In an opinion that will have a significant impact on the viability of debt for debt exchanges and out of court restructurings, Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York has refused in the Chapter 11 case of Residential Capital LLC (“ResCap”) to disallow a portion of the claims of a class of junior secured noteholders (the “JSNs”) that constituted unamortized “original issue discount” arising from a fair market value exchange of notes several years earlier. (Kelley Drye & Warren LLP represents the indenture trustee for the JSNs). A contrary ruling would have cast a shadow over such exchanges and would make out of court restructurings far more difficult to achieve. Judge Glenn’s opinion resolves a long-standing question left from the landmark Second Circuit Court of Appeals decision over twenty years ago in LTV Corp. v. Valley Fidelity Bank & Trust Company (In re Chateaugay Corp.).
“Original issue discount”, or “OID”, typically arises when a bond is issued in a face amount that exceeds the amount actually paid by the purchaser. The difference represents the interest on the bond. Such notes are often referred to as “zero coupon bonds” because although the OID amortizes over the life of the bond, the interest does not get paid to the holder of the note until the date the note matures and becomes due. Since Section 502(b) of the Bankruptcy Code disallows claims for “unmatured interest”, bankruptcy courts have disallowed claims arising from unamortized OID.
The IRS has determined that OID also arises for tax purposes in debt exchanges in which the old notes given up are worth less than the new notes issued. Financially distressed companies often solicit such exchanges in the hope of obtaining financial relief and thereby avoiding the costs and disruptions of a Chapter 11 case. Some exchanges are for notes in the same face amount (usually with reduced interest rates or extended maturities) and are referred to as “face value” exchanges. Other debt exchanges involve the issuance of new notes with a principal amount that more closely reflects the market value of the old notes, thereby lessening the amount of debt on the issuer’s balance sheet. These are referred to as “fair market value” exchanges.
In Chateaugay, the Second Circuit declined to reduce the claims of noteholders who had exchanged their notes in a face value exchange, ruling that in such situations unamortized OID should not be disallowed as “unmatured interest” under Section 502(b). The court held that disallowing unamortized OID as unmatured interest would discourage out of court debt exchanges, and “would likely result in fewer out-of-court debt exchanges and more Chapter 11 filings.” However, the Second Circuit expressly declined to extend its holding to fair market value exchanges, stating that it “might make sense” to treat unamortized OID as unmatured interest “where the corporation’s overall debt obligations are reduced.”
ResCap presented this precise situation. In 2008, ResCap and its affiliates were reeling from the mortgage crisis. In an effort to stave off bankruptcy and wishing to reduce the debt on its balance sheet, ResCap solicited a fair market value exchange in which it exchanged $6 billion in old notes for approximately $4 billion of new JSNs.
Over five years later, ResCap and its official committee of unsecured creditors (the “Committee”) were locked in a confirmation battle over the recovery to which the JSNs are entitled under ResCap’s plan of reorganization (the “Plan”). In addition to battling over the value of the collateral securing the JSNs, the Committee commenced an adversary proceeding, raising the issue left unanswered by Chateaugay and seeking a determination that the JSNs’ claims should be reduced, arguing that the unamortized OID arising from the 2008 fair market value exchange should be disallowed as unmatured interest.
Judge Glenn, however, rejected the Committee’s effort to draw a distinction between face value exchanges and fair market value exchanges, and ruled that the Second Circuit’s holding in Chateaugay should apply equally to unamortized OID arising from both. Judge Glenn noted that the only feature of a note that cannot be modified in a face value exchange is the principal amount of the debt. Otherwise, in both face value exchanges and fair market value exchanges, the new notes offered may, among other things, be secured by new or additional collateral, have modified interest rates and maturity dates, be granted seniority of payment over other obligations, and enhanced by affiliate guaranties. Accordingly, Judge Glenn determined “that there is no meaningful basis upon which to distinguish between the two types of exchanges.”
The Second Circuit stated in Chateaugay that if claims for unamortized OID arising out of face value exchanges were disallowed, “then creditors will be disinclined to cooperate in a consensual workout that might otherwise have rescued a borrower from the precipice of bankruptcy.” A ruling that unamortized OID arising from fair market value exchanges should be treated differently would similarly have made successful out of court workouts much harder to achieve. Judge Glenn’s extension of Chateaugay’s logic to apply with equal force to fair market value exchanges will make out of court workouts and restructurings easier for distressed companies to undertake.