In re Residential Capital: Unamortized OID Created by Fair Market Value Debt Exchange Allowed under Bankruptcy Code

Practical Law Legal Update 8-550-5883 (Approx. 6 pages)

In re Residential Capital: Unamortized OID Created by Fair Market Value Debt Exchange Allowed under Bankruptcy Code

by Practical Law Finance and Practical Law Bankruptcy & Restructuring

Background

On June 6, 2008, the mortgage loan originator Residential Capital (ResCap) completed a fair market value debt exchange. In this type of exchange, old securities are exchanged for new securities with a reduced principal amount that approximates the market value of the old securities and lessens the amount of debt on the issuer's balance sheet. In this particular transaction, ResCap exchanged about $6 billion of its outstanding unsecured notes for about $4 billion of new junior secured notes and $500 million cash (the Exchange). The Exchange created about $1.5 billion of OID, which was amortized over the life of the new notes. OID arises when the face value of a bond exceeds the amount that is actually paid for it. This difference represents deferred interest, which is paid to the holder of the bond on the maturity date.

On May 12, 2012, ResCap filed a petition for Chapter 11 bankruptcy in the SDNY Bankruptcy Court. As of the petition date, the unamortized OID on the junior secured notes was about $386 million. The junior secured noteholders (JSNs), through the indenture trustee (Defendant), submitted a proof of claim seeking to recover all principal, prepetition and postpetition interest and fees resulting from the Exchange.

ResCap and the creditors’ committee (Plaintiffs) asked the Bankruptcy Court to disallow the portion of the JSNs' claim representing unamortized OID as a claim for unmatured interest, which is disallowed under section 502(b)(2) of the Bankruptcy Code.

The Defendant argued that the JSNs' claim should be allowed in full, arguing that the Bankruptcy Court should extend the US Court of Appeals for the Second Circuit's ruling in LTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateaugay) to fair market value exchanges (961 F.2d 378 (2d Cir. 1992)). In Chateaugay, the Second Circuit held that unamortized OID generated by prepetition face value debt exchanges is not disallowable under section 502(b)(2) because to rule otherwise would be contrary to the strong bankruptcy policy of favoring and promoting consensual out-of-court restructurings. In a face value debt exchange, existing debt is exchanged for debt in the same face amount, but typically with reduced interest rates or extended maturities. The Second Circuit reasoned that disallowing unamortized OID in these situations would discourage creditors from cooperating in consensual workouts and increase bankruptcy filings. However, the Second Circuit explicitly declined to extend its ruling to fair market value exchanges, explaining that disallowing unamortized OID may be warranted where the issuer's overall debt obligations are reduced.

Both sides presented expert testimony at the trial. Specifically:

The Plaintiff's expert testified that it was "somewhat arbitrary" to distinguish between face value and fair value exchanges. Specifically, the expert noted that nearly all of the economic incentives that companies consider in connection with a debt exchange, such as additional security and modified interest rates and maturity dates, can be used in both face value and fair value exchanges.
Both sides' experts testified that there would be no disallowable OID generated if the new notes were issued in a face value exchange, but retained all of the same economic incentives offered in the Exchange because face value exchanges are expressly governed by the Second Circuit's decision in Chateaugay.

In asking the Court to disallow a portion of the JSN's claim to the extent the claim sought recovery of unamortized OID, the Plaintiffs argued, among other things, that:

The consideration involved in the debt-for-debt exchange (including the trading of unsecured notes for secured and structurally senior obligations) justifies not applying Chateaugay.
Disallowing unamortized OID is consistent with the "plain language" of section 502(b) of the Bankruptcy Code, which plainly disallows unmatured interest. Applying the plain meaning of section 502(b) would not lead to absurd results because those JSNs participating in the Exchange would still receive a greater recovery than those JSNs who did not participate.

Outcome

Ruling in favor of the Defendant, the Bankruptcy Court concluded that Chateaugay applied and therefore the Exchange did not generate any disallowable OID.

First, the Court discussed policy considerations, explaining that disallowing unamortized OID arising from fair value exchanges would disincentivize lenders from cooperating in out-of-court workouts, and therefore could lead to more bankruptcy filings. This result would be at odds with the strong bankruptcy policy in favor of "speedy, inexpensive, negotiated resolution of disputes."

Second, the Bankruptcy Court found no basis for distinguishing fair value exchanges from face value exchanges, and therefore concluded that Chateaugay is applicable to fair value exchanges. The expert testimony presented at trial "indicated that the two types of exchanges are virtually identical," making it arbitrary for the Bankruptcy Court to distinguish between them. The Court explained that in both types of exchanges:

The market value of the old debt is likely depressed.
OID is created for tax purposes.
There are concessions and incentives.
Companies have opportunities for out-of-court workouts to avoid the time and costs of a bankruptcy proceeding.

Third, the Bankruptcy Court noted that under Chateaugay and other precedents, how a transaction is treated for tax purposes is not determinative of its treatment for bankruptcy purposes.

Finally, the Bankruptcy Court discredited the Plaintiffs' argument regarding the application of the "plain language" of section 502(b). The Bankruptcy Court noted that:

Because the Bankruptcy Code does not define the term “unmatured interest” in section 502(b)(2), it would be debatable to apply the plain language rule.
Because courts should provide predictability to parties planning transactions, whether these transactions created disallowable OID should not depend on whether a party got a "good deal" in bankruptcy. To do so would create confusion in the market and would complicate an issuer's ability to avoid bankruptcy by cooperating with its creditors in an out-of-court workout.

Practical Implications

The Bankruptcy Court's decision is the first addressing the issue that was left open in Chateaugay regarding the treatment of unamortized OID in fair market value exchanges. Unless the Bankruptcy Court's decision is successfully appealed, it should assure lenders in the Southern District of New York that unamortized OID that results from debt-for-debt exchanges, whether face value or fair value, in prepetition out-of-court workouts will not be disallowed as unmatured interest. A contrary ruling would likely have made out-of-court restructurings more difficult to accomplish and resulted in more bankruptcy filings. However, this decision is not binding on courts in other jurisdictions and whether they will follow this ruling remains to be seen.

For more information on the treatment of OID in bankruptcy, see Practice Note, Postpetition Interest, Fees, Costs, and Charges in Bankruptcy: Original Issue Discount Problem.

In re Residential Capital: Unamortized OID Created by Fair Market Value Debt Exchange Allowed under Bankruptcy Code | Practical Law