Serta and Mitel: Fourth Quarter Rulings Bring Updates on Uptier Transactions

The year 2024 saw several high profile judicial decisions regarding the ongoing viability of uptier exchanges and similar transactions.

At the federal level, the Fifth Circuit in a case involving Serta Simmons Bedding, L.L.C. (“Serta”),[1] and Judge Marvin Isgur from the U.S. Bankruptcy Court for the Southern District of Texas in Wesco/Incora, each issued rulings narrowly construing debt documents and appearing to halt the prior trend of courts supporting uptier transactions.

On the same day the Serta Decision was issued, the New York State Supreme Court (Appellate Division, First Department) issued a decision upholding a similar but distinguishable uptier transaction by Mitel Networks (International) Limited and related entities (“Mitel”).[2] Each decision pays particular attention to the specific language in the underlying debt documents as well as the mechanics of the transaction. These decisions suggest that the ultimate viability of any uptier transaction is reliant on the language of the governing documents as well as the structure and mechanics of the restructured deal rather than judicial tolerance.

Uptier Transactions

An uptier transaction at its core involves the amendment of credit or debt facility by a borrower and certain of its financial creditors to allow the issuance of new super-priority debt. As the Serta Decision describes, “[b]ecause a majority of lenders in the existing facility must typically consent to such an amendment, the borrower purchases consent by allowing these lenders to exchange their existing debt for new super-priority debt, often at an above-market price.”[3] In an uptier, the borrower only needs a majority as opposed to unanimous consent to complete the transaction. This allows the borrower to play groups of creditors off of each other and avoid dealing with holdouts.

Additionally, the borrower may be able to obtain additional financing, while often decreasing its overall liabilities. Participating lenders or debt holders seek to improve their position by exchanging (now) junior debt for more senior debt “which is advantageous in bankruptcy where debt claims are often resolved by seniority.”[4] The primary controversy of uptier transactions is that the costs of the transaction “are born entirely by the minority lenders, who end up with subordinated debt worth less than before.”[5]

Serta Decision

In 2020, Serta entered into an uptier exchange with a majority of its first- and second-lien lenders to issue more than $1 billion in new super-priority loans. This was accomplished by Serta buying back debt from certain participating lenders (the “Prevailing Lenders" on a non-pro-rata basis through an allegedly “open-market” purchase (the “Serta Uptier”). The operative credit agreement at the time of the Serta Uptier (the “2016 Credit Agreement”) required pro rata distributions to lenders in the same class with certain exceptions.[6] The first exception was a Dutch auction open to all lenders on specific terms set forth in the agreement. The second exception permitted a lender to choose to assign or sell its rights under the 2016 Credit Agreement to Serta or its affiliates through an open market purchase. The phrase “open market purchase” was undefined in the 2016 Credit Agreement.

The Serta Uptier involved the Prevailing Lenders funding $200 million of new money and receiving new first-out super-priority debt. Additionally, these same Prevailing Lenders exchanged on a cash-free basis $1.2 billion of their existing first- and second-lien loans for approximately $875 million in second-out, super-priority debt. Each of these new forms of debt ranked senior in priority to the approximately $1 billion of first-lien and second-lien term loans that remained under the 2016 Credit Agreement.

Shortly after closing the Serta Uptier, the borrower and the Prevailing Lenders: (a) amended the 2016 Credit Agreement to permit the Serta Uptier; (b) labeled the Serta Uptier an “open market purchase”[7]; and (c) agreed that Serta would indemnify the Prevailing Lenders for future litigation regarding the Serta Uptier.

Lenders that were not chosen to participate in the Serta Uptier (the “Excluded Lenders”) brought suit in the Southern District of New York[8] arguing that the Serta Uptier was not an “open market purchase” as contemplated by the 2016 Credit Agreement. If correct, the terms of the Serta Uptier would need to be provided to all Lenders under the agreement, not just the Prevailing Lenders.

Before final adjudication of these claims, Serta and certain of its affiliates filed voluntary petitions for Chapter 11 in the U.S. Bankruptcy Court for the Southern District of Texas in early 2023. Serta, along with certain Prevailing Lenders, filed an adversary proceeding seeking declaratory judgment that the Serta Uptier had not violated the 2016 Credit Agreement. The Excluded Lenders brought breach of contract counterclaims for potential violations of the 2016 Credit Agreement.

The Bankruptcy Court ruled in favor of Serta and upheld the Serta Uptier, finding that the 2016 Credit Agreement provided Serta a great deal of flexibility to enter into liability management transactions under the “open market purchase” provision and that such provision did not require an exchange such as the Serta Uptier to be made equally available to all similarly situated lenders. The Fifth Circuit permitted direct appeal by the Excluded Lenders of the order granting partial summary judgment in favor of Serta.

