Octus covenant experts Julian Bulaon and Melissa Kelley argue that while the Fifth Circuit’s Serta decision reshaped the LME playbook, the era of lender-on-lender aggression is far from over — it has simply gotten more sophisticated.
Few corners of credit markets have generated more legal drama — or more contractual creativity — than the world of liability management exercises. Since Serta shocked the leveraged loan market in 2020 by using a bare majority of lenders to prime the minority, the industry has been locked in a continuous cycle of innovation and response: new loopholes discovered, new blockers named, new litigation filed and new structures engineered to stay one step ahead of the protections designed to stop them.
The Fifth Circuit’s 2024 ruling on Serta was supposed to be a turning point. In many ways, it was — but not an ending. In a recent conversation with ABF Journal editor in chief Rita Garwood, Julian Bulaon, head of liability management for Americas Covenants at Octus, and Melissa Kelley, deputy head of the Americas Covenants team and a former LME litigator with nearly a decade of experience in New York and London, explained why the market is still very much in motion, what the current wave of LMEs reveals, and why the 2028 maturity wall may be the next major inflection point.
This interview has been condensed and edited for clarity. Watch the full interview on YouTube or listen on Spotify.
Rita Garwood: For those who weren’t following credit markets closely in 2020, what exactly did Serta Simmons do — and why was it such a shock?
Julian Bulaon: In 2020, Serta Simmons executed what we now call a non-pro-rata contractual up-tier. Lenders holding a bare majority — around 51% — of Serta’s outstanding first-lien term loans exchanged their loans into new super-priority debt secured by super-senior liens on the collateral. The new facility included a first-out new money tranche, with the exchange debt sitting in the second-out tranche. The participating lenders did this by amending the credit documents to subordinate the existing term loan liens to the new super-priority debt. And on top of that, the majority amendment also stripped out restrictive covenants and other lender protections from the debt that was left behind. The result was that the excluded minority — that 49% — were left holding lien-subordinated, covenant-stripped paper. The shock was twofold. First, non-pro-rata up-tiers like this were generally considered a feature of the high-yield bond market, not first-lien term loans. First-lien term loans were supposed to be the safer instrument. Second, Serta’s credit agreement had actually closed the loophole used in an earlier transaction — a 2017 deal by a company called NYDJ — so the market thought it had already addressed this risk. Serta found a way around that fix. It’s helpful to understand Serta as two analytically distinct steps: the non-pro-rata piece — the unequal treatment of the 51% versus the 49% — and the contractual subordination piece, where minority lenders were subordinated without their consent. Both steps were intensely litigated, but it’s the non-pro-rata piece that ultimately became the focus of the Fifth Circuit’s 2024 decision.
Garwood: Melissa, most credit agreements have pro-rata sharing provisions treated as sacred rights. How did Serta’s majority lenders argue their way around that protection?
Melissa Kelley: The pro-rata sharing provision is a fundamental mechanism in credit agreements. It requires lenders to share any payments received in excess of their pro-rata share with all other lenders in the same class — essentially ensuring equal treatment that mirrors bankruptcy’s principle of similarly situated creditors receiving similar treatment. For that reason, it’s often protected as a sacred right. But pro-rata sharing provisions also typically include exceptions, and those exceptions are precisely what borrowers and majority lenders rely on to carry out liability management transactions. Serta’s credit agreement contained a pro-rata sharing provision that protected it as a sacred right — but expressly excluded from its coverage payments made through open market purchases. Serta and its majority lenders argued that the non-pro-rata exchange into the super-priority loan constituted an open market purchase, and therefore fell outside the provision’s reach. At the same time, Serta’s credit agreement lacked a sacred right against lien subordination. That gap permitted the priming debt to be put in place with majority consent. The open market purchase exception then permitted the non-pro-rata exchange into that priming debt. Those two loopholes, working together, are what enabled the transaction — and the lack of lien subordination protection gave rise to what is now known as the Serta blocker.
