This Alert is not another Serta gripe. Rather, this Alert is about the exception to the developing Serta credit agreement language that excludes debtor-in-possession financing as one type of senior financing that does not require an opportunity to participate pro rata.

This week, in the American Tire Distributors Chapter 11 cases, Delaware Bankruptcy Judge Goldblatt considered approval of a DIP credit agreement that included the "roll-up" of prepetition term loans into the principal balance of the DIP financing. The catch? Only the participating DIP Lenders would get an opportunity to pull prepetition debt into a priming, senior DIP facility. Obviously, that's a really bad result for the excluded prepetition term lenders. They objected.

On the one hand, the prepetition credit agreement provided "Serta protection" (an oxymoron) but excluded any "DIP financing" from that protection. On the other hand, the prepetition credit agreement prohibited changes to the waterfall and pro rata sharing requirement. So how is it that the DIP agreement could transfer only some of the prepetition term loans into the DIP, leaving the excluded term lenders with a non-pro rata dilution? Judge Goldblatt cautioned against this result: "What will happen, if I approve this, is that the minority lenders will sue and they will win and they will be entitled to the damage." The Debtors promptly modified their motion and removed the "roll-up" provision for the term lenders (as opposed to offering the juicy new money DIP to all Lenders). Judge Goldblatt was then "delighted" to approve the DIP.

A Few Observations

Before Serta, folks understood that the majority lenders typically could direct the agent to consent to a DIP financing (on a senior basis) because there was no requirement that all lenders be offered the same opportunity to provide the DIP. At the same time, desperate to find lenders willing to provide DIP financing, some debtors (and enterprising debt purchasers) realized that large market credit agreement often did not contain lender blocking rights for changes to the waterfall or the pro rata sharing provisions. As a result, and over the objections of non-participating lenders, bankruptcy courts started to approve the non-pro rata roll-up of prepetition debt into DIP facilities. (For example, see the DIPs in Aleris, Lyondell and Capmark).

As part of roll-ups, it has become somewhat of a "bankruptcy market practice" to look at the ratio of rolled-up prepetition debt to "new money," with debtors and lender participants constantly pushing to increase ratio (with American Tire proposed at about 3.4). Elevating prepetition debt into post-petition debt, of course, has the advantage of being a super-priority administrative claim (i.e., no cram-down and payment in full at confirmation). For the middle market credit facilities, these sorts of non-ratable transfers would be prohibited by contract; thus, these types of roll-ups were either not attempted or minority lenders objected (just as they effectively did in American Tire). (For example, see Appvion. )

In a post-Serta world, where lenders wanted a contractual right to participate in any facility that would prime the existing facility, company counsel pushed to include the exception for DIP financing. It is fair for any lender to question why DIP financing should be excluded. After all, why should it not be expected to allow all lenders in the prepetition facility to have the same opportunity to participate in the DIP facility? One answer is, as noted above, that was not the expectation pre-Serta. Any lender could offer a DIP and the debtor theoretically would want to encourage competition among the lenders as prospective DIP lenders. The majority could always direct the agent to object to a priming dip, but if the bare majority were providing the DIP (and getting the fees), the defense of the minority is to offer better terms (and be willing to fight the Agent's objection), or to otherwise enter into a voting agreement among lender to prohibit priming by a subset of lenders.

It is not entirely clear that any reference to the post-Serta exclusion for DIP financing is necessary. There is no amendment to the prepetition credit facility in the case of a DIP. The "subordination" occurs as a result of the priming allowance of the Bankruptcy Code. But cases get litigated and forms get longer.

In 2022, when parties first started to draft these exceptions, a thoughtful credit agreement excluded DIP financing from the new Serta language, but only if that DIP financing did not include any roll-up. (Dave & Busters). Other lenders followed suit and pressed for this roll-up exclusion to the Serta DIP exception. Fast forward to 2024 and requests for that thoughtful exclusion are met with cries of "not market." But it should be "market" – otherwise, the problem of being blown up from a non-pro rata up-tiering is merely postponed until the worst case scenario of Chapter 11. To be sure, sponsor counsel wants this exception to be able to induce a subset of lenders to make a DIP proposal that might otherwise not exist or would have been substantially more expensive (with more debt included in the refinancing).

But what happens when the DIP financing exclusion is added to the subordination language without the protection of pro rata participation for any roll-up of prepetition debt as part of the DIP financing? You find yourself back in time, as noted above. Some credit agreements allow for non-pro rata exchanges of prepetition debt for post-petition debt; other credit agreements have all lender blocks for changes to the waterfall and non-pro rata sharing. This relatively new Serta language with the DIP financing exclusion (without the "no roll-up" proviso) creates the possibility for a conflict of exactly the type in American Tire.