The Bankruptcy Court for the Southern District of New York overseeing the Residential Capital (“ResCap”) cases issued an opinion on November 15, 2013 (the “Opinion”)2 allowing the unamortized interest associated with original issue discount (“OID”) that was generated in a fair market value exchange and claimed by ResCap’s junior secured noteholders (the “Holders”). While the OID ruling is only one component of the Opinion,³ it may have far reaching implications, as already evidenced in the pricing of other OID notes that were the product of fair market value exchanges.

Facts and Background

The ResCap debtors engaged in prepetition financing transactions pursuant to which approximately $6 billion of old unsecured notes were exchanged for approximately $4 billion in junior secured notes and $500 million in cash.4 The exchange created $1.549 billion of OID amortized over the life of the junior secured notes.5 In an adversary proceeding within the ResCap bankruptcy cases, the Holders have argued, among other things, that they are oversecured (and therefore entitled to postpetition interest and fees) and sought an allowed adequate protection claim on account of diminution in the value of their prepetition collateral. At issue before the Bankruptcy Court was whether unamortized OID in the amount of approximately $380 million would be treated as an allowed component of the Holders’ claims.6

The ResCap debtors and the Committee (collectively, the “Plaintiffs”) asked the Bankruptcy Court to disallow that portion of the Holders’ claims attributable to OID.7 As a basis for disallowing the OID created in the fair market value exchange, the Plaintiffs relied on Bankruptcy Code section 502(b)(2), which disallows a claim “to the extent that… such claim is for unmatured interest.” 11 U.S.C. 502(b)(2). In response, the indenture trustee acting on behalf of the Holders moved to dismiss that count, arguing that, even if taxable OID was generated, it does not result in unmatured interest for bankruptcy purposes.8

The Bankruptcy Court denied the motion to dismiss and held a subsequent hearing to determine the “matter of first impression” of whether a fair market value exchange generates disallowable OID.9

During the subsequent hearing, the parties did not dispute that the exchange in question, whereby old securities were exchanged for new securities with a reduced principal amount equal to the fair market value of the old securities, was a “fair value” exchange.10 While the Second Circuit had previously held in LTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378 (2d Cir. 1992) that a face value exchange does not generate new OID for the purposes of claim allowance under the Bankruptcy Code, no court had decided the same question in the context of a fair market value exchange.

Unlike a face value exchange which modifies the outstanding debt’s terms or conditions but does not reduce its principal amount, a fair market value exchange involves the exchange of the principal amount of debt for a lower amount representing its fair market value. Chateaugay contained dicta suggesting that its ruling might not extend to a fair market value exchange.11 While acknowledging that Chateaugay specifically left open the possibility that different rules apply to fair market value exchanges, the Bankruptcy Court held that “despite the differences between face value and fair value debt-exchanges, the same rule on disallowance of OID should apply in both circumstances.”12

The Opinion

In its ruling on the OID issue, the Bankruptcy Court determined that there was not a meaningful basis to distinguish between OID generated pursuant to face value and fair value exchanges. As a result, the Bankruptcy Court held that Chateaugay is controlling regarding a fair value exchange.13 The Bankruptcy Court noted that issuers can use the same features in structuring both face value and fair market value exchanges.14 The Bankruptcy Court then listed the following elements as applicable to both face value and fair market value exchanges:

• the market value of the old exchanged debt is likely depressed in either situation;

• OID is created for tax purposes in both exchanges;

• there are concessions and incentives in either situation; and

• both exchanges offer companies the opportunity to restructure out-of-court, avoiding the time and costs of bankruptcy.15

The Bankruptcy Court also was persuaded that, should OID created in fair market value exchanges be disallowed, out-of-court debt restructurings would be more difficult and more bankruptcy filings would result.16 In particular, the Bankruptcy Court discussed the concern that, should the Court not extend Chateaugay, “bondholders could simply reject fair value exchanges altogether.”17

The Bankruptcy Court also cited Chateaugay and other precedent for the proposition that how a transaction is treated for tax purposes is not dispositive of its treatment for bankruptcy purposes.18 Finally, the Bankruptcy Court recognized that the Holders would receive a greater recovery than the noteholders who did not participate in the exchange, even if the exchange generated disallowable OID.19 Nevertheless, the Bankruptcy Court stated that the outcome of whether a transaction creates disallowable OID should not hinge on whether a party “got a ‘good deal’ in bankruptcy.”20

Impact of the Opinion

The Opinion is the first of its kind to find that unamortized OID generated in a fair market value exchange is allowable as a bankruptcy claim. As a result, the Opinion may have significant and immediate implications for investors holding notes with OID generated in fair market value exchanges. E.g., Caesars Entertainment, Energy Future Holdings and LBI Media, among others. We understand that, within hours of the Opinion being published, pricing jumped on Caesars Entertainment’s 10% second-lien notes due 2018.

Being a question of first impression, the Opinion’s import is yet to be seen as the time to appeal it has not lapsed and it is not binding on any other court.