Sweet Dreams, or a Nightmare? The Downfall of a King-Sized LME

By Evan Miller1

Distressed firms use liability management exercises (LMEs) to access cash over lenders’ objections. Two types of LMEs, dropdowns and uptiers, have grown in popularity. This article describes how LMEs operate in bankruptcy and how recent cases might (or might not) predict the future of LMEs.

In a dropdown, the borrower drops its collateral down to a wholly owned subsidiary.2 Dropdowns are possible because many loan documents give “investment baskets” to borrowers, which allow borrowers to invest noncash assets into unrestricted subsidiaries. The lenders’ lien is released, and the subsidiary issues new debt backed by the asset. The lenders who participate in the dropdown move their debt to the top of the repayment order, while nonparticipating lenders might be in trouble should a default occur.

Uptiers also improve participating lenders’ relative position, but function differently than a dropdown. In an uptier transaction, a borrower modifies its loan agreements to permit the issuance of additional debt. This newly issued debt is then elevated to a senior position, ranking above existing obligations in terms of repayment priority. Most loan documents only require that a majority of lenders make these amendments. To achieve sufficient consensus, the borrower offers superpriority debt in exchange for support to amend the loan documents.

By invoking the “open market” purchase provision in the loan documents, a borrower is able to circumvent its obligation to pay all lenders equally.3 The open-market exception empowers the borrower to buy old debt from the participating lenders with new superpriority debt. Participating lenders move to the front of the repayment line.

Uptiers received widespread attention in a recent appeal arising from Serta Simmons Bedding’s bankruptcy.4 After encountering economic misfortunes, Serta pursued an uptier transaction.

Refinancing

In 2016, Serta refinanced its debt with three credit facilities, the relevant facility in this dispute being the first-lien $1.95 billion term loan (hereinafter the “2016 credit agreement”).5 A simple majority could amend the 2016 credit agreement unless the amendment directly and adversely affected another lender’s “sacred rights.”

One of the lenders’ sacred rights was the right to pro rata, or equal sharing of payments. Under the pro rata sharing of payments, “no lender would have a superior right to the value of the collateral over any other lender.”6 If the lenders received any excess value, the loan documents directed that value to be shared ratably among all lenders. Serta could not alter the right to pro rata payment unless it obtained consent from every lender that would directly and adversely suffer from non-pro rata treatment.

Serta’s 2016 Credit Agreement featured two exceptions to pro rata treatment: (1) a Dutch auction, and (2) an open-market-purchase provision. Serta could make non-pro rata payments to its lenders — such as purchasing its debt from its lenders — by following the detailed procedures for a Dutch auction or making an open-market purchase.7 The 2016 credit agreement did not define an open-market purchase.8

Competition

Beginning in 2019, Serta faced severe economic headwinds and hired restructuring experts to explore potential solutions for its liquidity issues.9 Serta predicted that its cash would run out in July 2020.

Serta’s first-lien lenders moved quickly. One group (the “uptier lenders”) attempted to propose an LME that would include all first-lien lenders, but the debtor did not respond. The uptier lenders later discovered that Serta had been in discussions with another lender faction (the “dropdown lenders”) to negotiate a dropdown.10 Both lender factions rested their proposals on the open-market-purchase exception to nonratable treatment. Serta invited the uptier lenders to submit a proposal to compete with the dropdown lenders’ proposal and accepted the uptier lenders’ proposal.11 The dropdown lenders immediately realized that they had been “played” and “outmaneuvered.”12 Serta’s decision “had little precedent.”13

The dropdown lenders sued Serta in New York state court to enjoin the 2020 uptier transaction.14 They alleged, inter alia, that the 2020 uptier transaction breached the 2016 credit agreement and violated the duty of good faith and fair dealing. The state court denied the injunction because, in part, it believed that the open-market provision in the 2016 credit agreement could be read to allow for an uptier. The court doubted that the drop-down lenders would be able to successfully challenge the 2020 uptier’s legality.15

With the state court injunction defeated, the 2020 uptier closed as anticipated.16 The parties amended the 2016 credit agreement to allow more debt and superpriority liens.17 Serta received $200 million in new money with $875 million in exchanged loans that would be paid ahead of the other nominal first-lien lenders.18 Sensing litigation risk, the uptier lenders negotiated an indemnity clause that would protect them if other lenders challenged the 2020 uptier.19

In 2022, some of the objecting lenders tried again to stop the 2020 uptier in New York federal court.20 They sued for breach of contract and breach of the implied covenant of good faith and fair dealing. Serta moved to dismiss the claim, and the trial court denied the motion to dismiss, stating that the dropdown lenders had sufficiently alleged an inappropriate loan repurchase that did not occur in the open market.21

Serta’s Bankruptcy

In January 2023, Serta filed a chapter 11 petition in the Southern District of Texas.22 The uptier lenders filed an adversary proceeding to determine, inter alia, whether the 2020 uptier violated the 2016 credit agreement, or the duty of good faith and fair dealing. Serta and the uptier lenders prevailed on those claims at summary judgment, and the nonparticipating lenders appealed.

