Original issue discount and the "LTV risk" reconsidered.

• Author: Nemiroff, Craig
• Position: Case Note

Introduction

In the 1980s, corporate America increased its indebtedness at a fantastic rate, ballooning the corporate debt burden from $829 billion in 1980 to $2.1 trillion in 1990.(1) Companies that had financed their debt through the use of high-yield "junk bonds" eventually felt the weight of this mountain of new debt such that, by 1991, nearly 15% of all junk-bond companies were in default and many others were in serious financial distress.(2) As a result, companies increasingly tried to restructure their obligations in out-of-court workouts rather than face costly and time-consuming formal bankruptcy proceedings.(3) One popular form of out-of-court workout that emerged was the debt-for-debt exchange offer, in which a company would offer new obligations with more forgiving payment terms in exchange for more burdensome existing obligations.(4) If enough bondholders accepted the offer and tendered their bonds, the company could escape bankruptcy's costs and delays, and thereby distribute a higher payout to its creditors. These out-of-court workouts have generally been heralded as an efficient and cost-saving way for troubled companies to restructure their debts.(5)

On January 11, 1990, Judge Burton Lifland of the United States Bankruptcy Court for the Southern District of New York issued an opinion in In re Chateaugay Corp.,(6) which critics charged created a significant disincentive against use of the debt-for-debt exchange offer in prebankruptcy workouts. Judge Lifland ruled that bondholders who participated in the LTV Corporation's prebankruptcy debt-exchange offer held claims equal only to the fair market value of the old debt that was exchanged, rather than the face amount of the new debt.(7) Critics of the ruling argued that it would severely discourage creditors from participating in an exchange offer because they would be reluctant to have their bankruptcy claims reduced.(8) A new term, "LTV risk," was coined to describe the fear creditors supposedly had of participating in exchange offers after the Chateaugay decision.(9) Critics argued that this discouragement to creditors ran counter to the Bankruptcy Code's policy of encouraging out-of-court workouts.(10)

In 1992, after the district court affirmed the bankruptcy court's decision, the Second Circuit overruled it.(11) Specifically, the court held that, for the purpose of calculating claims, no reduction in the amount of the claim should occur when debt of equal face value is exchanged. The court reasoned that the Bankruptcy Code does not place such an obstacle in the way of out-of-court restructurings.(12) The Fifth Circuit, using similar logic, has reached the same conclusion.(13)

This Note argues that critics of the bankruptcy court decision in Chateaugay, and the courts of appeals who were influenced by these critics, ignored the economic substance of debt-for-debt exchange offers and created a claims-valuation regime directly contrary to the Bankruptcy Code. Whereas the Bankruptcy Code mandates that the face value of a bond shall not affect the bankruptcy claim of a debt instrument,(14) the Chateaugay reversal necessarily implies that the face amount of a debt instrument issued in the context of an exchange offer determines the bankruptcy claim associated with the new instrument. The courts of appeals disregarded the plain language of the Code in an attempt to encourage successful out-of-court workouts. This Note argues, however, that the reversal of Chateaugay was unnecessary for out-of-court workouts to remain a viable alternative to bankruptcy.

This Note first discusses the concept of original issue discount and how it has typically been interpreted in the bankruptcy setting. It then offers an explanation of Judge Lifland's analysis in Chateaugay and examines the analysis the appellate courts used in reaching contrary opinions. Next, the Note evaluates the two approaches to original issue discount in exchange offers and concludes that the bankruptcy court decision was improperly overruled. This Note argues that the appellate courts misinterpreted the economic underpinnings of a debt-exchange offer and fashioned a rule that creates enormous confusion and that may yield highly inequitable results if carried to its logical conclusion. Finally, the Note proposes that the promotion of out-of-court workouts--the sole reason for the Second Circuit's reversal--can be successfully accomplished through exchange offers in which the newly offered debt is senior to the old debt and this subordination is enforced in bankruptcy. The biggest threat to a successful exchange offer is a lack of creditor participation. This Note argues that creditors would be willing to participate in exchange offers that reduce their claims in bankruptcy if they could be reasonably assured that their bankruptcy recovery would be greater than the recovery of holdouts.

