Restructuring

In a recent memorandum decision, Judge Glenn denied a motion to dismiss a claim for the disallowance of unamortized original issue discount (OID).  Judge Glenn’s disposition of the partial motion to dismiss in Official Comm. of Unsecured Creditors v. UMB Bank, N.A. (In re Residential Capital, LLC  itself is not controversial, but his decision does touch upon an unresolved issue of first impression worth exploring further: whether bankruptcy courts should disallow OID arising from fair market value debt exchanges.
At its simplest, OID is the difference between the value of the proceeds of a bond or other debt instrument at the time it is issued and the face amount of the same bond or other debt instrument at its maturity.  For example, a corporation issues a zero coupon bond with a face value of $1,000 for an issue price of $800.  The bond’s OID is $200, or the difference between the bond’s face value and issue price.  OID is meant to compensate a lender for the use and forbearance of money.  Despite the OID being paid only when the debt matures, it is, in essence, interest and, from an accounting and tax perspective, OID is typically amortized over the life of the debt and treated as interest in addition to any periodic or regular interest under the debt instrument.
How is OID usually treated from a bankruptcy perspective?  Well, it depends.  Under section 502(b)(2) of the Bankruptcy Code, a claim for interest that has yet to accrue as of the petition date is generally considered a disallowable claim for unmatured interest.  Section 502(b)(2)’s legislative history unambiguously includes within the meaning of unmatured interest “prepaid interest that represents an original discounting of the claim…that would not have been earned on the date of bankruptcy.”  Thus, courts considering whether to disallow claims for OID agree that the Bankruptcy Code clearly requires them to disallow claims for unamortized OID.
This clarity is partially lost, however, when a company engages in a prepetition debt exchange, like in Residential Capital, LLC, that, for tax purposes, generates OID.  Prepetition debt exchanges can be either face value debt exchanges or fair market value debt exchanges.  In face value debt exchanges, old debt is exchanged for newly issued debt and the terms and conditions of the debt are changed but the outstanding principal amount of the debt remains the same.  In fair market value debt exchanges, old debt is exchanged for newly issued debt but the new debt is issued at a lower principal amount (usually determined by the market value of the old debt), thereby reducing a company’s overall debt obligations.
For face value exchanges, the law in the Second Circuit, at least, is clear.  LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay Corp.) holds that face value exchanges do not generate new OID disallowable in bankruptcy.  In reversing the bankruptcy court’s decision (which was affirmed by the district court), the Second Circuit in Chateaugay relied upon what it viewed as the “strong” bankruptcy policy favoring out of court consensual workouts over bankruptcy filings.  It reasoned that “[i]f unamortized OID is unallowable in bankruptcy, and if exchanging debt increases the amount of OID, then creditors will be disinclined to cooperate in a consensual workout that might otherwise have rescued a borrower from the precipice of bankruptcy.”  Moreover, disallowing OID arising from a face value debt exchange would create perverse incentives.  Holdouts who failed to exchange their debt would end up with claims in higher amounts than those creditors who cooperated with a struggling debtor by exchanging their debt.  The Second Circuit viewed its decision as necessary to incentivize creditors to cooperate with a troubled debtor and prevent a corresponding windfall to holdouts who refuse to cooperate and to an issuer that files for bankruptcy subsequent to a debt exchange.  The Second Circuit also noted that the face value debt exchange did not change the character of the underlying debt exchanged, but reaffirmed and modified it.  Accordingly, the OID on the new debt consisted only of the discount carried over from the old debt, i.e., the unamortized OID remaining on the old debt at the time of exchange.
For fair market value exchanges, the law in the Second Circuit provides little guidance.  The only court known to express any view on the issue is the Second Circuit in Chateaugay, which suggested that it might make sense to disallow OID generated by fair market value debt exchanges.