Garwood: The Fifth Circuit ultimately rejected Serta’s interpretation of “open market purchase.” What was their reasoning?
Kelley: The phrase “open market purchase” was not defined in Serta’s credit agreement. Serta and its majority lenders argued that it meant acquiring something for value in competition among private parties. The Fifth Circuit held that it meant something far more specific: a purchase of corporate debt occurring on the secondary market for syndicated loans. The Fifth Circuit reached that interpretation through two main routes. First, looking at ordinary dictionary and legal definitions — particularly from New York State courts and authorities — the court concluded that Serta’s proposed definition simply forgot the word “market.” The Fifth Circuit held that an open market purchase requires a designated market, not a general backdrop of free competition, and that the designated market in this context is the secondary loan market. Second, the court looked at the structure of the relevant provision itself. It contained two exceptions to pro-rata sharing: through a Dutch auction or by making open market purchases. A Dutch auction is, by definition, an auction — a discrete mechanism. Under a foundational principle of contract interpretation, every word must have meaning. If open market purchase simply meant any exchange for value among private parties, it would be functionally identical to a Dutch auction, and one of the two exceptions would be rendered meaningless. The Fifth Circuit rejected that outcome.
Garwood: We’re seeing a surge in LME activity — Medical Solutions, SonicWall, and others. Is this a last gasp before Serta’s precedent fully takes hold, or is the market finding new workarounds?
Bulaon: It’s evolution, not extinction. The Fifth Circuit’s interpretation of open market purchase is settled — that path is closed in that jurisdiction. But we’re very much in the post-Fifth Circuit era now, which means companies and majority lender groups have simply shifted to different exceptions and structures to achieve non-pro-rata outcomes. A few examples. Top-tier sponsors are now frequently and successfully negotiating for privately negotiated purchase exceptions to the pro-rata sharing provision — language that explicitly permits something other than an open market purchase, side-stepping the Fifth Circuit’s ruling entirely. There are also structures the market calls Extend and Exchange, pioneered literally weeks after the Fifth Circuit decision, which take advantage of other common exceptions to pro-rata sharing provisions. And in older vintage deals — some from 2019 that have been amended or refinanced multiple times — you still sometimes see the original NYDJ-type loophole carrying through. So, yes, the Fifth Circuit ruling changed the playbook. It did not end the game.
Garwood: Melissa, what makes the current situations at Medical Solutions, SonicWall, and STARS/Lionsgate legally distinct from earlier LMEs?
Kelley: Medical Solutions and SonicWall are both private, so we can’t discuss their documents. From what’s publicly reported, SonicWall appears to be heading toward a pro-rata LME — we don’t know whether that’s driven by document restrictions or other factors. More broadly, we have seen the market move toward more inclusive approaches. Some of us at Octus, Julian included, call them “kinder, gentler LMEs.” I’ve heard market participants say the transactions are getting more boring. Medical Solutions is reportedly a non-pro-rata LME with a significant delta in exchange economics between the STEERCO and non-STEERCO co-op lenders. What makes it interesting is the tiered treatment structure. My understanding is that the co-op was open to all, but established four potential tiers of lender treatment — and lenders were entering the co-op agreement without knowing what their eventual recoveries would be. Tiered economics aren’t new, but that uncertainty created real concern among some of the lenders involved. There’s also a holdout group that is co-oped and is reportedly represented by counsel. STARS, or Lionsgate as it’s now commonly referred to, is in a different category. It involved a non-pro-rata uptiering — specifically a bond swap — and is currently the subject of litigation. A motion to dismiss decision preserved a breach of contract claim based on a sacred right protecting against modifications to the notes’ guarantee that were adverse to holders or that released guarantors constituting all or substantially all of the value of that guarantee. That raises two issues we’ve seen before: whether excluded holders need to allege that the transaction amended the specific sacred right text itself, or whether amending other provisions relevant to that right is sufficient. The court said the latter. And the “all or substantially all” question is a genuinely thorny legal issue with no clear settled answer — it’s also implicated in Lionsgate and a number of other cases.
