In re Serta Simmons Bedding

The following is a case summary written by Chase A. Stone regarding the recent Fifth Circuit Court of Appeal’s recent opinion in In re Serta Simmons Bedding, L.L.C., 125 F.4th 555 (5th Cir. 2024), (as revised Jan. 21, 2025 and Feb. 14, 2025), including the discussion of the bankruptcy court’s earlier decision (which was directly appealed to the Fifth Circuit Court of Appeals).

Summary

1. Background

The Chapter 11 Bankruptcy Case and Decision – Market Context

Prepetition, the COVID-19 public health emergency imposed financial challenges on Serta Simmons Bedding, LLC (“SSB” or the “Debtor”), a mattress company, which was already facing a significant budget shortfall beginning in March 2020.  Among other things, SSB claimed it was under pressure because of mandated manufacturing facility closures, lack of liquidity, and market competition, all of which led SSB to restructure approximately $2.5 billion in its outstanding debt that it incurred in 2016.

The SSB’s financial difficulties, however, were neither unique, nor unanticipated.  As the U.S. Bankruptcy Court for the Southern District of Texas, Hon. David R. Jones presiding, later observed in his memorandum opinion (on appeal), the American commercial syndicated lending ‘market’ has evolved significantly since the 2008 financial crisis to address the situation that SSB faced. In response to market conditions, over the past fifteen years, commercial borrowers like SSB have bargained with their commercial lenders, to implement greater flexibility in loan agreements, which now contain ‘loosened’ terms, in order to avoid bankruptcy and liquidation. 

As the Fifth Circuit Court of Appeals subsequently noted, while these loan agreements are “innovative,” insofar as allowing distressed companies to seek improvements to financial positions, and stay alive, the means to effectuate such innovation is not without controversy.

In November 2016, SSB bargained for flexibility in its loan agreement, hereinafter called the “2016 Credit Agreement.”  In particular, the 2016 Credit Agreement allowed SSB—in concert with its lenders—to self-manage its own capital structure, and by extension, manage liability, through “uptiering”.  In particular, the 2016 Credit Agreement allowed SSB to undertake subsequent debt, and concurrently, renegotiate the priorities of existing debt.  As both courts observed, “uptiering” is an exception to the longstanding, customary, ‘ratable’ treatment which is a ‘sacred right’ that commercial lenders expect, since uptiering, as a mechanism, allows borrowers to run afoul of equal treatment by offering priority debt to certain lenders who participate and subordinating others.  Id. at 567-68.

Specifically, the 2016 Credit Agreement permitted SSB to repurchase its debt from its lenders, on a non-pro rata basis, through either two options: the “Dutch auction,” open to all of its existing lenders, or through an “open market” purchase, involving fewer than all of its existing lenders.  The provision under the 2016 Credit Agreement that allows for this is § 9.05(g), which the Bankruptcy Court noted was “generally known to all lenders” and was, by some accounts “being fairly typical for any competitive process, auction or competitive financing.” In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *4 (Bankr. S.D. Tex. June 6, 2023) (procedural history omitted).  Id. at 568-69.

Thus, pursuant to the 2016 Credit Agreement, SSB negotiated with certain of its lenders to obtain $200 million in new financing through the “open market” under § 9.05(g); in exchange, such funds were secured as $200 million in first-out, super-priority debt.  These so-called “Prevailing Lenders” then negotiated to exchange $1.2 billion of their existing first-lien and second-lien loans, for approximately $875 million in second-out, super-priority debt.  This transaction paves the way for the controversy that ensued. Id. at 569. 

2. Procedural History

Pre-Petition Negotiations

As discussed in the lower court’s memorandum, in 2020, a small group of lenders, the so-called “Objecting Creditors”, who held first-lien loans, presented SSB with a “drop-down” proposal to aid in SSB’s restructuring.  Pursuant to § 9.05(g) of the 2016 Credit Agreement, under the ‘drop-down’ proposal, SSB’s most valuable assets would be transferred to a new subsidiary, and upon doing so, the Objecting Creditors would advance new funds, secured by SSB’s valuable assets (while existing debt was discounted and repurchased) held by the new entity.

In essence, the drop-down proposal offended the ‘sacred’ right of ratable treatment because it would simply remove SSB’s valuable collateral base, which served as the security for the other lenders’ loans, and allow the Objecting Creditors to obtain a higher-priority security interest, while advancing new funds.  The Objecting Creditors negotiated without the participation of all SSB’s lenders on the grounds that the “open market” provision of under § 9.05(g) of the 2016 Credit Agreement provided this exception to ratable treatment. Id. at 565, 567, 581. 

