I. OVERVIEW OF LIABILITY MANAGEMENT TRANSACTIONS

A.    Bankruptcy Process Overview

Liability management transactions are just one component of the wider American bankruptcy system. The standard resolution method for companies that are in distress and cannot pay back their debts is to seek protection from the courts by filing for bankruptcy. The now-bankrupt company—protecting itself against creditors—generally files under one of two types of bankruptcy stipulated under the United States Bankruptcy Code: Chapter 7 or Chapter 11.

Chapter 7 bankruptcy, informally referred to as “liquidation bankruptcy,” refers to when a company sees no viable path for future solvency and seeks to unwind its business by selling its assets to repay creditors. Because Chapter 7 involves the formalized dissolution of the business, it is considered a quicker and more straightforward process than its counterpart.

Chapter 11 bankruptcy is known as “reorganization bankruptcy.” It is used when a company is temporarily unable to pay its debts but believes it can attain financial solvency. In this scenario, the company will work with its creditors to restructure both its operations and financial profile to eventually return to a semblance of normalcy.

When a corporation formally files for bankruptcy under Chapter 11, its creditors are grouped into classes depending on the nature of their debt. For example, creditors that hold secured debt—debt collateralized by a specific asset of the company—are grouped and can vote collectively as a class. If this class of creditors is negatively affected or “impaired” by the reorganization plan and both a majority of individual creditors representing over two-thirds of the dollar amount loaned vote in favor of the plan and those with a majority by loan value, the plan is accepted.

To explain via a simple example, let’s say there is a class of lenders composed of three lenders who loaned $100 to a company; Lender A lent $40, Lender B lent $40, and Lender C lent $20. If the company they loaned the money to declares bankruptcy and cannot pay back the full $100 to these creditors, they are considered impaired. For this class to approve a bankruptcy plan, two of the three creditors representing at least $66.66 of the total loan amount must agree to any reorganization plan.

If there are multiple classes of creditors, all impaired classes need to assent to the reorganization plan for a straightforward acceptance. However, if some classes don’t accept the plan, companies can use a “cramdown” mechanism, which is an appeal to the court to force the rejecting classes to accept the plan.

While the votes of each class are treated equally, the actual repayment of the outstanding loans follows their place of seniority in the capital structure. For example, creditors in the second-lien class are not entitled to repayment until the first-lien class has been paid in full. Therefore, it is in the interest of lenders to be as high as possible in the capital structure to maximize the likelihood of repayment.

This presents a major dilemma for creditors lower in the capital structure. In many Chapter 11 bankruptcy proceedings, they will receive only a fraction of what they loaned to the company due to the priority of claims ahead of them. 

That is why many creditors and companies have turned to nonstandard bankruptcy resolution methods, commonly called out-of-court restructurings. Out-of-court restructurings have a number of advantages: they are faster, more flexible, and more discreet than formal Chapter 11 proceedings.

Liability management transactions (LMTs) have emerged within the spectrum of out-of-court restructurings. LMTS are used as preemptive measures by creditors concerned about being shortchanged in the Chapter 11 proceedings to stave off significant losses. LMTs are considered aggressive maneuvers, and they have been utilized when certain creditors view the impending bankruptcy as a zero-sum game or to gain an advantage in the restructuring discussions.

B.    Common LMT Structures

As the strategy has grown since its adoption, it has taken on a number of different forms and structures. There are a number of tried-and-true LMT structures:

1. Double Dip: A “double dip” is when a company creates a non-guarantor subsidiary to access additional loans from creditors who want a higher place in the capital structure. A group of creditors will then lend money to this new entity, which then loans the funds back to the parent company. This structure creates two claims for a creditor: one under the previous debt and another through the new non-guarantor subsidiary. A notable example of a double dip occurred in 2023 with Wheel Pros, an aftermarket wheels distributor. Wheel Pros, along with 70% of its first-lien creditors, issued a new loan directly to the company while also issuing more loans through a restricted subsidiary, which transmitted it via an intercompany loan back to Wheel Pros. The combination of these two new instruments gave those creditors a bigger seat at the top of the capital structure.