According to the creditors’ committee’s complaint, ResCap engaged in a prepetition fair market value debt exchange.  The creditors’ committee asserted (and the court took as true for purposes of deciding the motion to dismiss) that $6 billion of old unsecured notes were exchanged for approximately $4 billion face value of new junior secured notes and $862 million in cash.  For every $1,000 in face amount of old unsecured notes tendered, a noteholder was entitled to receive $800 of the new junior secured notes.  Holders of the old unsecured notes were also given the opportunity to elect to receive cash in lieu of the new junior secured notes pursuant to a “modified Dutch auction” process, at which the clearing price was $650, in cash, per $1,000 in face amount of new junior secured notes.  The creditors’ committee believed that the exchange resulted in at least $1.548 billion of taxable OID, measured by the difference between the $800 face amount of the new junior secured notes upon issuance and the trading value of those new notes on the issue date, which value the creditors’ committee asserted was below $800.  As of ResCap’s petition date, the creditors’ committee estimated approximately $2.12 billion of the new junior secured notes remained outstanding and at least $377 million of OID remained unamortized.
The creditors’ committee sought to disallow the unamortized OID as unmatured interest under section 502(b)(2), arguing that the Chateaugay exception did not apply because the ResCap exchange was fundamentally different from the Chateaugay exchange.  The creditors’ committee asserted that the exchange here more closely resembled two separate transactions:  the purchase of outstanding debt at fair market value and the sale of new bonds at fair market value.  In such instance, the holders of the new bonds would have claims in bankruptcy only equal to the cash value of the old bonds, discounted for OID.  Furthermore, the creditors’ committee observed that the creditors’ participation in the ResCap fair market value exchange was a function of incentives not found in a face value exchange – namely, the old unsecured notes were exchanged for new secured notes with a senior right to payment and the overall indebtedness of the company was reduced.  As a result, the creditors’ committee asserted that disallowing OID in this situation would not discourage workouts and encourage windfalls to holdouts, which were concerns stressed by the Second Circuit in Chateaugay.
In response, the indenture trustee for the new junior secured notes moved to dismiss the OID count in the complaint.  In the first instance, it disputed the creditors’ committee’s allegation that the exchange generated any taxable OID.  But even if it accepted the allegation as true, the indenture trustee argued that the court should not automatically apply tax law to determine the appropriate treatment of OID claims in bankruptcy and Chateaugay’s holding should be extended to ResCap’s fair market value exchange because it implicated the same policy concerns.  Indeed, the indenture trustee observed that more reason existed to apply Chateaugay’s holding here.  Because fair market value exchanges reduce a company’s overall indebtedness, such exchanges more often aid distressed debtors than face value exchanges.  It would be inequitable, the indenture trustee argued, to punish participating noteholders who voluntarily agreed to reduce the size of their principal claims to the benefit of the distressed debtor, by further reducing a portion of their claim as unamortized OID.
Judge Glenn denied the indenture trustee’s motion to dismiss.  He agreed that the exchange at issue was a fair market value debt exchange for which existing case law failed to provide a clear answer regarding whether the taxable OID generated under such an exchange should be disallowed under section 502(b)(2).  He also noted that the general rule is that unamortized OID should be disallowed in bankruptcy and that he did not believe the exception articulated in Chateaugay was determinative here.  The court agreed with the creditors’ committee that the facts of the case differed significantly from the facts in Chateaugay.  First, he noted that the Chateaugay exchange did not reduce the debt on the debtor’s balance sheet.  Here, the ResCap exchange reduced ResCap’s overall debt obligations, correspondingly reducing the debt on ResCap’s balance sheet.  This meant that disallowing the OID claim would not result in a reduction of actual liabilities without a corresponding balance sheet reduction.  Moreover, the Chateaugay court was concerned that holders of old bonds who were unwilling to cooperate with the debtor in an out of court workout would have a larger claim while holders of new bonds in the same principal amount who were cooperative would have a smaller claim.  Here, disallowing OID would not result in providing a windfall to the holdout noteholders.  The old unsecured notes differed greatly from the new junior secured notes – the new notes were secured.  As the creditors’ committee explained at the hearing, the holders who declined the exchange offer retained a $1,000 claim on which they would now recover approximately $360.  Holders who participated in the exchange offer now stood to recover at least $685.
Ultimately, Judge Glenn concluded that he would need a fuller evidentiary record before he could make a determination on the issue.  The decision provides little clarity on whether, as a matter of law, unamortized OID newly generated by a prepetition fair market value debt exchange should be disallowed as unmatured interest under section 502(b)(2).  But in denying the motion to dismiss, Judge Glenn makes clear that he has not foreclosed that outcome and, therefore, claims reflecting new OID arising from fair market value debt exchanges remain fair game for disallowance.