The last day of 2024 was a momentous one for the syndicated loan markets. In New Orleans, the Fifth Circuit Court of Appeals, whose decisions are binding on federal district and bankruptcy courts in Louisiana, Mississippi and Texas, ruled that Serta Simmons Bedding’s 2020 uptier exchange was not a permissible “open market purchase” within the meaning of its governing credit agreement. In New York, on the other hand, the Appellate Division of the Supreme Court of New York, First Department, whose decisions are binding on state courts in New York City, ruled that the 2022 uptier transaction of Mitel Networks complied with the terms of its governing credit agreement. What do these seemingly conflicting rulings mean for the syndicated loan market?
Uptiering 101
Uptiering is a fairly new and controversial phenomenon whereby a majority of lenders under a credit agreement agree to sell/exchange existing loans to the borrower in exchange for higher-priority obligations. To accomplish an uptier, the borrower typically needs to amend its existing credit agreement to allow for (i) the incurrence of superpriority debt; (ii) the subordination of existing debt; and (iii) in many cases, a new intercreditor agreement. Because uptiering appears to contravene the long-established norm of ratable (i.e., equal) treatment among lenders, which is generally considered a “sacred right”, it has evoked strong reactions from detractors who have called it, among other things, “a cannibalistic assault by one group of lenders . . . against another” and “acts of financial war”. Serta’s 2020 uptier is generally acknowledged as the first major uptier but it has been followed by many others since then.
The benefits of an uptier transaction, not surprisingly, accrue to the borrower and participating lenders, while the excluded lenders are left holding the bag. From the borrower’s perspective, uptiering is a valuable tool which affords the opportunity to access new capital (which might not otherwise be available to it) and to potentially deleverage through discounted exchanges. Moreover, because the borrower only needs a majority of existing lenders to engage in an uptiering, it can play lender groups against each other in order to extract the best possible terms. For participating lenders, uptiering can be quite lucrative. Apart from the prospect of receiving a higher interest rate on loans as well as various uptiering-related fees, participating lenders receive an improved position in the creditor line with likely improved recoveries in the event of bankruptcy. The excluded lenders end up with subordinated debt worth less than before the uptiering and the prospect of diminished recoveries in the event of bankruptcy.
The Serta Ruling
Serta Simmons Bedding was an already financially troubled company when COVID hit in 2020. Hoping to shore up its weak financial position, Serta amended its 2016 First Lien Term Loan Agreement with the consent of a majority of its lenders so as to allow it to enter into an uptier transaction. The uptier had two components. First, the participating lenders would provide Serta with $200 million in new-money loans consisting of first-out, superpriority debt. Second, the participating lenders would exchange $1.2 billion of first and second lien loans for approximately $875 million of second-out, superpriority debt. Serta and the participating lenders labeled the exchange an “open market purchase”, which was one of two exceptions (the other being Dutch auctions) to the pro rata sharing (i.e., ratable treatment) requirement in the credit agreement.
Not long thereafter, certain excluded lenders sued Serta and the participating lenders in the US District Court for the Southern District of New York. The Southern District denied Serta’s motion to dismiss the suit, finding that the term “open market purchase”, as used in the credit agreement, was sufficiently ambiguous to allow for several different interpretations. Before the Southern District could rule on the merits of the case, Serta filed for bankruptcy under Chapter 11 in the Southern District of Texas. The next day, Serta and several of the participating lenders filed an action for declaratory judgment against certain excluded lenders. The point of the declaratory judgment action was to get the bankruptcy judge’s blessing of the uptiering as well as confirmation that the uptiering did not violate the terms of the credit agreement. The bankruptcy court, siding with Serta and the participating lenders, ruled that the uptiering was a valid “open market purchase”. The excluded lenders appealed to the Fifth Circuit.
In a lengthy opinion, a panel of the Fifth Circuit reversed the bankruptcy court, ruling that the 2020 uptier transaction was not a permissible “open market purchase” under the credit agreement. The court took particular issue with the definitions of “open market purchase” proposed by Serta and the participating lenders. Essentially, Serta and the participating lenders contended that a transaction for value among private parties via competitive negotiations constitutes an open market purchase. The court disagreed, noting that the proposed definitions missed what it viewed as the most important component required for an “open market purchase” - a specific market. Citing New York law and various financial sources (including a guide published by the Loan Syndications and Trading Association), the Fifth Circuit explained that an “‘open market’ is a specific market that is generally open to participation by various buyers and sellers.” In the context of the uptier transaction, the court held that “[a]n ‘open market purchase’ … takes place on such a market as is relevant to the purchased product – here, the secondary market for syndicated loans.” Thus, in the court’s view, if Serta wished to make an “open market purchase” of its outstanding first and second lien loans, it should have bought them back on the secondary loan market and not in private exchanges.
The Mitel Ruling
On the same day as the Serta decision, the New York Appellate Division, First Department, ruled that an uptiering transaction by Mitel Networks complied with the terms of its governing credit agreement. Unlike the Serta credit agreement, the Mitel credit agreement did not have an “open market purchase” exemption to the “sacred right” of ratable treatment. Instead, the Mitel credit agreement expressly allowed the borrower to “purchase by way of assignment and become an Assignee with respect to Term Loans at any time.” The Appellate Division concluded that this language allowed Mitel to purchase the participating lenders original loans in a cashless exchange on a non-pro rata basis. The court was not moved by the excluded lenders’ contention that the cashless exchange was not a “purchase”, but rather a “refinancing” or “exchange”, and thus outside the scope of the “purchase” rights conferred by the credit agreement.
The Appellate Division also rejected the excluded lenders’ assertion that the uptiering involved “sacred rights” (i.e., rights under a credit agreement that can only be amended via unanimous consent). In so holding, the court noted that the Mitel credit agreement only required the consent of lenders “’directly and adversely affected’ by a change in loan terms”. In the court’s view, the effect of the uptiering on the excluded lenders’ loans was indirect. The Appellate Division added that, had the parties to the governing credit agreement wanted “effective or functional” amendments to be subject to unanimous consent in addition to “actual, textual” amendments, they could have negotiated for the inclusion of such language.
Finally, the Appellate Division rejected the excluded lenders’ claim that the uptiering breached the implied covenant of good faith and fair dealing. Specifically, the court noted that:
The agreements, which were negotiated by sophisticated parties, contain specific, detailed provisions regarding when [the excluded lenders] are entitled to pro rata treatment and when they are not. Although the agreements contain limitations on the acquisition of new debt, they also allow the borrower to purchase loans ‘at any time’ and permit amendments by majority consent with enumerated exceptions. Had the parties wanted to prohibit amendments such as those at issue here, they could have done so, but they did not. (emphasis added)
What It Means
The impact of the Serta decision remains to be seen. Will other courts find the Serta decision persuasive? Time will tell. It should be kept in mind that the Southern District of New York did find the Serta “open market purchase” language ambiguous. In the meantime, the legal ground has shifted, and the syndicated loan market will need to anticipate the new risks posed by Serta. Here are some ways the market may respond:
Shifting Credit Provision Preferences. Lenders may want to mitigate uptier risk by requiring the inclusion of a Serta-type “open market purchase” provision in any credit agreement to which it is a party. Borrowers, on the other hand, may want to push for non-pro rata language along the lines of what was used in the Mitel credit agreement to allow for maximum freedom of maneuver.
Broader Liability Management Exercises. Market participants could seek to craft/amend credit agreement provisions to allow for discounted debt exchanges open to all but with varying economic inducements.
Less Reliance on Liability Management Exercises. Market participants may be discouraged from engaging in liability management exercises due to the uncertainty caused by the Serta decision.
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