2. Drop-Down: In a drop-down transaction, a parent company will typically place an asset into an “unrestricted subsidiary.” Like a non-guarantor subsidiary, it is placed outside the company’s guarantees, but it has the added advantage of also being exempt from the parent company’s loan covenants. This new entity can then issue debt which is beholden just to the creditors who engage in the LMT, leaving a smaller asset base to the rest of the creditors. A famous example of a drop-down transaction took place in 2016 when J. Crew “dropped down” IP assets into an unrestricted subsidiary and issued new loans against the new entity.

3. Uptier: As mentioned before, this structure was notably used by Serta Simmons. In one form of an uptier transaction, a creditor or group of creditors will issue new debt to the distressed company in exchange for their existing debt being elevated to a superpriority status in the capital structure. In such a scenario, they would be first in line to receive repayment in event of any reorganization, cutting the line and leaving existing creditors in a significantly worse position. 

The growth in use of LMTs has spawned a whole universe of derivative and hybrid structures, with creditors and debtors alike adapting these basic frameworks to their specific needs. As concern grows about booking significant losses in a traditional Chapter 11 bankruptcy proceeding, LMTs are an increasingly utilized part of restructuring toolkits.

II. SERTA SIMMONS BEDDING SITUATION OVERVIEW

Illinois-based Serta Simmons Bedding LLC (Serta for short) is a mattress and bedding products distributor. In 2016, Serta signed two credit agreements: one for $1.95 billion in first-lien loans and another with $450 million in second-lien loans. These agreements contained a pro rata sharing clause, a standard provision which says that any payment that a borrower makes to lenders must be proportionate in their amount within the overall loan balance. This is common credit agreement language and is seen as a “sacred right” of a lender, and in Serta’s First Lien Credit Agreement, unanimous consent is required from the first-lien lenders to amend it.

An exception was written into the First Lien Credit Agreement in §9.05(g). If Serta organized a Dutch auction or, more importantly, an “open market purchase”—where a lender could sell back some or all of its debt to Serta in an open market—then the pro rata sharing clause would not apply and there would not be a requirement of universal agreement to allow the purchase. When COVID hit and Serta’s business was reeling from financial losses, the company used that exception to execute an LMT with a majority of the lenders to secure more liquidity and amend the two credit agreements.

Under this deal, Serta incurred $200 million in new superpriority debt. The participating group of lenders would uptier approximately $1.2 billion of the existing debt in exchange for $875 million of debt that was only subordinated to the new $200 million. In other words, the holders of the remaining $800 million of first lien debt and all second lien debt were now less likely to receive substantial repayment. Unsurprisingly, lawsuits followed.

The excluded lenders immediately filed in both New York state and federal courts. In June 2020, the New York State Supreme Court denied a preliminary injunction filed by one of the excluded creditors, allowing the transaction to move forward. The Court noted that “[t]he Credit Agreement seems to permit[] the debt-to-debt exchange on a non-pro rata basis as part of an open market transaction.”

In March 2022, Judge Katherine Failla of the Southern District of New York ruled that it was unclear whether the transaction was justified under the open market purchase exception. However, Judge Failla refused to block the transaction. “On a plain reading of the term, the [Uptier Exchange] depicted in the Complaint did not take place in what is conventionally understood as an ‘open market,’” Judge Failla wrote. The Southern District of New York ruled that discovery was needed to understand if the agreement was within the nature of Serta’s credit agreements.

While the litigation was pending, Serta filed not only for Chapter 11 bankruptcy in the United States Bankruptcy Court for the Southern District of Texas but also a motion to certify that the uptiering transaction was justified under the open markets purchase clause. 

In January 2023, Judge David Jones of the United States Bankruptcy Court in the Southern District of Texas ruled in summary judgement—without a full trial—that it was “very easy for me” to find that it was an open market transaction. Judge Jones’ ruling was surprising not only because it was given without a full trial and that it so quickly dismissed the concerns of Judge Failla, but also because it did not provide any guidance as to how the court viewed open market transactions. This resulted in the uptiering lenders receiving virtually all of the remaining equity in the Serta bankruptcy proceedings, and the rest of the lenders being left out in the cold.

    Serta’s use of the uptiering transaction virtually wiped out hundreds of millions of dollars in claims, underscoring why LMTs are referred to as “creditor-on-creditor violence.” As of 2023, the uptiering was considered to be an open market purchase and the uptiering lenders were in a strong position to recover their loans. Meanwhile, the excluded lenders were planning an appeal.