Due to the Objecting Lenders’ proposal, the Prevailing Lenders’ initial attempt to negotiate with SSB, as an ad hoc group, fell on deaf ears.  For its part, the Prevailing Lenders’ proposal sought participation of all of SSB’s first- and second-lien lenders. After evaluating the Objecting Lenders’ proposal, SSB invited the Prevailing Lenders to submit a competing proposal, which the Fifth Circuit Court of Appeal would later label as the “uptier” transaction.  Consequently, the Prevailing Lenders proposed to advance $200 million of new money plus $875 million of exchanged loans with the first lien loans exchanged at 74% and the second lien loans exchanged at 39%. This was the proposal that SSB accepted.  Id. at 569-70. 

As the Bankruptcy Court noted, the record in the case illustrated that the Objecting Lenders had “recognized” that the 2016 Credit Agreement, which they were subject to, had “looseness” in its terms, allowing for a “liability management solution; and [] the stripping of first lien lender protections.”  In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *4 (Bankr. S.D. Tex. June 6, 2023), appeal dismissed sub nom. Matter of Serta Simmons Bedding, L.L.C., No. 23-20410, 2024 WL 4708974 (5th Cir. Nov. 7, 2024), and rev’d in part sub nom. In re Serta Simmons Bedding, L.L.C., 125 F.4th 555 (5th Cir. 2024), as revised (Jan. 21, 2025), as revised (Feb. 14, 2025). Utilizing the intended ‘looseness’ under § 9.05(g), the Prevailing Lenders and the Objecting Creditors presented SSB with proposals which each provided SSB with additional funding, but at the expense of each other’s loans and security interests.

Shortly thereafter, upon learning that SSB had reached a deal with the Prevailing Lenders, the Objecting Lenders filed lawsuits in New York state court to enjoin the transaction, by requesting a preliminary injunction.  The New York state court denied the Objecting Lenders’ request based upon a likelihood of success on the merits.  A second lawsuit, identical to the first, was filed in New York in November 2022.  As the Bankruptcy Court’s memorandum opinion summarized, the negotiations and later arguments presented by the Objecting Creditors were apparently “reflective of the true motives of the Objecting Lenders in these proceedings, including an objective lack of good faith.” In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *6 (Bankr. S.D. Tex. June 6, 2023) [appellate procedural history omitted].

Chapter 11 Petition Filed and Adversary Proceeding(s) Initiated

On January 23, 2023, SSB filed its voluntary Chapter 11 petition in the Southern District of Texas.  The following day, SSB filed a complaint to initiate an adversary proceeding against the Objecting Lenders (for ease of understanding, the author refers to the Objecting Lenders without identifying them specifically, because the individual lenders forming the composition of these groups may have changed at various points, and therefore, it proved challenging to summarize otherwise), seeking declaratory relief. 

The Debtor specifically sought a determination that the 2020 restructuring with the Prevailing Lenders did not violate the implied covenant of good faith and fair dealing under 2016 Credit Agreement.  The Objecting Lenders countersued, seeking a determination by the Bankruptcy Court that the 2020 restructuring did violate the 2016 Credit Agreement, and therefore, sought to void the transaction, as well as claim money damages.  Id. at 569-570. 

The Bankruptcy Court granted partial summary judgment in favor of the Debtor, declaring that the “open market purchase” under § 9.05(g) was clear and unambiguous and that the 2020 restructuring was consistent with the terms, as provided, under the 2016 Credit Agreement.  The Objecting Creditors appealed.  While the appeal was pending, due to the interrelationship between the adversary proceeding, and the main bankruptcy procedure, Bankruptcy Court held a trial on confirmation of the Debtor’s Chapter 11 plan, along with the remaining unresolved claims, counterclaims, and cross-claims.  Id. at 570. 

Outcome of the Trial Court’s Decision

With respect to plan confirmation, both the Objecting Lenders and the U.S. Trustee objected to confirmation of the Debtor’s plan.  The Objecting Creditors objected on the grounds that, among other things, the plan “impermissibly allows the Debtors’ prepetition indemnity” in favor of the Prevailing Lenders.  The U.S. Trustee objected to confirmation of the Debtor’s plan on the grounds that independent directors/managers received exculpations which were far too broad under existing precedent in the Fifth Circuit Court of Appeals.  The Bankruptcy Court sustained the U.S. Trustee’s objection and rejected the Objecting Lenders’ arguments regarding the indemnity.

