Secured creditors enjoy certain protections under the Bankruptcy Code, including priority over unsecured creditors. Accordingly, to the extent the value of a debtor's assets equals or exceeds the amount of total secured debt, a secured creditor typically should be paid the full face amount of its claim. However, a recent opinion by Judge Prudence Carter Beatty of the United States Bankruptcy Court for the Southern District of New York in the chapter 11 cases of Solutia Inc. highlights an exception to this general rule: purchasers of secured debt that is issued at a discount are not entitled to a claim for the face amount of the debt.
The credit crisis that began in the summer of 2007 abruptly changed the leveraged loan market from an issuer's market to a buyer's market. As the buyers of senior secured term loans and other debt went on a virtual strike, banks originati ng loans found themselves unable to sell the debt. That caused a corporate credit crisis and left originating banks holding underwater debt on their balance sheets. In an attempt to combat the trend, banks began requiring issuers to agree to "flex: terms, i.e., terms that provide banks with the flexibility to modify certain economic terms of loans to make them more attractive to buyers. As a result, it is common today for senior secured term loans to be issued at a discount, which offers buyers an attractive yield to maturity. While these discounts enable banks to "sweeten the deal" for buyers, buyers should be aware that their yield to maturity could be at risk in the event that the issuer commences a chapter 11 case.
The Treatment of OID in Bankruptcy
In bankruptcy, the allowance of a creditor's claim is governed by section 502 of the Bankruptcy Code, which provides that the allowed amount of a claim should be determined as of the date the bankruptcy case is commenced. Consistent with this rule, claims for unmatured interest are disallowed. 11 U.S.C. Section 502(b)(2). The Bankruptcy Code does not define unmatured interest; however, courts have explained that interest is unmatured when it has not been earned as of the petition date. In re U.S. Lines, Inc., 199 B.R. 476, 481 (Bankr. S.D.N.Y. 1996). Accordingly, as a general rule, creditors are not entitled to interest that has not accrued as of the petition date. Prior to Solutia, this rule had been applied to unsecured debt issued at a discount.
When debt is issued at a discount, the issuer receives less than the face amount of the debt at issuance, but owes the face amount at maturity. The difference between the face amount and the money received is known as original issue discount (OID), which amortizes over the life of the debt. Because the amortization resembles interest accrual, courts have held that OID constitutes interest for purposes of treatment under the Bankruptcy Code.
As such, in 1992, the Second Circuit ruled in In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992), that an unsecured creditor's claim for OID that remained unamortized as of the petition date must be disallowed as Òunmatured interestÓ pursuant to section 502(b)(2) of the Bankruptcy Code.
The legislative history of section 502(b)(2) of the Bankruptcy Code supports this holding, using unamortized OID to illustrate the section's operation: "a claim on a $1,000 note issued the day before bankruptcy would only be allowed to the extent of the cash actually advanced. If the original discount was 10 percent so that the cash advanced was only $900, then notwithstanding the face amount of [the] note, only $900 would be allowed." See H. Rep. No. 595, 95th Cong., 1st Sess. 352-53 (1977), reprinted in 1978 U.S.C.C.A.N. 5787, 5963, 6308-09. The legislative history adds that to the extent OID has amortized prior to the petition date, "the interest component of the note would have to be pro-rated" to disallow the unaccrued portion of interest.
The OID Analysis for Secured Debt in Solutia
Before the current credit crisis, it was unusual for secured debt to be issued with OID.As a result, no bankruptcy court had rendered an opinion regarding the treatment of OID on secured debt. However, on November 9, 2007, Bankruptcy Judge Prudence Carter Beatty opined that the Bankruptcy Code requires unamortized OID to be disallowed, even when the underlying debt is secured.
The facts in Solutia were relatively simple. In July 2002, Solutia issued $223 million of secured notes, for which it received $181.7 million in cash. Thus, the notes were issued with OID of $41.3 million, which was scheduled to amortize during the life of the notes. But by the time Solutia commenced its chapter 11 cases, only a fraction of the OID had amortized.
Nonetheless, the indenture trustee for the notes filed a proof of claim for $223 million -- the full face amount of the notes. Solutia objected to the claim, asserting that, based on section 502(b)(2) of the Bankruptcy Code and the Chateaugay decision, the indenture trustee's allowed claim should not include any unamortized OID, notwithstanding the fact that the notes were secured.
The bankruptcy court ruled in favor of Solutia, holding that "a note issued at a discount is not allowable for its face amount. Rather it is allowable at the face amount less the unaccrued portion of the OID." In re Solutia Inc., 379 B.R. 473, 486 (Bankr. S.D.N.Y. 2007). The court explained that the Bankruptcy Code disallows unmatured interest (and unamortized OID) to prevent a fundamental unfairness that would otherwise result: if unmatured interest was recoverable in bankruptcy, "a discounted note paid off early in its life span would therefore have a higher claim value than one paid off later." Id. at 487.
The court reasoned that the unfairness of such a result "is just as real with a secured claim as an unsecured one." Accordingly, because the court could discern no "bankruptcy policy reasons…to warrant different treatment for unsecured and secured OID," the court found the secured status of the notes irrelevant for its OID analysis. Id.
The indenture trustee also sought allowed claims for "expectation damages" and other amounts, which the bankruptcy court's opinion addressed. However, that part of the opinion is beyond the scope of this article. After the bankruptcy court rendered its decision, the indenture trustee appealed. Solutia and the indenture trustee settled the dispute prior to being heard on appeal.
The Ramifications for Buyers of Secured Debt with OID
Buyers of secured debt in today's leveraged loan market should take careful note of the Solutia decision, and be aware that the extensive protections and priority afforded secured creditors under the Bankruptcy Code do not guarantee that the full face amount of their claims will be paid if the debt was originally issued at a discount. An unaware and uniformed buyer of secured OID debt may find itself suffering a loss that is unanticipated in light of the protections otherwise offered by the Bankruptcy Code for secured debt.
(Opinions expressed are those of the authors, not of Dow Jones Newsletters.)
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