An unsecured creditors committee brought an action against an indenture trustee and collateral agent (a) seeking to recharacterize a facility as a secured financing, (b) requesting a declaratory judgment that liens did not extend to released collateral and loans, and (c) seeking partial disallowance of claims of noteholders on the basis that the claims included original issue discount (OID) that should be disallowed as unmatured interest. In this decision the bankruptcy court ruled on the trustee’s motion to dismiss these claims.
As is often the case, the Chapter 11 debtors agreed to a series of stipulations regarding the validity of pre-petition credit facilities and liens as a condition for obtaining post-petition financing, but with the caveat that the unsecured creditors committee would be given time to investigate and potentially challenge the claims and liens. After months of investigation, the creditors committee obtained court authorization to pursue a variety of claims on behalf of the debtors.
One area of challenge involved a Master Repurchase Agreement pursuant to which debtors agreed to “sell” mortgage loans to a third party for a “purchase price” of $250 million, and agreed to “repurchase” the loans for an amount equal to the purchase price plus a “price differential” equal to LIBOR plus 4.75%. As a repurchase agreement, the transaction had the benefit of Sections 555 and 559 of the Bankruptcy Code that provide protection from avoidance actions and excluded closing out the repurchase from the automatic stay.
The committee attempted to recharacterize the facility as a secured financing so that it would not have the benefit of these provisions. The court rejected the committee’s arguments and granted the motion to dismiss this claim – among other things, concluding that it doesn’t matter whether a repurchase agreement is a true sale or a financing for purposes of Sections 555 and 559.
With respect to the issue regarding release of collateral, the relevant credit documents granted liens on all assets of certain debtors except for “Excluded Assets.” Certain collateral was initially included in the category of Excluded Assets, but later was released. However, since the applicable security agreement “does not contain a traditional savings clause through which previously excluded property automatically became subject to a lien once the reason for the exclusion is removed,” the court decided that it required additional evidence and denied the motion to dismiss this count. (Once again, tiny technical details can make a big difference.)
The third area considered by the court involved the committee’s contention that a portion of the noteholder claims should be disallowed on the basis that it constituted unmatured interest. As background, Section 502(b)(2) of the Bankruptcy Code provides that a claim will be disallowed to the extent that it is for unmatured interest.
As a corollary, generally unamortized OID (original issue discount) constitutes unmatured interest that should be disallowed. A Congressional committee report on Section 502(b) gave as an example a bankruptcy claim based on a note with a face value of $1,000 issued the day before bankruptcy that included an original issue discount of 10%, so that only $900 cash was advanced. The $100 discount was viewed as an interest component of the note that must be amortized, and should be disallowed to the extent it is for interest post-petition (i.e. the entire $100 in the example).
However, this case involved a note exchange, as opposed to issuance of new notes. The bankruptcy court noted that the Second Circuit has held that a “face value exchange of debt (as opposed to a fair market value exchange) in a consensual out-of-court workout does not result in the generation of disallowable OID.” As described by the Second Circuit, in a fair market value exchange the old note is exchanged for a new note with a reduced principal amount based on the market value at which the old note was trading. In contrast, a face value exchange substitutes a new note for the old note that involves modification of terms or conditions but does not reduce the principal of the note.
In deciding that a face value exchange does not give rise to new disallowable OID in a bankruptcy (regardless of the treatment for tax purposes), the Second Circuit relied on a “strong bankruptcy policy in favor of the speedy, inexpensive, negotiated resolution of disputes, that is an out-of-court or common law composition.” If exchange debt increased the amount of OID, then creditors would not be inclined to cooperate. (The bankruptcy court also noted that the Fifth Circuit agreed that a face value exchange does not generate disallowable OID for policy reasons, without expressing an opinion on whether a fair market value exchange creates OID.)
In this case, the debtor offered (1) to exchange old unsecured notes for new secured notes with significantly different terms, and (2) to purchase a limited number of old notes for cash in a modified Dutch auction. As a result, the debtor exchanged approximately $6 billion of old notes for approximately $4 billion of new notes and $862 million in cash. As of the petition date, the outstanding face amount of the new notes was $2.2 billion. The committee contended that at least $377 million was unamortized OID. The parties agreed that the note exchange was a fair market value exchange. So the question was whether this generated disallowable OID.
The trustee started by arguing that the basis for OID disallowance was not applicable here: Disallowance is because a debtor receives less cash than the face amount of the notes. Here the debtor extinguished $1,000 of old notes by exchanging $800 of new notes. The trustee also argued the policy reasons favoring out-of-court restructurings.
The committee made several arguments in response, including that the new notes were received in a fair market value exchange, and the holders should have a claim limited to the cash value of the old bonds that were tendered, discounted for OID, because the exchange was the equivalent of a cash purchase.
In the end, the court left resolution of this issue for another day as it denied the motion to dismiss on the basis that the record was insufficient to make a decision as a matter of law.
Although the exchange offer resulted in a reduction of the face amount of the debtor’s outstanding notes, in the context of the bankruptcy it appears that the holders of the new notes will likely receive a significantly higher distribution. According to the committee, holders of old notes who declined the exchange offer have a $1,000 unsecured claim and will recover $360, while note holders who participated in the exchange offer now expect to recover $658 plus potential post-petition interest. It will be interesting to see what the court does. Stay tuned.
Vicki R. Harding, Esq.