On November 15, 2013, the United States Bankruptcy Court for the Southern District of New York (Glenn, J.) issued a lengthy decision1 in the Chapter 11 case of Residential Capital, LLC (“ResCap”). An important holding contained in this decision is that the bankruptcy claims of holders of notes issued with original issue discount (or OID) for tax and accounting purposes in a “fair value” exchange (an exchange for notes with a lower face amount) need not be reduced by any unaccreted OID.2
ResCap was one of the largest originators and servicers of residential mortgage loans. ResCap had a complicated capital structure, and among billions of dollars of funded debt, it had more than $2 billion of 9.625% Junior Secured Notes (the “JSNs”) outstanding from a debt-for-debt exchange completed in 2008. In the exchange, ResCap swapped more than $6 billion of various series of outstanding unsecured notes for $862 million in cash and JSNs in a reduced face amount (80%), albeit with more attractive terms, including being secured by collateral and being structurally senior. The value of the JSNs, determined by the clearing price in a modified Dutch auction of the JSNs to enable a cash-out option for existing holders, was less than their face amount ($650 per $1,000), creating substantial OID. Approximately 63% of the outstanding old notes were exchanged for JSNs.3
As of the time of the bankruptcy filing, the JSNs had approximately $370 million in unaccreted OID, and various parties argued that this OID should not be allowed as part of the JSNs’ claims, but rather should be treated as “unmatured interest”, which would be disallowed under Bankruptcy Code § 502(b)(2). The JSNs countered that the exchange should not create disallowable OID for bankruptcy claims purposes under LTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateauguay), wherein the court held that a “face value” exchange (an exchange for notes with the same face amount) did not create new disallowable OID, so the full face amount was potentially recoverable in bankruptcy.4 The face value exchange in Chateauguay was technically distinguishable from the ResCap fair value exchange at issue, and the court heard extensive expert testimony on the underlying contexts and strategies in which both types of exchanges are utilized in corporate restructurings.5
First, the court reviewed the legislative history of section 502(b)(2) and concluded that there was no basis for distinguishing fair value exchange OID from face value exchange OID for bankruptcy purposes. Then, it noted that Chateauguay was based on the Bankruptcy Code’s policy of promoting cooperative out-of-court restructuring efforts, including consensual exchange offers, and attempting to avoid costly and protracted bankruptcy cases, and that such rationale applied equally to both types of exchanges. For these reasons, the court concluded that the unaccreted OID on the JSNs should not be disallowed as unmatured interest.6
Although not binding in other Circuits or even in other courts in the Southern District of New York, this ruling, which was anticipated by many practitioners, should provide lenders and investors with additional comfort that participating in a fair value or similar exchange that involves a reduction in face amount of claims should not result in an unintended further reduction of their claims in bankruptcy. As such, this decision should continue to encourage overleveraged companies and their lenders to seek to reduce debt, where appropriate, in a rational manner.