Garwood: Julian, how does the market typically respond to a new LME tactic — and where does the blocker-naming process stand today?
Bulaon: The market’s response to a particularly alarming LME is to craft new contractual protections — blockers — designed to shield lenders from that specific type of transaction in the future. And the fun part is that blockers end up named after the company that pioneered the tactic. A Serta blocker, for instance, is a sacred right requiring individual lender consent to contractually subordinate a lender’s lien or payment priority to other debt. If one had been in Serta’s credit agreement, the transaction couldn’t have happened. Following the 2020 up-tier, we saw a steady increase in the prevalence of Serta blockers in BSL documentation — from less than 50% of issuances in 2020 to a far higher share today. We’ve been naming blockers for at least ten years, starting with J.Crew in 2016 — the notorious IP drop-down — right through to Xerox in February 2026, which executed a similar drop-down in a way that still managed to push the boundaries almost a decade after J.Crew, when people thought that problem had been solved. Some blockers are now very prevalent — Serta, J.Crew, and Chewy are the so-called Big 3 in the BSL market. Others — Envision, At Home, Wesco and Clora, Pluralsight, Xerox — haven’t achieved the same market-wide uptake, although they’re increasingly standard in post-LME and post-restructuring documents, where lenders take care to close every loophole they themselves exploited. What’s driving that differential isn’t awareness — people know what these blockers are, especially if they’re reading Octus. It’s negotiating power. There’s too much money chasing too little supply, and sponsors know it. When lenders aren’t in a position to win these protections at the negotiating table, they don’t get them.
Garwood: Melissa, does going pro-rata offer a genuinely safer legal harbor for sponsors, or is any priority-shifting move now subject to litigation regardless of how it’s structured?
Kelley: I wouldn’t say it offers a completely safe harbor, but litigation risk is clearly elevated with non-pro-rata transactions. Most of the significant LME litigation we’ve seen — from J.Crew through to Lionsgate — has involved non-pro-rata structures. That said, never say never. There’s a case involving a Swiss vending machine company called Selecta, involving New York law-governed debt, where the first step was a pro-rata discount exchange — but after that pro rata exchange, minority holders were given a chance to swap into debt that would recover their par value but that lacked standard sacred rights protections, meaning that there were no restrictions against a subsequent majority amendment. Because an ad hoc group already held a majority of that new debt, lenders excluded from the group were effectively guaranteed to face a non-pro-rata LME in the next step. The first transaction — the pro-rata step — is itself now the subject of interesting litigation. So yes, pro-rata structures generally carry less litigation risk. But the structure alone isn’t determinative. What the new debt looks like, and what protections it carries, matters enormously.
Garwood: What does the pending bankruptcy court remand in Serta actually put at stake — and could a ruling in the majority lenders’ favor upend the loan market?
Kelley: Following the Fifth Circuit’s ruling on the open market purchase question, the participating lenders in Serta have pivoted to a new argument: that the pro-rata sharing provision doesn’t apply to the up-tier transaction in the first place. Their position is that the provision only covers cash payments, and the super-priority debt exchange was not a cash payment. The argument is that the provision was always understood in the industry as addressing accidental overpayments — computer errors, inadvertent disbursements — not intentional restructuring transactions. This argument has been made before courts with increasing frequency, including in connection with priming DIP roll-ups in American Tire, Del Monte, and JCPenney. American Tire and JCPenney settled. Del Monte is still pending. Bulaon: I’ll add that while the argument isn’t inherently crazy — it has been made in multiple other contexts — it strikes me as lacking credibility in this particular case given the litigation history. We’ve spent nearly six years operating on the assumption that the pro-rata sharing provision was relevant and applicable, debating intensely what an open market purchase means. None of that analysis matters if the pro-rata provision doesn’t apply in the first place. To arrive at that conclusion now, after all of this, would be extraordinary. If that argument prevails, it has serious consequences for the loan market — which is precisely why I think the bankruptcy court is unlikely to take that direction. But the question is officially in front of the court, and we’re waiting.
