Fifth Circuit Rejects Equitable Mootness Application in the Strongest Possible Terms, Excises Indemnity

At a Glance

• The United States Court of Appeals for the Fifth Circuit rejected the application of equitable mootness in the strongest possible terms.
• The Court ruled in favor of Appellant Citadel by concluding that the indemnity was not justifiable as a settlement and violated the equal-treatment rule of Section 1123(a)(4) of the Bankruptcy Code and thus should be excised from the plan of reorganization.
• This Court also held that the the original Uptier Transaction failed to qualify as an “open market purchase.”

In a landmark decision, the United States Court of Appeals for the Fifth Circuit rejected the application of equitable mootness in the strongest possible terms, stating that if the doctrine rendered the bankruptcy court’s decision not reviewable, it would allow debtors and creditors to shield even obviously unlawful acts from appellate review. In doing so, the Fifth Circuit excised a provision in the Chapter 11 plan of reorganization (Plan) of Serta Simmons Bedding (Company) which obligated the Company to indemnify certain of its pre-petition creditors. In its decision, the Fifth Circuit also reversed the bankruptcy court’s summary judgment ruling, holding that the Uptier Transaction (defined below) was not an “open market purchase” as defined in the operative credit agreement. The decision represents a significant victory for Citadel Equity Fund Ltd., which objected to the indemnity provision because its inclusion in the Plan violated the Bankruptcy Code and jeopardized Serta’s prospects of a successful reorganization. Faegre Drinker represented Citadel in the bankruptcy court.

In 2020, Serta entered into an Uptier Transaction with a group of existing lenders to restructure its debt and to issue new, super-priority debt. The Uptier Transaction resulted in disparate treatment of Serta’s prior group of lenders, effectively creating two lender groups — the Favored Lenders that participated in the transaction and the Excluded Lenders that did not. As a part of the Uptier Transaction, the Company agreed to indemnify the Favored Lenders for certain liabilities arising from the Uptier Transaction. Before Serta filed for bankruptcy in the Southern District of Texas, the Excluded Lenders began litigation against the Favored Lenders in the Southern District of New York, arguing that the transaction was a material breach of their 2016 credit agreement with Serta because it failed to qualify as an “open market purchase.” Because the outcome of the litigation could trigger the Indemnity, it threatened to debilitate the Serta.

After Serta filed for chapter 11, in an effort to relieve Serta of the Indemnity post- bankruptcy, Citadel¹ and some Excluded Lenders challenged the Indemnity under Section 502(e)(1)(b) of the Bankruptcy Code, which disallows contingent indemnity claims for which the debtor is co-liable. Following receipt of Citadel’s objection to the Indemnity, as well its objection to confirmation of the Plan with the Indemnity in existence, Serta amended the Plan on the eve of the confirmation hearing to reflect that a “new” indemnity was included as part of an alleged settlement and represented that the Company’s agreement to this so-called new indemnity was a prerequisite to it obtaining the liquidity it needed to survive and eventually restructure. At trial on the merits, the Favored Lenders and the Company conceded that the original Indemnity should be disallowed under Section 502(e)(1)(b) of the Bankruptcy Code and such concession was reflected in the Court’s confirmation order. However, the Bankruptcy Court confirmed the Plan with the new indemnity in place due to its existence as a part of an alleged settlement. Citadel and the Excluded Lenders immediately appealed the Order and sought direct certification from the Fifth Circuit, which was granted.

On December 31, 2024, the Fifth Circuit issued a unanimous decision that reversed the bankruptcy court’s approval of the plan provision requiring the reorganized debtor to indemnify the Favored Lenders for any damage award resulting from the Excluded Lender’s breach of contract claims. Agreeing with Citadel, the Fifth Circuit held that the Plan improperly included the “offending indemnity” relating to the Uptier Transaction, which was not justifiable as a settlement and violated the equal-treatment rule of Section 1123(a)(4) of the Bankruptcy Code.

The Fifth Circuit also held that the original Uptier Transaction failed to qualify as an open market purchase. The Court concluded that an open market referred to a designated market, “not merely the background of free competition that characterizes much of modern American commerce.” If not, the proposed, more expansive definitions of “open market purchase” would have swallowed the Dutch auction exception included in the credit agreement, which allowed for disparate treatment of lenders under either an open market purchase or a Dutch auction.

The Fifth Circuit’s ruling highlights the need for careful consideration of the consequences that can arise from aggressive debt restructuring strategies favoring one group of lenders over another and serves as a cautionary tale for debtors who are considering structuring a plan that provides disparate treatment for creditors of a particular class. It also changes the landscape of the equitable mootness doctrine going forward given that the Fifth Circuit forcefully rejected any effort to dismiss the appeal on equitable mootness grounds.

The Faegre Drinker team involved included Jim Millar, Kristen Perry, Paige Naig, Mark Taticchi and Alex Harrell.