Financial sponsors are expected to pursue more creative ways to execute liability management exercises after an appeals court called into question common strategies sponsors have employed to deleverage distressed portfolio companies.

“Borrowers will need to find some other language that might work or another creative way that could mean treating creditors ratably, yet differently,” said Deborah Kovsky-Apap, restructuring partner at Troutman Pepper Locke.

Late last year the US Court of Appeals for the Fifth Circuit overturned rulings by disgraced Judge David Jones in the bankruptcy case of Serta Simmons Bedding that blessed the company’s aggressive uptier LME that relied on a non pro rata distressed debt exchange effected through an “open market purchase.”

In many LMEs, issuers have employed the open market purchase clause in their credit agreements to buy back only a portion of their debt at a negotiated discount, making an end run of the “sacred right” that issuers treat all lenders the same way.

The appeals court ruled that an open market purchase has to occur in secondary market for syndicated loans and thus Serta’s debt exchange was not allowed under its credit agreement. The court didn’t rule on the permissibility of common LME structures like drop downs and uptiers.

(Late last week, the appeals court granted Serta and a group of lender appellees a 21-day extension to file a rehearing of their petitions. The appellees are reviewing the panel’s disposition of the issues and are considering whether to seek rehearing or rehearing en banc, as reported.)

“This is not the silver bullet that kills of these LME transactions. It’s a good cautionary tale of reading the documents carefully and considering the implications of a court’s review and interpretation,” said Brian Lohan, head of the US restructuring and insolvency practice in Clifford Chance, about the Serta decision. “Any transaction in which you are trying to do something that’s not allowed within the four corners of the credit agreement could be affected,” he added.

Market participants now expect sponsors to take advantage of a strong investor demand in the primary market to add language to new credit agreements that permit borrowers to make non pro rata purchases of loans, said two of the attorneys and a buysider.

“I think that as long as the broadly syndicated market is hot and oversubscribed, what ends up happening is the words of the new documents, as new deals happen, go from open market purchases to private purchases,” the buysider said.

Xtract suggested in a recent report that issuers could draft agreements to allow purchases in “open market transactions or other privately negotiated transactions.”

The ruling may not protect lenders to existing credit agreements either. With the support from a majority of its lenders, an issuer pursuing an LME could revise its credit agreement to add language to facilitate a non pro rata deal, said two additional attorneys. “More games can be played,” added one of the attorneys, who cautioned that revising the agreement could open a company up to litigation.

Additionally, companies can focus on their refinancing baskets to determine what carveouts exist for pro-rata financings, said another restructuring attorney. They can also look at structures that utilize capacity at unrestricted subsidiaries since these boxes are not bound to credit agreements, so long as debt can be transferred at the unrestricted subsidiary, the attorney added.

Issuers can differentiate pro rata distressed exchanges completed through open market purchases by offering different fees to creditors with lenders who negotiate the deal receiving a backstop fee, the attorney continued.

“This stuff is still going to be done if a lawyer thinks there’s enough wiggle room in the credit agreement to negotiate an undefined term,” said the second buysider, adding that any benefit from the court decision won’t “really change anything for the foreseeable future.”

On the other hand, the bruising experience with LMEs of recent years has led lenders to place a greater focus on tightening up documents, said a third buysider. They added that the Serta decision was not a “final nail in the coffin” for aggressive uptiering attempts, but said investors will remain “very vigilant and aggressive” about closing off space for abuse or compensating for any added risks in other deals.

“I think where CLOs will differentiate themselves is really understanding when LMEs are possible – and at the first time of problems, selling their position, knowing it could be catastrophic if an uptiering transaction happens,” added the first buysider.

Though considered an effective way of extending financial runway for borrowers, the long-term merits of employing LMEs to fixing companies’ balance sheets remains open to debate with several borrowers becoming distressed again for filing for bankruptcy.

Some attorneys expect the lasting impact of Serta will be that it changes the risk calculous for borrowers contemplating LMEs that pit one group of creditors against another.

“Serta could chill aggressive LMEs not because of the open market purchase issue, but because it’s another example like Robertshaw and Incora where an aggressive LME has resulted in a tremendous amount of money and creditor value being torched due to expensive litigation and attendant longer and uncertain Chapter 11 process,” said Michael Handler, a restructuring partner at King & Spalding.