Garwood: Are you seeing a shift in how lender groups form around distressed situations — and are those dynamics changing the nature of LMEs themselves?
Kelley: Yes, and in a couple of meaningful ways. The first is that lender groups are co-opping earlier in the process. When I started practicing, it was typically a group of distressed funds spotting an opportunity, calling the agent or trustee, interviewing law firms — the classic beauty parade. Now, as soon as debt drops below par, law firms are knocking at the doors of CLOs. The law firms active in this space, on both the lender and borrower side, are genuinely well-oiled machines with dedicated practices built around identifying these opportunities early. The rationale is to have a group in place that can push toward a consensual LME — though there are always exceptions. A large, aggressive holder may prefer to act alone. And minority lenders or holdouts who are willing to gamble on par recovery at maturity — or who are simply prepared to litigate — will often form their own countervailing group. The second shift is that co-op agreements are now increasingly including explicit carve-outs making clear that the obligations under the agreement don’t extend to the provision of new money that is completely unrelated to the existing debt. That’s a direct response to the Optimum lawsuit filed against the co-op group there. The market’s general view is that the Optimum situation doesn’t portend broader systemic risk — but it’s being addressed in the documents regardless in this limited way.
Garwood: ABL and asset-backed lenders often feel insulated by their collateral position. Are LME tactics bleeding into that space?
Bulaon: Fortunately for those lenders, not really — and I do mean fortunately, because asset-backed finance has its own significant challenges to navigate in the wake of First Brands. But there are structural reasons why ABL and revolver lenders are less exposed. Those lenders are generally viewed as civilians in an LME scenario — non-combatants. Unlike funded term debt, a revolving or asset-backed facility is an ongoing operational relationship that the borrower relies on for day-to-day liquidity. In most LMEs we see, the revolver or asset-backed facility is either taken out at par or rolled into the new LME structure on the most favorable terms. I can’t recall a recent example where a revolving or other cash flow-type lender was forced to take a haircut or accept terms they didn’t consent to. That said, well-advised revolver and ABL lenders aren’t relying on that custom — and they’re right not to. Relying on relationship and convention is dangerous in this market. A good example: last year, Hertz’s revolving lenders agreed to a maturity extension amendment, but only on the condition that the amendment include the full suite of LME blockers. That effectively ensures that if Hertz pursues an LME, it will need to be structured on terms the revolver lenders can accept.
Garwood: If 2020 through 2024 was the era of lender violence, what do you call what comes next?
Bulaon: First, I want to acknowledge the framing — 2020 to 2024 really was its own distinct era. You can trace the modern LME era back to J.Crew in 2016, but that 2020-to-2024 window was the Wild West period, before the Fifth Circuit stepped in and attempted to impose some order. But I don’t think 2024 marked the end of lender-on-lender violence. The Fifth Circuit’s Serta decision wasn’t the only ruling that dropped on New Year’s Eve 2024. There was also Mitel, out of New York, which upheld a non-pro-rata up-tier — just on different facts and contractual language. When you read those two decisions together, the message is clear: permissibility comes down to what the contract says. Non-pro-rata isn’t going away. People just have to read the documents more carefully. If I had to give the next era a name, I’d call it stochastic lender violence. Characterized by a steady flow of regular LMEs that still force haircuts — people don’t love them, but we’re used to them, they’re no longer entirely unexpected — punctuated by moments of extreme aggression and innovation. Xerox earlier this year was a good example: a drop-down financing that still managed to push the boundaries almost a decade after J.Crew, when the market thought that particular problem was solved. I expect we’ll see more of that, especially as we approach the 2028 maturity wall.