While the appeal was pending, the Bankruptcy Court confirmed a plan of reorganization over the objection of the Excluded Lenders. In doing so, the Bankruptcy Court held that "based on the overwhelming evidence adduced at trial, the [Serta 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." The Bankruptcy Court went on to hold that "the 2020 [Serta Uptier] Transaction is binding and enforceable in all respects," and entered an order confirming the Chapter 11 plan on June 6, 2023.[9]

The Fifth Circuit decision opens with a recitation of certain principles of corporate finance: “[r]atable treatment is an important background norm of corporate finance. Pursuant to this norm, a borrower must treat all of its similarly situated lenders, well, similarly.”[10] Ratable treatment is such an important norm that it is often described as a lender’s “sacred right” under syndicated loan agreements.[11]

The Serta Decision concludes that the Serta Uptier does not constitute an “open market purchase” under the 2016 Credit Agreement, reversing the Bankruptcy Court. The Fifth Circuit reasoned that “an open market purchase is a purchase of corporate debt that occurs on the secondary market for syndicated loans.”[12] The Fifth Circuit was not persuaded that open markets exist wherever there is competition, but rather that that phrase “open market” necessarily meant that the relevant transaction had to occur on the appropriately designated market for such type of transaction. All possible permitted buyers must have a chance to interact with the sellers, not just a preselected few. “In this case, the relevant product is first-lien debt issued under the 2016 Agreement, and the market for that product is the ‘secondary market’ for syndicated loans.”[13] In light of this ruling, the Fifth Circuit also held that the Excluded Lenders’ counterclaims for breach of contract against the Serta debtors and the Participating Lenders may be viable and remanded such claims to the Bankruptcy Court for further consideration.

Mitel

On the same day as the Serta Decision, the Mitel Decision was entered in the Appellate Division of New York State Court reversing the trial court’s decision to deny motions to dismiss two challenges to a 2022 uptier transaction entered into by Mitel (the “Mitel Uptier”). The Mitel Uptier is similarly structured to the Serta Uptier, including certain cashless exchanges of securities for new super-priority debt.

The relevant exchange in Mitel, however, did not turn on the phrase “open market purchase” but rather whether the company was allowed to “purchase” loans “at any time” in a manner that would permit non-pro-rata payments to lenders in the same class. Section 9.04 of the relevant credit agreement “authorizes the borrower to ‘purchase by way of assignment and become an Assignee with respect to Term Loans at any time.’”[14] Such purchases did not have to be made pro rata, but rather just to the lender tendering its debt.

In the Mitel Decision the court reasoned that nothing in the relevant agreements would suggest that an exchange or refinancing of debt could not be a “purchase” under Section 9.04. Therefore, the debt exchanges that involved only certain lenders, while excluding others, were permitted under the credit agreement. In addition, the Mitel court found that Mitel Uptier did not violate Section 9.08(b)(1) of the credit agreement, which protects sacred rights provisions because such section “only requires the consent of ‘each Lender directly adversely affected’ by a change in loan terms.’”[15] The court reasoned that the exchange of the debt by the participating lenders into super-priority debt, which subordinated the non-participating lenders, only “indirectly” affected such non-participating lenders.

Additionally, the Mitel court took the view that none of the uptier-related amendments actually “waived,” “amended,” or “modified” the terms of the original loans. Instead, the “the participating lenders’ loans were assigned back to the borrower, cancelled, and then replaced with new loans with their own, new terms.”[16]

Conclusion

The Serta Decision, which was widely anticipated, and provides a strong rebuke to the underlying uptier, may signal a reversal in the recent judicial trend of approving uptier transactions. The decision warns that relying on contractual exceptions to the norm of ratable treatment “will often not justify an uptier.”[17] In the same line, however, the court articulates that every contract should be scrutinized on its own terms.

The Mitel Decision, issued on the same day, did exactly that and applied the contractual exceptions to pro rata distributions found in the governing documents. Until such time as a broader judicial consensus on uptier transactions emerges, each transaction’s viability is likely to depend on the specific language of the applicable documents—as well as the relevant secondary sources used when contract language is deemed ambiguous by courts.

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[1] In re Serta Simmons Bedding, L.L.C., No. 23-20181, 2024 WL 5250365 (5th Cir. Dec. 31, 2024) (the “Serta Decision”).

[2] Ocean Trails CLO VII v. MLN Topco Ltd., Case No. 2024-00169, 2024 WL 5248898 (N.Y. App. Div., 1st Dep't, Dec. 31, 2024) (the “Mitel Decision”).

[3] Serta Decision at 5.

[4] Id.

[5] Id.

[6] The pro rata distribution provisions of the 2016 Credit Agreement were “sacred rights” under the agreement. Accordingly, any amendment that would alter the pro rata sharing requirement would need to be authorized by all lenders affected thereby, not just a simple majority.

[7] Open Market Purchases are one of the two express exceptions to the pro-rata sharing provision in the 2016 Credit Agreement.

[8] See LCM XXII Ltd. v. Serta Simmons Bedding, LLC, No. 21-03987, 2022 WL 953109 (S.D.N.Y. Mar. 29, 2022)

[9] In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820 at * 13–14 (Bankr. S.D. Tex. June 6, 2023)

[10] Serta Decision at 4.

[11] Id.

[12] Id. at 29.

[13] Id. at 31.

[14] Mitel Decision 2–3.

[15] Mitel Decision at 2.

[16] Id.

[17] Serta Decision at 54.