With respect to the interpreting whether the parties had valid claims for breaching the covenant of good faith and fair dealing, the Bankruptcy Court applied New York law, which governed the underlying 2016 Credit Agreement, to determine, in part, whether each party “reasonably understood the contract or contractual provision at issue to state a duty to take or refrain from taking a particular action.” In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *12 (Bankr. S.D. Tex. June 6, 2023) [procedural history omitted] (citing Cordero v. Transamerica Annuity Serv. Corp., 39 N.Y.3d 399, 410, 211 N.E.3d 663, 671 (2023).)  Id. at 578-580.

As the Bankruptcy Court concluded in its memorandum, with deference to the sophistication of the parties, the lenders collectively were “keenly aware that the 2016 Credit Agreement was a ‘loose document’ and understood the implications of that looseness.” In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *13 (Bankr. S.D. Tex. June 6, 2023) [procedural history omitted]. Moreover, the Court wrote that, “[o]n the scale of equity, it is the conduct of the Objecting Lenders that raises an eyebrow.” In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *13 (Bankr. S.D. Tex. June 6, 2023).  Ultimately, the Bankruptcy Court held that “this litigation ends with each party receiving the bargain they struck—not the one they hoped to get” in reference to the 2016 Credit Agreement.  In re Serta Simmons Bedding, LLC, No. 23-90020, 2023 WL 3855820, at *13 (Bankr. S.D. Tex. June 6, 2023) [procedural history omitted].

As a result, the Bankruptcy Court concluded that the Prevailing Lenders’ uptier transaction was not prohibited by the 2016 Credit Agreement, that the transaction was binding and enforceable in all respects, and that all claims for breach of the implied duty of good faith and fair dealing are denied, as well as all claims for breach of the 2016 Credit Agreement were denied.

3. Result And Reasoning of Appeal

Appellate Court’s Reversal

The Bankruptcy Court certified a direct appeal to the Fifth Circuit Court of Appeals, which accepted.  In this appeal, the Objecting Lenders challenged two key issues: (1) First, they argued that the uptier did not qualify as an “open market purchase” under the 2016 Credit Agreement, and thus violated the ‘sacred’ ratable-sharing provisions, and (2) Secondly, the Objecting Lenders contested the inclusion of indemnity provisions in the reorganization plan, claiming these provisions unfairly benefitted the Prevailing Lenders.  Applying New York law, the Fifth Circuit in In re Serta Simmons Bedding, L.L.C. interpreted the meaning of the phrase “open market purchase,” in the 2016 Credit Agreement. Id. at  574, 576, 578-80.    

Jurisdiction

The Fifth Circuit Court of Appeals reviewed the Bankruptcy Court’s jurisdiction and authority to enter declaratory judgment  in the adversary proceeding.  As non-Article III courts, bankruptcy courts are limited by the Constitution, which overrides federal bankruptcy law regarding their ability to issue final judgments in core proceedings.  Id. at  573 (citing Stern v. Marshall, 564 U.S. 462, 482 (2011).)  

Specifically, a Bankruptcy Court may only enter a final judgment if the claim falls within the “public rights” exception.  See id. (citing Stern v. Marshall, 564 U.S. 462, 482 (2011).)  In particular, the public rights exception applies to claims that are determined by the Legislative or Executive branches, arise from a federal statute or statutory scheme, or depend on the adjudication of a claim created by federal law. See id.

The Bankruptcy Court’s declaratory judgment was based on a breach of contract—a classic state-law claim involving two private parties.  The counterclaims, which dealt with breach of contract and breach of the implied covenant of good faith and fair dealing, were also ordinary state-law claims between private parties.  Since these claims had no connection to federal branches or federal law, Stern would ordinarily bar their adjudication by the Bankruptcy Court.  Id. at 573.

The only (major) exception is if the parties expressly or impliedly consent to the Bankruptcy Court’s jurisdiction. In this case, the Fifth Circuit Court of Appeals found that the parties had impliedly consented to the Bankruptcy Court’s jurisdiction, though it had not analyzed or made specific findings on that issue. 

Lastly, the opinion also addressed a procedural argument raised by the Prevailing Lenders, who claimed that the Excluded Lenders’ appeal was defective because they failed to attach the judgment to their appeal under Federal Rules of Bankruptcy Procedure, Rule 8003(a)(3)(B). The court quickly dismissed this argument, clarifying that this was not a jurisdictional defect.

Appeal to the Fifth Circuit – The Uptier Violated The 2016 Credit Agreement

As explained by the Fifth Circuit Court of Appeals, SSB’s 2016 Credit Agreement contained the ‘sacred right’ of ratable treatment, which requires pro-rata sharing for any payment or prepayment of principal, payment of interest, or conversion within any given class of debt issued by the debtor.  Id. at 56 [procedural history omitted].  The 2016 Credit Agreement expressly adopted this principle, requiring payments to be allocated equally among lenders in the same class, under § 2.18:

“[E]ach [b]orrowing, each payment or prepayment of principal of any [b]orrowing, each payment of interest with respect of the Loans of a given Class and each conversion of any [b]orrowing . . . shall be allocated pro rata among the Lenders in accordance with their respective Applicable Percentages of the applicable class.”

