New York Bankruptcy Court allows claims for unmatured interest arising from original issue discount created in fair value debt-for-debt exchange
February 2014 | LEGAL & REGULATORY | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
The United States Bankruptcy Court for the Southern District of New York recently confirmed bankruptcy plans for Residential Capital, LLC (ResCap) and its affiliated debtors under Chapter 11 of the United States Bankruptcy Code. While the cases were extraordinarily complex, one litigated issue that warrants particular discussion is the Bankruptcy Court’s decision to allow the claims of certain junior secured noteholders (JSNs) for unmatured interest arising from original issue discount (OID) that was created in a fair value debt-for-debt exchange.
The ResCap decision is significant to the extent OID is considered a form of deferred interest because the Bankruptcy Code provides that claims for unmatured interest will not be allowed in bankruptcy cases. Moreover, while cases before ResCap had allowed unmatured interest arising from OID created in face value debt-for-debt exchanges, those decisions left open the question of whether the same reasoning would apply to fair value exchanges in which “old securities [are] exchanged with new securities with a reduced principal amount that in theory approximate[s] the market value of the old securities.” Official Committee of Unsecured Creditors v. UMB Bank, N.A., et al. (In re Residential Capital, LLC, et al.), 501 B.R. 549, 577 (Bankr. S.D.N.Y. 2013).
“An exchange offer made by a financially troubled company can be either a ‘fair market value exchange’… [in which] an existing debt instrument is exchanged for a new one with a reduced principal amount, determined by the market value at which the existing instrument is trading… [or a face value exchange, which,] by contrast, involves the substitution of new indebtedness for an existing debenture, modifying terms or conditions but not reducing the principal amount of the debt.” Id. at 577 & n. 24 (citingLTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378, 381-82 (2d Cir. 1992)). The Bankruptcy Court noted OID is a form of “deferred interest created when a bond is issued for less than the face value the borrower contracts to pay at maturity… [which] accretes over the life of the note but is payable only at maturity... [and] is amortized for tax and accounting purposes over the life of the bond.” Id. at 585. But, to the extent OID is a form of deferred interest, the Bankruptcy Code provides that claims for unmatured interest will not be allowed in a bankruptcy case. See 11 U.S.C. § 502(b) (authorising court to allow claim “except to the extent that… such claim is for unmatured interest.”).
Before filing for bankruptcy protection on 14 May 2012 (Petition Date), ResCap and certain of its affiliates were one of the largest originators and servicers of residential mortgage loans in the United States. In June 2008, ResCap issued the JSNs as part of a fair value debt-for-debt exchange offer, exchanging approximately $6bn of outstanding unsecured notes for approximately $4bn of junior secured notes and $500m in cash. Id. at 576-77. In the bankruptcy cases, the JSNs asserted claims against ResCap for the then-unpaid principal amount of the junior secured notes of approximately $2.222bn (as of the Petition Date, including pre-petition interest). The JSNs claim included amounts for unamortised OID created in the 2008 exchange totalling $386m as of the Petition Date (OID Claim), with $1.549bn having amortised before the bankruptcy cases commenced. Id. at 585-586.
ResCap and the statutory creditors’ committee appointed in its bankruptcy cases argued the OID Claim constituted unmatured interest which should be disallowed. The Bankruptcy Court disagreed.
The 1992 Chateaugay decision from the United States Court of Appeals for the Second Circuit determined that even though unamortised OID is unmatured interest for purposes of section 502(b) of the Bankruptcy Code, policy considerations militated in favour of allowing claims for OID created in face value debt exchanges: “[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. We must consider the ramifications of a rule that places a creditor in the position of choosing whether to cooperate with a struggling debtor, when such cooperation might make the creditor’s claims in the event of bankruptcy smaller than they would have been had the creditor refused to cooperate.” Chateaugay, 961 F.2d at 382 (expressing concern that prospect of disallowed claims for OID “would likely result in fewer out-of-court debt exchanges and more Chapter 11 filings.”).
Chateaugay, however, limited its holding to face value exchanges where “rather than changing the character of the underlying debt” it is reaffirmed and modified. The Second Circuit specifically noted that disallowance of OID “might make sense in the context of a fair market value exchange, where the corporation’s overall debt obligations are reduced.” Id.
With respect to the JSNs OID Claim, the Bankruptcy Court took instruction from Chateaugay. See ResCap, 501 B.R. at 587 (“Since Chateaugay is the law of the Circuit, and holds that unamortized OID should not be disallowed in the case of a face value exchange, the Court concludes that the unamortized OID generated by the fair value exchange here should not be disallowed from the JSNs’ claim.”). The Bankruptcy Court identified at least four reasons why “there is no commercial or business reason, or valid theory of corporate finance, to justify treating claims generated by face value and fair value exchanges differently in bankruptcy:” (i) “the market value of the old debt is likely depressed in both a fair value and face value exchange;” (ii) “OID is created for tax purposes in both fair value and face value exchanges;” (iii) “there are concessions and incentives in both fair value and face value exchanges; and (iv) “both fair and face value exchanges offer companies the opportunity to restructure out-of-court, avoiding the time and costs – both direct and indirect – of a bankruptcy proceeding.” Id. at 588 (noting “the evidence presented at trial indicated that the two types of exchanges are virtually identical, and it would be arbitrary to distinguish between them.”).
By confirming that claims for OID created in fair value debt will be allowed in bankruptcy cases notwithstanding the Bankruptcy Code’s prohibition against unmatured interest claims, the ResCap decision has enhanced the efficacy of debt-for-debt exchanges as a consensual restructuring alternative for financially distressed companies. See, e.g., id. at 589 (“Determining whether the transaction created disallowable OID should not depend on if the noteholders or the debtors got a ‘good deal’ in bankruptcy. That rule would create confusion in the market and would likely complicate a financially distressed company’s attempts to avoid bankruptcy with the cooperation of its creditors.”).
James C. Tecce is a partner at Quinn Emanuel Urquhart & Sullivan LLP. He can be contacted on +1 (212) 849 7000 or by email: email@example.com.
© Financier Worldwide
James C. Tecce
Quinn Emanuel Urquhart & Sullivan LLP