Restructuring

Creditors can breathe a small sigh of relief.  In a much anticipated follow-up to his initial decision on a motion to dismiss, Judge Glenn recently concluded in Official Comm. of Unsecured Creditors v. UMB Bank, N.A. (In re Residential Capital, LLC) that unamortized original issue discount (OID) arising from fair market value debt exchanges should not be disallowed by bankruptcy courts as unmatured interest under section 502(b) of the Bankruptcy Code.
The Parties’ Positions
As readers may recall, we’ve previously blogged about this issue of first impression and Judge Glenn’s initial disposition of it in his decision regarding the motion to dismiss; here, we quickly summarize again the key facts before we turn to Judge Glenn’s final decision on the merits.
The ResCap creditors’ committee had filed a complaint seeking, among other things, to disallow as unmatured interest the unamortized portion of the junior secured noteholders’ claim that represented OID generated by a prepetition fair value debt exchange.  They argued that the ResCap exchange differed significantly from a face value debt exchange.  Accordingly, they contended that the decision by the United States Court of Appeals for the Second Circuit in LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay) was inapplicable, and the junior secured noteholders’ claim for unamortized OID should be disallowed.  In Chateaugay, the Second Circuit held that unamortized OID generated by prepetition face value debt exchanges should not be disallowed in bankruptcy for policy reasons.  Disallowing unamortized OID generated by a face value exchange could, contrary to “strong” bankruptcy policy, disincentivize creditors from cooperating in a consensual workout that might prevent a bankruptcy filing altogether.
Unsurprisingly, the indenture trustee disagreed with the creditors’ committee’s position and moved to dismiss the OID count in the complaint.  It argued that the ResCap exchange was, in fact, substantially similar to a face value debt exchange, and, therefore, Chateaugay’s holding should be extended to the exchange to preclude disallowance of the junior secured noteholders’ claim for unamortized OID.
Judge Glenn denied the indenture trustee’s motion to dismiss and expressed his agreement with certain points raised by the creditors’ committee.  Ultimately, however, he reserved his judgment on whether unamortized OID generated by a prepetition fair market value debt exchange should be disallowed and concluded that he would need a fuller evidentiary record before resolving the issue as a matter of law.
The Experts’ Testimony
Subsequent to Judge Glenn’s decision on the motion to dismiss, the parties participated in a six-day hearing where multiple issues, including this one, were tried.  Both sides presented expert testimony relating to how the unamortized OID generated by the ResCap exchange should be treated in bankruptcy.  The parties agreed on several basic facts, including that the exchange was a fair value exchange, the junior secured noteholders were sophisticated investors familiar with the risks of investing in OID bonds and taxable OID was generated by the exchange.  The parties disagreed, however, on the amount of the unamortized OID as of the petition date.
The creditors’ committee’s expert emphasized in his testimony the economic incentives for noteholders that were built into the exchange:  yield, security and seniority.  He testified that the exchange was attractive to noteholders (regardless of the bankruptcy treatment of OID) because of the competitive effect of the yield on the new junior secured notes, the fact the new notes were secured where the old notes were not, and because the new notes were structurally senior to the old notes.  In fact, hold-outs who did not participate in the exchange retained a $1000 par unsecured claim, on which they were projected to recover $363.  In contrast, holders who participated in the exchange received $800 of new junior secured notes, on which they were projected to recover $840.  The creditors’ committee’s expert also testified to the benefits of the exchange to ResCap, namely that it allowed ResCap to reduce its overall debt obligations and extend its debt maturities, enhancing the credit strength of the obligor on the junior secured notes and allowing ResCap to avoid bankruptcy for 4 more years.
The junior secured noteholders’ expert, in contrast, stressed facts that supported a conclusion that the ResCap exchange did not generate disallowable OID and that disallowing OID in fair value exchanges would discourage out-of-court workouts because noteholders would likely reject such exchanges or demand more consideration from distressed companies such that engaging in such exchanges would become more difficult.  He noted that ResCap’s disclosures regarding the exchange did not warn of the possibility that unamortized OID generated by the exchange could later be disallowed in a bankruptcy.  He also testified that the lower than typical participation rate of 63% by noteholders in the exchange suggested to him that the market placed little value in the “structural enhancements” offered as consideration to induce participation.  Like the creditors’ committee’s expert, the junior secured noteholders’ expert testified to the benefits of the exchange to ResCap.  If ResCap had not executed the exchange, in the expert’s opinion, the Company would not have been able to service its debt obligations without third party intervention.  The successful completion of the exchange reduced ResCap’s outstanding debt, decreased its debt service and extended existing maturities.
