2) Open Market Purchases. More simply put, this exception is saying if either a Dutch Auction or Open Market Purchase is used when a company repurchases debt, the company does not have to offer the repurchase to all holders of said debt - this means a non pro-rata purchase is possible.

In today’s paper, we will only focus on open-market purchases as that is the exception the Participating Lenders argued allowed for a non pro-rata uptier to be effectuated. The reason the open market purchase was used in the case of Serta was because of the ambiguity surrounding the definition of an open market purchase, as the credit documents never provided a specific definition or interpretation of this term. Generally, an open market purchase is when a company purchases credit in an open market, like the secondary bond market. In an uptier transaction, the company uses an open market purchase when deciding whose debt to repurchase. The participating lenders argued that if the company and creditors intended for open market purchases to be available to all lenders, it would have explicitly stated that, and thus, a company could purchase select lenders' debt on the open market [1].

The non pro-rata transaction was proposed mid-2020, and as you would imagine, the non-participating lenders immediately challenged the transaction's validity from this open-market repurchase on June 11, 2020. Specifically, Apollo challenged two main parts of the transaction. First, they argued the uptier “effectively” stripped the collateral securing the non-participating lender’s debt. Secondly, Apollo argued that participating lender’s use of open market purchases did not fit the ‘conventional’ definition. Both these arguments can be seen in Figure 3 and 4 below.

Judge Andrea Masley of the New York State Supreme Court was presiding over the non-participating lenders' claims. However, Judge Masley immediately dismissed this argument in mid 2020 because no collateral had been stripped - all that was changed was that more senior pieces of debt were issued/created. Even if this new issuance put the non-participating lenders out of the money in a liquidation or bankruptcy, the transaction could not be reversed unless an actual violation of rights had occurred (such as actually stripping collateral) [1],[2]. Additionally, Judge Masley stated that it was not the place of the court to make a judgment on what open market purchases consist of, as the term on its own is too ambiguous (we will touch on this more in our bankruptcy analysis section).

While Apollo initially dropped their claims after Judge Masley’s decision, it appeared as though they were waiting to relaunch their litigation (which as we will discuss below, occurred when Serta Simmons filed for bankruptcy). The primary reason for Apollo’s decision to ‘pause’ their litigation is because, given that Serta was the first iteration of a non pro-rata uptier, Judge Masley had no precedent to rely on in her decision. Thus, Apollo waited to relaunch their investigation as they wanted to wait and see how other non pro-rata uptiers occurred and if they were litigated as well (and of course, given the novelty of the transaction, Apollo very well may have wanted to keep the door open for them to use the transaction themselves in the future for another company in their portfolio).

Bankruptcy and Indemnification of Uptier Litigation

Despite completing the uptier transaction, Serta Simmons struggled to turn around their business and filed for Chapter 11 bankruptcy in January 2023. With this filing, Serta had a restructuring support agreement that proposed a debt reduction from approximately $1,900mm (approximately 200mm of the $2,100mm of debt from the uptier was paid down) to $315mm [1].

Notably, the participating lenders requested summary judgment on all litigations regarding the 2020 uptier transaction on the second bankruptcy day. The summary judgment would halt all litigation regarding the validity of the uptier transaction, so the participating lenders requested it to prevent the non-participating lenders from relaunching their litigation for the uptier transaction, which would alter recoveries in bankruptcy proceedings drastically. The presiding judge over this case was Judge Jones, who ultimately granted the participating lenders' request for summary judgment. As we will talk about in the next section, we will refer to this as the indemnification of litigation claims. Although the restructuring support agreement was slightly altered from the proposed restructuring agreement pre-filing, the vast majority stayed intact, with plan recoveries outlined below [2]:

• First Out Claims: Pro-rata share of the New Term Loans post-reorganization (size of the New Term Loan is $315mm)

• Second Out Claims: 100% of post-reorganization equity, subject to dilution

• Non-Participating 1L and 2L Lenders: Pro-rata share of 1% of post-reorg equity.

Before the plan was finally approved, the non-participating lenders filed an appeal in the 5th Circuit Court of Appeals to Judge Jones' ruling. However, this filing did not alter Judge Jones' stance that the uptier was a valid transaction, and Serta Simmons exited bankruptcy in June 2023 [3].

5th Circuit Review

The 54-page review from the fifth circuit included a detailed analysis of why the uptier transaction should not stand. Below, we will highlight parts of this analysis and add our stance on the situation, whether or not the fifth circuit reached the 'right' judgment, and what the implications of this decision are.