The parties then litigated the pre-petition indemnity at confirmation. The initial plan featured the pre-petition indemnity provisions as an executory contract that Serta would assume. After several amended plans, the pre-petition indemnity became as a “settlement indemnity” under § 1123(b)(3). Rather than indemnify the lenders who participated in the 2020 uptier, it indemnified lenders who then owned debt issued from the 2020 uptier.23

The bankruptcy court confirmed the plan,24 holding that the open-market provision allowed Serta to make non-pro rata payments to the uptier lenders. The court held that the 2020 uptier was the result of “good-faith, arm’s-length negotiations.”25 The court also upheld the settlement indemnity as a valid business-judgment exercise.26 The bankruptcy court viewed the entire dispute as “[s]ophisticated financial titans engag[ing] in a winner-take[s]-all battle.”27

While this might seem like a “hard result,” this decision would be helpful because it would prevent “unrestrained behavior.”28 According to the bankruptcy court, if lenders did not like this outcome, they could draft less permissive agreements.29 The dropdown lenders appealed the plan confirmation to the Fifth Circuit.30

Reversal

On Dec. 31, 2024, the Fifth Circuit vacated the bankruptcy court’s decision in the adversary proceeding and remanded it back to the bankruptcy court to resolve the claims of nonparticipating lenders in the 2020 uptier. The panel reversed the bankruptcy court’s approval of the indemnity clause.31

The Fifth Circuit held that the term “open-market purchase” meant a purchase on the secondary market for syndicated loans, not a competitive, arm’s-length negotiation between two parties.32 Dictionary definitions of “open market” pointed toward one market, one forum — where buyers and sellers freely competed.33 With this definition in mind, the Fifth Circuit analyzed the Federal Reserve’s “open market operations.”34 The Federal Reserve must purchase securities on the open market,35 which meant the open securities market. If an open market is one appointed place for all buyers and sellers to compete on price, then the 2020 uptier was not an open market purchase because the uptier and dropdown lenders were competing with each other, not the open market.

The panel found further support in its holding by evaluating the other exception to pro rata treatment, the Dutch auction.36 If the uptier lenders’ argument was correct, a Dutch auction would also be an open-market purchase because it was a competitive process between the borrower and its lenders. Applying such an expansive definition would render the Dutch auction provision meaningless, an outcome that New York contract law would not countenance.

The Fifth Circuit also struck the indemnity provision from the confirmed plan.37 The Bankruptcy Code prohibits “any claim for reimbursement or contribution of an entity that is liable with another the debtor ... to the extent that ... such claim for reimbursement or contribution is contingent as of the time of allowance or disallowance of such claim for reimbursement or contribution.”38 The uptier lenders made a claim against Serta that was contingent on legal challenges to the 2020 uptier for which the uptier lenders and Serta were jointly liable.39 Thus, § 502(e)(1)(B) of the Bankruptcy Code flatly prohibited the settlement indemnity.40

Looking to Czyzewski v. Jevic Holding Corp.,41 the panel looked for a “work-around” to § 502(e)(1)(B).42 The bankruptcy court’s reliance on § 1123(b)(3) was misplaced because § 1123(b)(3) did not “affirmatively provide for back-end resurrection of claims already disallowed on the front end.”43

Although the indemnity may have changed forms throughout the plan-confirmation process, the settlement indemnity operates the same way as a pre-petition indemnity. Both indemnities covered the same liability, and although the parties were not identical, the settlement indemnity was functionally the same as the pre-petition indemnity.

The Fifth Circuit held that the settlement indemnity was impermissible independent of its failure to comply with § 502(e)(1)(B), because the Code provides that “a plan shall ... provide the same treatment for each claim or interest of a particular class.”44 The Fifth Circuit cited case law from other jurisdictions for the proposition that intraclass treatment need not be identical, but should result in equal treatment.45 The panel declined to define the “exact scope” of § 1123(a)(4), but held that the settlement indemnity was comfortably outside of § 1123(a)(4)’s outer bounds.46 All relevant lenders received settlement indemnity, but only the uptier lenders stood to benefit from the “millions or tens of millions” in potential value flowing from the settlement indemnity, while others received nothing. Such a disparate result violated § 1123(a)(4).47 The Fifth Circuit concluded that all contracts should be read on their own terms, but the open-market exceptions in other loan documents likely cannot bear the weight of an uptier.48

Aftermath

The uptier lenders sought an en banc rehearing, arguing that the Fifth Circuit’s decision upset the lending market and should have sent the definitional question of open-market purchase to the New York state courts.49 The uptier lenders felt justified in their request because a New York state court upheld a similar uptier the same day that the Fifth Circuit decided Serta.50 The uptier lenders also argued that reversing the indemnity provision was an unlawful altering of the parties’ contractual expectations.51 The Fifth Circuit denied the petition for rehearing.52

The Fifth Circuit decision contains two important takeaways for the future of LMEs. First, broad, ill-defined open-market provisions will not reliably hold the weight of an uptier. Second, indemnity clauses tying the participating lenders to the debtor have a dubious future in bankruptcy under § 502(e)(1)(B). If LMEs are just rearranging the chairs on the Titanic, an indemnity clause may be as useful as a parachute on a sinking ship.

In reading the tea leaves from the Mitel bankruptcy, filed in the Southern District of Texas after the Serta decision, it is possible that restructuring professionals will be quicker to cut deals instead of litigating an LME to finality. Despite prevailing recently on its contentious uptier in New York state court,53 no creditors objected to the plan and the bankruptcy court confirmed the plan on April 17, 2025.54 If Mitel achieves its restructuring objectives, it will consummate the plan by May 23, 2025.55 Perhaps this strategy evolved in Serta’s shadow. Perhaps it did not. Only time will tell how many sleepless nights restructuring professionals must endure as they navigate the stormy waters of LMEs.

Evan Miller is a term law clerk to Hon. Robert J. Faris of the U.S. Bankruptcy Court for the District of Hawaii in Honolulu.