Most importantly, the court noted that the experts agreed that little difference exists between a face value exchange and a fair value exchange, making “disparate treatment for the two exchanges in bankruptcy economically illogical.”  The court also noted that both experts further agreed that under Chateaugay, if the exchange had been a face value exchange, but all other inducements for participation remained the same, there would be no disallowable OID.  Moreover, both experts admitted that if OID from fair value debt exchanges could be disallowed, then distressed issuers would need greater incentives to entice creditors to participate in such exchanges.
The Court’s Conclusion
Based upon the evidence presented at trial, the court found that there existed “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.  First, the market value of the old debt is likely depressed in both a fair value and face value exchange.  Second, OID is created for tax purposes in both fair value and face value exchanges.  Third, there are concessions and incentives in both fair value and face value exchanges.”  Moreover, both kinds of exchanges offer companies out-of-court restructuring opportunities to avoid the cost and expense of a bankruptcy filing.  Accordingly, the court concluded that Chateaugay’s holding should control in both situations.
The court noted that even the creditors’ committee’s expert admitted that distinguishing between the two types of debt exchanges would be “somewhat arbitrary.”  In fact, he acknowledged that nearly all the features available in a debt-for-debt exchange could be used in both a face value and fair value exchange:  “(1) granting security in the issuer’s collateral, (2) interest rate, (3) maturity date, (4) payment priorities, (5) affiliate guarantees, (6) other lending covenants, (7) redemption features, (8) adding or removing a sinking fund or conversion feature, and (9) offering stock with the new debt.”  In other words, two debt exchanges could be identical in all respects, except with respect to the face value of the bond.  The court concluded that “despite [the creditors’ committee’s] contention that the consideration involved in the [ResCap exchange] – trading the unsecured notes for secured and structurally senior obligations – justifies breaking from the Second Circuit’s decision in Chateaugay, the evidence presented at trial indicated that the two types of exchanges are virtually identical, and it would be arbitrary for the Court to distinguish between them.”
Lastly, the court disposed of the creditors’ committee’s argument that the plain language of section 502(b) of the Bankruptcy Code should be enforced unless it leads to an absurd result.  Section 502(b) provides that a claim for unmatured interest is disallowable.  According to the creditors’ committee, because the junior secured noteholders’ recovery would still exceed that of the original noteholders even if unamortized OID was disallowed, the plain language rule should apply.  The court disagreed, stating that application of the plain language rule was “debatable” because the meaning of “unmatured interest” was far from clear.  The term is not defined in section 502(b).  On the other hand, the court found that predictability was of paramount importance to parties when planning transactions.  In the court’s view, the determination of whether a debt exchange generates disallowable OID should not be driven by a post hac inquiry into whether the party who exchanged ended up better than the party who didn’t.  Such a rule would create uncertainty and confusion in the market, impairing the ability of distressed issuers to successfully engage its creditors in out-of-court workouts – precisely the concern underscored by the Second Circuit in Chateaugay.
Although Judge Glenn’s decision may not be the final word on this issue and certainly is not binding on other courts, it should give serious pause to parties considering whether to seek disallowance of claims for unamortized OID arising from other fair market value debt exchanges.  Parties should take note of the fact that the Chateaugay decision stood largely unchallenged within the Second Circuit the last two decades, has been followed by at least one other circuit court, and now has been extended from face value debt exchanges to apply to fair value debt exchanges.  These facts may reflect a general consensus among the legal and restructuring community that the Second Circuit’s reasoning in Chateaugay is both legally and commercially sound.  At a minimum, they reflect that the weight of the sparse case law that exists on this issue is against parties that seek to disallow claims for unamortized OID arising from fair value debt exchanges, a reality these parties should account for when deciding whether the costs of pursuing such litigation will outweigh its benefits.