When the non-participating lenders initially challenged the uptier transaction in 2020, Judge Masley ultimately ruled that the term open-market purchase was so ambiguous in the 2016 credit document that it was neither fair nor the place for a court to decide what open-market purchases constitute (see Figures 3 and 4 above). When the non-participating lenders challenged the indemnification request in bankruptcy courts, Judge Jones took a polar opposite stance, stating that it was incredibly clear that an open market purchase could be used in this manner (see Figure 5 below). The non-participating lenders are responsible for ensuring actions like this would not occur when the credit document was initially created. 

The 5th Circuit of Appeals has now taken a third stance, stating that it is clear that the uptier transaction did not constitute an open market purchase within the meaning of the 2016 credit agreement, as seen in Figure 6 below. [1].

The crux of the argument from the fifth circuit that the company did not engage in an open market repurchase relies on the notion that Serta Simmons engaged in an open purchase, not an open market purchase. The participating lenders tried to argue that an open market purchase occurs when there is a transaction between two parties, where something is obtained for monetary value. However, the court challenged this, stating the participating lenders definition better fits an open purchase. For it to be an open market purchase, the transaction must occur on an established market, such as the stock exchange or secondary bond market. Specifically, they referenced an example from the Federal Reserve to demonstrate this point [1]. The Federal Reserve continually engages in open market purchases/sales by making these transactions on the securities market (a defined market rather than a vague environment defined by the interactions between two parties) [1].

Earlier in this paper, we mentioned that one of the key arguments the participating lenders had in support of the uptier was that the credit document did not explicitly state that an open market purchase had to be available to all lenders. In bankruptcy court, Judge Jones took the 'silence' on the matter / the exclusion of the 'available to all lenders' portion as an explicit removal [1],[2],[3]. However, the fifth circuit took the opposite stance, stating that the statement 'available to all lenders' portion is implied. Specifically, the fifth circuit held that "open" inherently implies that everyone is treated equally and has an opportunity to sell/purchase securities (see Figure 7 below).

The fifth circuit also rejected the counterargument that because the non-participating lenders provided their liability management transaction, they should have been aware of the consequences. Before the participating lenders offered their non pro-rata uptier to Serta Simmons in 2020, some of the non-participating lenders offered a drop-down transaction, another form of liability management transaction which would have likely required a similar interpretation of an open market purchase. The argument from the participating lenders was rejected by the 5th Circuit, however, because even if some of the non-participating lenders knew about the implications / interpretations of the credit document, not all of the non-participating lenders were involved in the alternative restructuring proposal [1]. Although we cannot say with certainty, if all of the non-participating lenders were to have been involved in the alternative restructuring proposal, it is possible that the 5th circuit would be unable to reject this counterargument. Fascinating. 

In our opinion, this is the aspect of the ruling that the court got ‘most’ correct. Like we just mentioned, the participating lenders would indeed have a valid argument supporting the validity of their uptier transaction (as the non-participating lenders in theory all would have had a similar interpretation as the participating lenders of the term ‘open market purchases’). However, not all of the non-participating lenders participated in their restructuring proposal, meaning not all creditors would have equally known about the implications of the term ‘open market purchase’. It is not the job of a court to make a ruling based on what creditors 'should' have known. All a court can do is look at the facts of the situation. In this case, certain creditors were not directly made aware/involved with the open market purchase provision and the varied interpretations of it.

With the fifth circuit establishing that the open market purchase was incorrectly interpreted (and thus, the 2020 uptier transaction was invalid and a violation of the credit agreement), it concluded that the Plan Indemnity was not allowed [1],[4]. As a reminder, this indemnification was in favor of the participating lenders, where the lenders agreed to equitize part of the outstanding secured claims in exchange for indemnification for the reorganized debtors for any liability regarding the 2020 transaction. Ultimately, the 5th Circuit of Appeals ruled that the only viable option was to excise the indemnification and reverse the bankruptcy court's approval of the reorganization plan concerning the indemnification of the 2020 uptier transaction [4]. Going forward from here, the reorganization plan will still stand, but any damages / lost claims that the non-participating group would have had if they were treated pari passu with the participating lenders will be owed directly from the participating groups recoveries.