III. FIFTH CIRCUIT COURT OF APPEALS DECISION

This leads to the crucial December 2024 ruling. On December 31, 2024 the U.S. Court of Appeals for the Fifth Circuit issued a decision that challenged the fundamental underpinning of the uptier’s legality, ruling that it was not an open market purchase and did, in fact, violate the 2016 First Lien Credit Agreement’s pro rata sharing clause. Because of this, the Fifth Circuit reinstated the excluded lender’s breach of contract lawsuit. Furthermore, the Court ruled that the indemnification provisions written into the uptiering agreement are invalidated.

A.    Serta’s Uptier is not an Open Market Purchase

After dismissing many of the procedural objections of the prevailing lenders, the Court turned to the thrust of the case: whether the uptiering conducted by Serta and the participating lenders was truly an open market purchase. The Court decisively rejects the defense of the lenders and Serta in making its decisions, and its rationale is elaborated below.

In keeping with New York court tradition, the Fifth Circuit relied on multiple dictionaries—including Black’s Law Dictionary, the authoritative legal dictionary used by courts nationwide to provide definitional context for its decisions—to understand what an “open market transaction” is. The Black’s Law Dictionary defines it as a “market in which any buyer or seller may trade and in which prices and product availability are determined by free competition.” In understanding this practically, the Court uses the Federal Reserve’s open market operations as an analogy. “As the Federal Reserve has explained, federal law ‘requires’ it to make these open market purchases in—where else?—‘the open market.’” (31) This is in contrast to the definition of a market according to participating lenders, who argued that it meant “a transaction in which something is obtained for monetary value in a market where prices are set by competitive negotiations between private parties.” If this were true, then any transaction executed in a free market economy would be considered an open market transaction. The inclusion of the word market in §9.05(g) implies that an open market purchase must occur in a specific market, such as secondary markets or the bond market, not just any ad hoc transaction conducted openly by two consenting parties.

Secondly, the Court noted that the lenders’ definition of “open market purchase” negates the distinction between the two exceptions defined in §9.05(g): the open market purchase and Dutch auction. If the lenders’ definition of an open market was the occurrence of a transaction amongst competition between private parties, then there would be no practical difference between a Dutch auction and an open market purchase. Given that contracts are generally interpreted so that each individual clause carries weight and is not superfluous, the lenders’ definition of an open market cannot be true. Accordingly, the lenders’ broad definition of “open market” could not be sustained.

The Court then proceeded to reject three arguments brought by the lenders.

First, the lenders argued that since Dutch auctions are explicitly defined as needing to be open to all lenders—while open market purchases are not—that they can conduct an open market purchase that isn’t open to all lenders. The Court rejected that argument by pointing out the word “open” is found in both open market purchase and in the Dutch auction definition, rendering this distinction moot.

Second, the prevailing lenders presented evidence that the excluded lenders had themselves tried to execute a similar maneuver with Serta after learning about the uptier, showing that  they functionally agree with the prevailing lenders’ definition. The Court rejected this argument by saying that not only was there little evidence that all the excluded lenders participated in this singular attempt or that the attempt actually resembled the prevailing lenders’ actions, but also that there is no evidence that the excluded lenders actually thought an uptier was a permitted open market transaction.

Finally, the prevailing lenders pointed to a definition of the open market purchase provided by the Loan Syndications and Trading Association (LSTA), an authoritative trade group quoted by both sides, which nominally supported their position. The Court rejected this on the grounds that the LSTA is not legally binding and that the lenders cherry-picked a part of LSTA’s definition to support their position; the LSTA’s real definition of open market purchases is more complex and less supportive of the lenders’ position. 

B. Indemnification Clause Invalidation

    The secondary issue in the case was whether the indemnity—or promise of liability coverage—issued to the prevailing lenders during the uptier was legally binding. To protect it, the prevailing lenders and Serta brought up the concept of equitable mootness to argue that the indemnity clause should remain in the agreement. The Court rejected that argument.

Firstly, the Court determined that the plan didn’t pass the three-part test necessary to establish equitable mootness. In order to be equitably moot, it must be determined whether a “(i) whether a stay has been obtained, (ii) whether the plan has been ‘substantially consummated,’ and (iii) whether the relief requested would affect either the rights of parties not before the court of the success of the plan.” While the Court determined that the first two conditions were met, the third one was not. Removing their indemnity led to no clear impact on the success of the plan or on the rights of both Serta and the prevailing lenders.