1. Original Issue Discount and Its Legal Significance

   The intrinsic economic value of a bond is equal to the present value of the coupon payments plus the present value of the principal payment at maturity, all discounted at the market rate of return that corresponds to the risk characteristics of the security. When the market rate of return is more than the stated coupon rate, the market will discount the price of the bond, and the bond will trade for less than its face value. Such a bond is said to be selling at a "discount" from face value. The amount by which the face value exceeds the actual issuing price is called "original issue discount" (OID).(15) Original issue discount is therefore nothing more than a market adjustment to reflect the difference between the face value of a bond and its issuing price. As such, the discount represents the additional interest that accumulates over the life of the bond in excess of the interest paid out as coupon payments.(16) Bankruptcy Code [sections] 502(b) explicitly prohibits asserting a claim for such unmatured interest.(17) For example, suppose Company A issued bonds with a face amount (amount due at maturity) of $1000 for an issue price of $700. Such bonds have $300 of original issue discount.

   In bankruptcy, interest stops accruing on the date the petition for relief is filed. To the extent that on a given date interest has not yet accrued, it is classified for bankruptcy purposes as "unmatured." The legislative history of [sections] 502(b) recognizes that the face amount of a bond is an inappropriate measure for valuating the claim of a creditor. Congress believed that the more appropriate measure was the sale price of the bond, i.e., the dollar amount loaned to the debtor, plus any interest that has accrued since the date of issue.(18) Thus, bonds issued at a discount contain "unmatured" interest to the extent that the face value exceeds the issue price; this unmatured interest is amortized over the life of the bond such that at maturity the market value of the bond eventually "catches up" to the face value. Courts have consistently held that unamortized original issue discount is unmatured interest and therefore is not an allowable claim.(19) If Company A in the above example were to declare bankruptcy immediately after issuance of the securities, [sections] 502(b) would only permit holders of the securities a claim of $700 in bankruptcy. Section 502(b) would not allow a claim for the $300 of original issue discount. Commentators generally agree that this reduction in claim is the appropriate and equitable treatment of purchasers of bonds issued at a discount.(20) Such a policy makes perfect sense, for there is no reason that the Bankruptcy Code should favor those creditors who purchase discount bonds over those who purchase bonds at par or at a premium. The principle of equitable distribution of claims to creditors includes the notion that value received for a bond is the fairest measure of what is owed and, hence, the proper measure of the creditor's claim.

   Not all new debt instruments are issued for cash, however. In a debt-for-debt exchange offer, bondholders surrender old debt in exchange for new debt of the issuing corporation.(21) Prior to the Chateaugay decision, no court had ruled whether original issue discount could occur for claims-valuation purposes in a debt-for-debt exchange offer in which the new debt has a face value in excess of the market value of the surrendered instrument. From a purely economic perspective, such transactions do generate OID because the face amount of the new bonds exceeds what the bonds are worth when issued. However, original issue discount is also a legal construct, and courts are empowered to refuse to recognize OID, even when it may exist economically, if such recognition would otherwise violate bankruptcy policy. If bankruptcy courts are to hold that an exchange offer generates original issue discount, tendering creditors will have claims in bankruptcy equal only to the market value of the old securities. Thus, recognition of OID in a debt-for-debt exchange offer has the potential to make tendering creditors worse off than those who hold out if the debtor later files for bankruptcy.

   There is, therefore, the potential for conflict between the competing concerns of accurately valuing the claims of creditors subsequent to an exchange offer and ensuring that out-of-court workouts are not unduly discouraged by such a valuation regime. When presented with this dilemma, Judge Lifland stressed the importance of economic substance and held that an exchange offer can generate original issue discount.(22) Two years later, the Second Circuit held that bankruptcy policy favoring out-of-court settlement of claims dictates that an exchange offer does not generate original issue discount.(23) This Note proposes that an exchange offer can create original issue discount when the face amount of the new debt is greater than its market value at issuance, but that this recognition of OID does not kill the potential for...