As we have stated above, there were aspects of the ruling that the fifth circuit was correct in making (namely, the decision about the open market purchases). However, one overlooked consideration was that even after the Serta Transaction, the credit market has continued to see a steady, if not increasing, usage of these transactions. This increase occurred even though companies had an option to intentionally tighten credit documents to prevent uptier transactions by occuring. This is colloquially known as ‘Serta Blockers’, and it would require that the consent of all affected creditors is needed for amendments that would have the effect of subordinating certain claims (effectively blocking non pro-rata uptiers).

While the appeals court opinion mentioned that industry usage is not an indicator of the law that must be upheld, we must ask ourselves whether the Fifth Circuit of Appeals is the right court to make that decision in the first place. The 5th circuit, or any court outside of the bankruptcy court, does not necessarily have the requisite expertise, nor continually follows the restructuring landscape, arguably leading them to not be able to make the most informed decision when compared to the bankruptcy court judges. Restructuring is an evolving landscape, especially in recent years, and the commonplace usage of this transaction structure/interpretation of open market purchases undoubtedly should have been accounted for when evaluating a term that is ambiguous on its own. 

Credit Language and LME Implications

Regardless of our opinions of this decision, the implications of this ruling will be drastic for future bankruptcy cases that feature a company that previously engaged in an uptier restructuring. It is likely that other companies that used a non pro-rata uptier will have their claims challenged, as negatively affected lenders will look to claw back whatever value they can get. Uptiers are likely to be incredibly scrutinized in bankruptcy courts with this precedent set, with new definitions being laid out for terms like open market purchases [5].

Going forward, there are many impacts that this deal will have on the ability of liability management transactions to be consummated. However, one key question you may have is, can we expect to see LMT's continue to be in 2025? While we cannot predict the future, we can make a strong estimate that we will see much of the same activity that we saw in 2024, albeit with a slight decline in uptier transactions. We hold this belief for a few reasons.

Earlier in this paper, we mentioned a key argument the participating lenders held in support of non pro-rata uptier’s was that, even after the creation of Serta Blockers, companies continued to use the uptier transaction and did not include Serta Blockers in the respective credit agreements. Although this was done when uptier transactions were viewed as ‘acceptable’, we have to ask ourselves: does the ruling fundamentally change the perspective that creditors have? It is true that creditors will realize that the open market purchase will be unsuccessful in a non pro-rata transaction, but given creditor’s willingness to avoid adding in Serta Blockers after Serta’s 2020 uptier, it is reasonable to assume that they may amend the credit documents to allow uptiers to occur without any opportunity of contention. There are two main ways that these amendments can take forms: with respect to open market purchases and dutch auctions.

Looking at the first, we know the reason that Serta’s uptier transaction failed was because there was too much ambiguity surrounding the term, open market purchase, and it's true definition was subject to the judge presiding over the case (we got 3 different perspectives from 3 judges alone!). However, we anticipate that creditors will circumvent the 5th circuit's ruling by simply being more specific about what open market purchases actually are and how they work in a pro rata sharing exemption. Admittedly, the company who seeks to incorporate a more specific meaning of open market purchases would need significant bargaining power over creditors [8].

Another option, that is more likely to occur than the aforementioned changes to open market purchases, is the increased usage of Dutch Auctions to create non-pro rata uptiers. As a quick reminder, a Dutch auction is a method used to buy back debt where lenders bid the price at which they are willing to sell their loans. The borrower typically buys back the debt starting from the lowest price offered until the target amount is reached. While we did not focus on this in this paper, Dutch Auctions are currently being used to create non pro rata uptiers by offering the debt exchange to all lenders (that way a company is not subject to litigation surrounding pro rata sharing provisions), but offering certain incentives with regards to the Dutch Auction to certain lenders (effectively creating a non-pro rata exchange) [8]. These incentives come in the form of backstopping fees, which are fees creditors can get for guaranteeing that they will provide a certain amount of money in a capital raise or exchange. The company does not have to provide the ability to backstop to all lenders [8].

Another reason for why liability management transactions will be used in 2025 is because, as we have discussed in length in a variety of other Pari Passu articles, non-pro rata uptiers are not the only form of liability management transactions. Companies can still use pro-rata uptiers, drop-downs, double-dips, and pari-plus transactions in the future. Regardless of what transaction is used and how frequent we see them in 2025, it is undeniable that the 5th circuit’s ruling has delivered a massive shockwave through the restructuring community, and only time will tell what the true implications of this will be.

Sources: [1],[2],[3],[4],[5],[6],[7],[8]

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