Further, under the 2016 Credit Agreement, ratable treatment could not be modified or waived without the unanimous consent of all affected lenders unless an exception applied.  See id.  That exception is under § 9.05(g):

[A]ny Lender may, at any time, assign all or a portion of its rights and obligations under this Agreement in respect of its Term Loans to any Affiliated Lender on a non-pro rata basis (A) through Dutch Auctions open to all Lenders holding the relevant Term Loans on a pro rata basis or (B) through open market purchases ….

Id. at  568.

On appeal, the Prevailing Lenders argued that the uptier was an open market purchase under the 2016 Credit Agreement, as it was “a transaction in which something is obtained for monetary value in a market where prices are set by competitive negotiations between private parties.” Id. at 580.  However, the Fifth Circuit rejected this argument as “flawed” and found that an open market is “one tied to a specific market, like the stock market or the commodities market or the securities market. An open market is a designated market, not merely the background concept of free competition that characterizes much of modern American commerce.” Id at  580. 

The Fifth Circuit Court of Appeals further canvassed dictionary definitions, in applying New York law to define contract terms:

“Black’s defines open market as “[a] market in which any buyer or seller may trade and in which prices and product availability are determined by free competition.” The OED similarly defines open market as “[a]n unrestricted market in which any buyer or seller may trade freely, and where prices are determined by supply and demand.” And Webster’s defines open market as “a freely competitive market in which any buyer or seller may trade and in which prices are determined by competition.”

Id. at 579 [procedural history omitted]  [internal citations omitted].

Fundamentally, the Fifth Circuit opined that “an open market purchase occurs on the specific market for the product that is being purchased.” Id.  This type of market is—

generally open to buyers and sellers, and its prices are set by competition. So if SSB wished to make a § 9.05(g) open market purchase and thereby circumvent the sacred right of ratable treatment, it should have purchased its loans on the secondary market.  Having chosen to privately engage individual lenders outside of this market, SSB lost the protection of § 9.05(g).

Id. at 580–81 [procedural history omitted].  Additional arguments raised by the Debtor and the Objecting Lenders regarding the Objecting Creditors’ course of performance (e.g., ”performing in such a manner that would indicate the 2016 Agreement allowed uptier”), as well as citing to trade group literature on syndicated loans, were not persuasive.

The appellate court observed that lenders who uptier may “improve their net position by jumping the creditor line,” giving them an advantage in bankruptcy proceedings.  In re Serta Simmons Bedding, L.L.C., 125 F.4th 555, 567 (5th Cir. 2024).  By contrast, the costs of an uptier transaction are “born entirely by the minority lenders, who end up with subordinated debt worth less than before.” Id.  Such a practice has been described by some as “unthinkable under [pre-pandemic] commercial norms.” Id. (citation omitted).  In essence, SSB’s private negotiations with lenders circumvented the secondary market, disqualifying the transaction from § 9.05(g)’s exception to ratable treatment.  Thus, the Fifth Circuit Court of Appeals vacated, in part, and remanded for reconsideration the Objecting Lenders’ breach of contract counterclaims.

Plan Indemnity

The Appellate Court also weighed the inclusion of the indemnity and held that SSB’s reorganization plan violated the Bankruptcy Code.  Under 11 U.S.C. § 502(e)(1)(B), contingent claims for reimbursement where the claimant is co-liable with the debtor are disallowed.  Consequently, Fifth Circuit Court of Appeals held that the “pre-petition indemnity” for the Prevailing Lenders who participated in the 2020 uptier transaction was disallowed.  Moreover, while the Debtor attempted to reintroduce the indemnity in the plan as a “settlement indemnity” under § 1123(b)(3)(A), this was an improper way to evade § 502(e)(1)(B). As a result, the appellate court ruled that § 1123(b)(3)(A) does not allow resurrection of claims explicitly disallowed elsewhere in the Bankruptcy Code.  As the opinion held:

The pre-petition indemnity mirrored the terms of the 2020 Uptier indemnity and was intended to satisfy the claims of the lenders that participated in the uptier. The settlement indemnity was on the exact same terms and was intended to protect the very same group of lenders, excluding those few of the Prevailing Lenders that sold their super-priority debt between 2020 and 2023.