More than just the technical test for equitable mootness, the Court took issue with the crux of the prevailing lenders’ argument in justifying the existence of their indemnification. The lenders argued that they wouldn’t ever have supported the uptier without the indemnity clause, and so, removing it causes an unfair playing field by leaving them unduly exposed. If this were true, “the appellate courts are effectively stripped of their jurisdiction over bankruptcy courts,” as removing even one provision would necessitate the rewriting of the agreement as a whole. (45) If a reorganization plan had to be entirely rewritten every time there was an unlawful clause, our judicial system would grind to a halt. “We do not accept the appellees’ invitation to upset the norms of appellate review by complying with their implausible interpretations of a judge-made, atextual doctrine of ‘pseudo abstention.’” (45)

The Fifth Circuit Court of Appeals took direct aim at the core logic behind both Serta’s uptiering rationale and subsequent legal protections by rejecting the prevailing lenders’ basic definitions and reasoning.

IV. COMPARATIVE JURISDICTIONAL ANALYSIS

While Serta was part of the initial wave of both uptiering and LMTs in general, a number of significant cases had been concurrently working through the courts. They produced important decisions that provide both comparable and contrasting precedent and guidance.

1. Mitel Networks Corp.

On the same day as the Serta decision, the New York Supreme Court First Appellate Division ruled on an uptiering case involving Mitel Networks (“Mitel”), a Canadian telecommunications company. In October 2022, participating lenders provided Mitel with $156 million in superpriority loans and uptiered their first- and second-lien loans, with 5% and 18% discounts, respectively. Excluded lenders, whose loans were newly subordinated as a result, sued both the participating lenders and Mitel in the New York State Supreme Court for violating their rights as lenders. The defendants responded that there was nothing in the credit agreements that prevented them from executing this transaction. The New York Supreme Court denied both the defendants’ motion to dismiss and many of the plaintiffs’ specific legal claims. Both sides appealed the decision.

Unlike the Fifth Circuit in Serta, the Appellate Division ruled that Mitel’s uptiering was legitimate, provided that the facts on the ground differed between the two cases. Specifically, while Serta’s exception to the pro rata sharing clause contained the phrase “open market purchase,” Mitel’s exception did not include such a phrase. Since there was nothing further in the agreement that prevented a transfer of different tranches of debt and nothing further to qualify the definition of purchasing —which an uptier certainly qualifies for on a basic level—the court came to a different conclusion.

2. Incora

    In March 2022, aerospace company Incora (formally known as Wesco Aircraft Hardware Corp.) started feeling the COVID-induced cash crunch that halted much of its operations. With Incora fielding over $2 billion in debt—approximately $1.5 billion in senior secured debt and $550 million in unsecured debt—Incora, along with some of its creditors and private equity owner Platinum Equity, were looking for ways to advantage themselves in the eventual restructuring. In this case, the problem with doing an outright LMT is that this coalition had a mere majority, not the two-thirds majority needed to amend the credit agreements in their favor.

To circumvent this, the coalition arranged for  Incora to issue another $250 million in senior secured notes to its members, thereby creating the two-thirds majority necessary to amend the agreements. The coalition subsequently executed an uptier; the new capital structure had both the new $250 million and around $1 billion of the participating lenders’ existing loans uptiered to a First Lien. Another roughly $500 million uptiered to a “First-and-a-Quarter-Lien,” and the remaining approximately $640 million was deeply subordinated. Naturally, the excluded lenders promptly filed a complaint with the New York State Supreme Court.

Soon after the excluded lenders filed in the New York State Supreme Court, Incora filed for Chapter 11 bankruptcy, moving the jurisdiction of the case to the U.S. Bankruptcy Court to the Southern District of Texas. The excluded lenders argued that the $250 million issued to the participating coalition violated their existing senior secured notes credit agreement since it would negatively impact their positions as creditors. However, Incora and the participating lenders argued that they followed the explicit protocols outlined in the senior secured notes credit agreement, which mandated that a simple majority of the class had to vote in favor of the new issuance, which is what happened.

Judge Marvin Isgur of the Bankruptcy Court ruled that the $250 million issuance and subsequent uptiering transaction did, in fact, violate the original senior secured notes credit agreement. Given that the new notes issuance and uptiering were virtually simultaneous, Judge Isgur ruled that it constituted an attempt to remove some of the collateral that the excluded lenders were entitled to under the credit documents. Judge Isgur additionally ruled that the pivotal $250 million was merely an unsecured loan—not a senior secured loan—and would therefore not affect the reorganization of the capital structure. By ruling with the excluded lenders, Judge Isgur expressed implicit disapproval of the extremely literal interpretation of credit documents.

