Creditors have recently made some headway in collecting the full amount to which they are contractually entitled pursuant to various debt instruments. In In re Calpine Corp.,1 reported in our summer 2007 newsletter, the Bankruptcy Court for the Southern District of New York permitted a secured creditor to collect damages (albeit in the form of an unsecured claim) caused by dashed expectations due to the early repayment of its debt. The First Circuit Court of Appeals also recently permitted a secured creditor to collect a prepayment penalty, whether such penalty is reasonable or unreasonable, provided it was enforceable under state law. 2
This has spurred creditors to make ever more aggressive, or, at the very least, more hopeful, arguments regarding what they have a right to recover. Under these circumstances, courts have had to set parameters on the extent of justifiable recovery in a bankruptcy scenario. For example, in another decision from the Calpine bankruptcy, addressing the rights of convertible noteholders, the United States District Court for the Southern District of New York found that holders of these instruments were not entitled to damages resulting from the loss of conversion rights.3 Similarly, in In re Solutia, Inc.,4 the Bankruptcy Court for the Southern District of New York limited the amount a holder of unamortized original issue discount can recover in a chapter 11 case.
In Solutia, currently on appeal, the Bankruptcy Court for the Southern District of New York granted the joint objection of the debtors and the creditors’ committee and disallowed a significant portion of a claim asserted on behalf of certain secured noteholders. Specifically, the Bankruptcy Court (i) disallowed the indenture trustee’s claim for unamortized original issue discount (“OID”), (ii) ruled that the indenture trustee’s strategic attempt to de-accelerate the debt, which had accelerated automatically on the petition date, was in violation of the automatic stay and therefore void, (iii) refused to adopt the “dashed expectations” theory of damages that was endorsed by Judge Burton Lifland in Calpine, notwithstanding Solutia’s repayment of the debt before its stated maturity date, and (iv) rejected the indenture trustee’s attempt to recover due to the change in control effected by the plan.
Pre-petition, Solutia issued its 11.25% Senior Secured Notes due 2009 (the “Notes”) in the face amount of $223 million. The indenture trustee filed a proof of claim for the $223 million face amount of the Notes plus interest, fees, and expenses thereon. It was undisputed that, at the time of Solutia’s bankruptcy filing, the Notes were fully secured. Accordingly, the debtors paid the interest on the claim at the contract rate (with no payment of the OID) during the pendency of the chapter 11 cases. At the time of the hearing on the objection to the indenture trustee’s claim, Solutia’s plan (which was subsequently confirmed by the Bankruptcy Court) provided for the claim to be paid in the amount of the principal funded at issuance of the Notes plus OID accrued through the effective date of the plan.
Original Issue Discount
The indenture trustee sought to collect the aggregate face amount of the notes, notwithstanding that the original purchasers of the Notes paid substantially less for the Notes than the amount reflected on their face—an “original issue discount” or “OID.” Judge Beatty rejected this position, instead agreeing with the debtors and the creditors’ committee that the principal of the debt should be limited to the amount that was actually advanced to Solutia when the Notes were issued. Accordingly, the Bankruptcy Court decided that OID is properly treated as interest that accrues over the life of the loan and, consistent with the treatment of interest, only the portion accrued through the petition date was properly allowed as part of the base amount of the trustee’s claim. The noteholders’ allowed claim also includes OID for the period between the petition date and the effective date, as part of the pendency interest to which they are entitled.
De-Acceleration of the Notes
Pursuant to the provisions of the indenture, the debt accelerated automatically as of the petition date. Therefore, instead of the Notes maturing in 2009, they matured in 2003, when Solutia filed its chapter 11 petitions. By letter dated April 7, 2007, a majority of noteholders attempted to rescind the acceleration so that they could later assert a claim for “expectation damages” as a result of Solutia’s proposed prepayment of what would be an unmatured debt. The Bankruptcy Court held that the noteholders’ deacceleration letter was in violation of the automatic stay and therefore void ab initio. A subsequent motion by the indenture trustee for relief from the automatic stay with respect to the letter was also denied. Writing that the Bankruptcy Court should not “supply what is absent” in the indenture, Judge Beatty rejected what she viewed as an attempt by the noteholders to position themselves to invoke the recent decision in Calpine by which Judge Lifland awarded noteholders damages for loss of the originally bargained-for stream of payments when notes were paid prior to maturity. It should be noted, however, that in Calpine, the pre-payment was voluntary, in connection with the debtors’ refinancing efforts, well in advance of the plan process.
With respect to the issue of expectation damages as a result of the alleged “prepayment,” the Bankruptcy Court determined that it is not a prepayment to pay a debt on its maturity date. Judge Beatty reasoned that, because the acceleration rendered the notes immediately payable, no prepayment took place. Furthermore, although the parties could have included a “yield maintenance” clause in the indenture, which would permit a lender to receive the contract rate of interest even after acceleration of the debt, the indenture for the Notes did not provide for yield maintenance. Given the acceleration of the debt, and absent a yield maintenance clause, the indenture trustee could not recover interest payments that would accrue after plan effectiveness.
Change of Control
The indenture for the Notes allows noteholders to compel Solutia to repurchase the Notes in the event of a change of control at 101% of the principal amount plus accrued and unpaid interest. Because Solutia’s then-proposed plan would result in the appointment of a new board of directors and unsecured creditors owning a majority of the reorganized company’s common stock, the indenture trustee sought to take advantage of this change of control right. Accordingly, the indenture trustee’s claim included a premium as if the change of control contemplated by the plan had occurred already. Judge Beatty agreed with the objectors that, because the claim is valued as of the petition date (according to section 502(b) of the Bankruptcy Code), the change of control implemented after the effective date is irrelevant to the value of the indenture trustee’s claim.
The creditors in the Solutia case may have merely pushed too hard. Asking the Court to enforce the post-petition de-acceleration, labeling a plan’s restructuring of the equity as a change of control under the debt documents and modifying OID to allow full and current collection of the debt is a far cry from enforcement of a contractual or even an implicit pre-payment penalty. While the result in Solutia was not good news for creditors, it does not detract from the decisions of other courts which have made possible the enforcement of contractual provision in less ambiguous (or ambitious) circumstances. The Solutia case nevertheless shows us that literal enforcement of even an over-secured creditor’s contractual claim may indeed be altered in a bankruptcy setting.