Fair Value Debt-for-Debt Exchange Does Not Create Disallowable Unmatured Interest under the Bankruptcy Code. Official Committee of Unsecured Creditors v. UMB Bank, N.A. (In re ResCap), 501 B.R. 549 (Bankr. S.D.N.Y., Nov. 15, 2013).
In a matter of first impression of importance to bondholders, Judge Glenn ruled on November 15 in ResCap that fair value debt-for-debt exchanges do not create disallowable unmatured interest under the Bankruptcy Code even though they may generate OID for tax purposes.
OID, or original issue discount, is a form of deferred interest that occurs when a bond is issued at a discount to its face value. For accounting and tax purposes, OID is amortized over the tenure of the bond, with the face amount of the bond becoming payable at maturity, plus interest. This can lead to claim allowance disputes in bankruptcy because section 502(b) of the Bankruptcy Code permits disallowance of claims for “unmatured interest,” which is generally considered to be prepaid interest that would be considered unearned on the date of a bankruptcy filing.
It is well settled that a claim for unamortized OID on an ordinary discounted security will be disallowed. However, treatment of a claim for unamortized OID generated in a debt-for-debt exchange has been less clear. In 1992, the Second Circuit held in In re Chateaugay, that a face value debt-for-debt exchange offered as part of a consensual workout did not generate new OID that is disallowable under section 502(b) of the Bankruptcy Code. But Chateaugay left open the treatment of a distressed exchange at fair value. Such a fair-value exchange may generate taxable OID because the face amount of the new debt exceeds the fair market value of the old debt tendered as consideration for the new debt. Judge Glenn’s decision in ResCap directly addressed this question for the first time.
Four years before its bankruptcy filing, ResCap completed a fair value debt-for-debt exchange in which it offered to exchange its then-outstanding unsecured notes for junior-lien notes in a reduced principal amount. Approximately $6 billion of old notes were exchanged for approximately $4 billion of junior secured notes and $500 million in cash, generating $1.55 billion of OID, in economic terms, which would amortize over the life of the new notes.
Once in bankruptcy, ResCap and the Official Committee of Unsecured Creditors sought to disallow the unamortized portion of this OID as “unmatured interest.” Their experts suggested that such fair value exchanges would not be chilled, even if OID was disallowed in bankruptcy, because economic incentives built into such exchanges – such as yield, security and seniority features – would still make them attractive. The noteholders’ expert countered that these incentives might not outweigh the prospect of disallowance of OID in bankruptcy, which would discourage out-of-court workouts. The experts agreed, however, that there is little reason to distinguish between face value exchanges and fair value exchanges in the marketplace.
Judge Glenn’s ruling stemmed from identifying this point of agreement between the experts. He found that no “meaningful” commercial or business basis exists for distinguishing between face value and fair value exchanges. Accordingly, the same rule established by Chateaugay for face value exchanges should apply to fair value exchanges. Judge Glenn also reasoned that this outcome enhanced “predictability” and avoids “confusion in the market.”
ResCap will come as a relief to lenders, offering assurance that, at least in the Southern District of New York, unamortized OID generated by debt-for-debt exchanges (whether face value or fair value) in connection with prepetition consensual workouts will not be subject to disallowance as unmatured interest.