3. American Tire Distributors

    In the period between Serta’s initial ruling by the Bankruptcy Court and eventual reversal by the Fifth Circuit, many credit agreements started to feature language that came to be known as “Serta blockers.” Serta-blocking language are stricter terms that require unanimous (or near unanimous) consent to change or subordinate existing claims in a capital structure reorganization, expressly designed to prevent uptiers. North Carolina-based American Tires Distributors were among the many companies that adopted this trend, though its agreement did allow for an out-of-court transaction if the lenders were compensated on a pro rata basis. 

There was, of course, a loophole. Even with the strengthened Serta-blocking language, the credit agreement did not expressly cover an LMT executed through a debtor-in-possession (DIP) financing. American Tire Distributors tried to circumvent a Serta blocker by doing an uptier via a debtor-in-possession financing for a select group of lenders. In November 2024, Judge Craig Goldblatt of the United States Bankruptcy Court for the District of Delaware ruled that such a maneuver—the uptiering of loans using a DIP facility—violated the credit agreement’s pro rata sharing clauses despite not being expressly covered in the agreement.

While Serta Simmons’ saga is important given its original position in the LMT trends, it is not the only decision receiving scrutiny from the courts. A clear theme emerging from these three cases is the game of inches played out through the technical differences in credit agreements. It is an arms race between sophisticated lenders, each trying to secure the best possible credit terms or be found on the wrong end of a years-long legal battle.

Furthermore, there is a contest not just between the wordsmithing of credit agreements but between those who choose to manipulate its strict literal meaning versus those who give stronger credence to the spirit of the agreement, as seen in Incora and American Tires. With both dynamics at play, LMTs are proving to be a force here to stay for the foreseeable future. 

V. IMPLICATIONS FOR FUTURE LIABILITY MANAGEMENT TRANSACTIONS

The Serta ruling will have an impact on future uptier and general LMT structuring, as well as language that is included in credit agreements.

1. Credit Agreement Language

As creditors grow wiser to the threat LMTs pose to their likelihood of repayment, a number of defensive strategies are becoming more common. The contrast in rulings between Serta and Mitel plainly shows the weakness of having even minimally ambiguous terms. Pro rata sharing exceptions will continue to strengthen their already-rigorously defined exceptions and spell out purchasing procedures in a way that will allow for the buyback of lenders’ debt, but with the protection of other lenders involved.

In addition to tightening purchase exceptions, credit agreements will likely continue to include and expand blockers such as “Serta blockers” to expressly prohibit an uptiering transaction from taking place in either form or function. This is happening in tandem with the expansion of sacred rights to create unanimous or near-unanimous consent to amend credit terms.

2. LMT Evolution

With the Fifth Circuit ruling that uptiers do not qualify as open market purchases, uptiering is effectively disqualified within the group of credit agreements that include this language. Moreover, given the courts’ disqualification of both Serta and Incora’s uptiering transactions, creditors may think twice before choosing a legally fraught transaction structure. Mitel’s ruling shows that uptiering has a future, though both potentially participating and excluded lenders will be wiser to such formulations. Alternative foundations for uptiers are developing, including language that allows for non-pro rata sharing clauses or non-open market purchases. This case also does not impact alternative LMT techniques such as drop-downs or double dips. 

There will also be more consideration given to the pre-LMT maneuvering, which can serve to assent or block the transaction. Through the attempted Incora LMT, we can see the importance of participating creditors to gather the requisite votes and that courts have frowned upon aggressive tactics to achieve such a majority. In this environment, we may see more creditors creating either formal or informal alliances to deter an LMT from coming to fruition.

CONCLUSION

Despite the Fifth Circuit’s prevention of further use of Serta’s uptiering template, the LMT universe has expanded greatly since the initial 2020 legal battle. There are many alternative structures—including possibilities within the uptiering strategy—that provide legally-protected continuity to LMTs as a recourse method for lenders. As lenders will discuss maintaining the integrity of their loan values, LMTs will stand out as a potent tool in a zero-sum environment. This genre of recourse is here to stay, albeit in an ever-evolving form.