Id. at  591.

Moreover, the indemnity violated the equal treatment requirement under 11 U.S.C. § 1123(a)(4).  Although all creditors in Classes 3 and 4 nominally received the indemnity, its actual value varied significantly.  For Prevailing Lenders who participated in the uptier transactions, the indemnity was worth millions.  For others, it was worth little or nothing. Such disparity in value constituted impermissible unequal treatment within the same creditor class.

Author’s Comments

The Fifth Circuit Court of Appeals’ opinion strongly supports the principle of equal, ratable treatment of lenders, which is a “sacred right” amongst syndicated commercial lenders. In its view, SSB violated this sacred right by privately engaging individual lenders to uptier—as a strategy to manage its capital structure and liability—at the expense of the Objecting Lenders. However, in reversing, the Fifth Circuit Court of Appeals appears to have issued an opinion at odds with its own stated views in support of the open market.

As a threshold matter, in its initial discussion of jurisdiction, the appellate court appeared prepared to reject the Bankruptcy Court’s decision on jurisdictional grounds alone, as this dispute (centering on the 2016 Credit Agreement) was simply a state law contract claim. Had the Fifth Circuit Court of Appeals decided not to recognize the parties’ implied consent to the Bankruptcy Court’s jurisdiction, the outcome of this appeal may have been very different.

After disposing of the jurisdictional arguments, the Fifth Circuit Court of Appeals defined its concept of the open market—apparently without consideration of many of the factual findings that the Bankruptcy Court had put forth.  For example, as the Bankruptcy Court noted in its trial court opinion, the negotiations between SSB and its lenders were characterized as being fairly typical for any competitive process, auction, or competitive financing.  The fact that both groups—the Objecting Lenders and the Prevailing Lenders—had each availed themselves of the same exception under the 2016 Credit Agreement, for the same purpose, was made clear in the Bankruptcy Court’s record.

Functionally, the Fifth Circuit Court of Appeal’s reversal of the Bankruptcy Court’s decision can be viewed as a regulation of the open market, which contradicts the principles of the market that the opinion espouses.  The appellate decision is therefore internally contradictory on several levels.  Overall, the decision has imposed a limit on the decision-making of a private company, which will have ripple effect beyond the case.  Specifically, the appellate court has placed a hand on SSB’s ability to choose among private lenders, and thereby regulated SSB’s ability to negotiate the terms with such private lenders.

In part, though the syndicated lending ‘market’ is inherently dissimilar from the paradigmatic stock exchange referenced throughout the opinion, it is a market nonetheless.  The negotiation of the 2016 Credit Agreement was therefore a product of that market.  However, the Fifth Circuit Court of Appeals imposes a ‘visible hand’ on the competition of the syndicated lending market, while in essentially the same breath, seeking to defend its normative concept of the ‘open’ market.  The market allowed SSB to negotiate, even at the expense of certain lenders offering less favorable terms, by soliciting competitive offers, to avoid liquidation.  By prohibiting uptiering, the Fifth Circuit Court of Appeals will likely distort the broader syndicated loan market, as the opinion sends a clear message, which risk-averse lenders are likely to take heed of.

What is more, the practice of priming existing lienholders, like uptiering, is not unfamiliar to bankruptcy courts. In fact, the Bankruptcy Code goes even further by empowering bankruptcy courts to avoid liens under 11 U.S.C. § 522—arguably the most immense authority in the entire Code—in addition to granting bankruptcy courts the power to prime existing lienholders by approving Debtor-In-Possession (DIP) financing pursuant to 11 U.S.C. § 364(c).  In this case, prepetition, SSB negotiated with the Prevailing Lenders to prime its existing lienholders; yet, there appears to be little substantive difference if SSB had instead negotiated with those same lenders to secure DIP financing post petition.  In both scenarios, the result is the priming of existing lienholders, whether accomplished by court approval or a corporate resolution.  While DIP financing is a well-established feature of Chapter 11 proceedings, the Fifth Circuit Court of Appeals rejects uptiering—a practice where existing lienholders are similarly primed to avoid liquidation—even though uptiering is freely negotiated outside of court, and may be functionally identical.

Ultimately, the findings of the trial court about the competitive nature of SSB’s negotiations with lenders were disregarded—apparently as “clear error”—on de novo review. If this decision were taken on certiorari, such factual findings would be of prime importance.

These materials were authored by Chase Stone, an Associate at the Beverly Hills firm of Ervin Cohen & Jessup LLP with editorial contributions from ILC members Kathleen A. Cashman-Kramer, a director at Fennemore LLP’s San Diego office and Hon. Meredith A. Jury (ret.).