Authors: Richard L. Wynne and Lance Miller, Jones Day
Debt exchanges have long been utilized by distressed companies to address liquidity concerns and to take advantage of beneficial market conditions. A company with burdensome debt obligations might seek to exchange existing notes for new notes with the same outstanding principal but with borrower-favorable terms (a “Face Value Exchange”). Alternatively, the company could attempt to exchange existing notes for new notes with a lower face amount (a “Fair Value Exchange”). Under either scenario, a debt exchange will create “original issue discount” (“OID”) equal to the difference between the face amount of the new notes and the value generated by the exchange for the company (i.e., the fair market value of the old notes). For tax and accounting purposes, OID is treated as interest that is amortized over the life of the note, with the face amount scheduled to be paid on maturity.
When a company files for bankruptcy, however, unaccrued OID should arguably be disallowed under section 502(b)(2) of the Bankruptcy Code as “unmatured interest.” However, to encourage out-of-court restructurings, both the Second and Fifth Circuit Courts of Appeal have ruled that unaccrued OID from Face Value Exchanges should not be disallowed. In In re Residential Capital , LLC, 501 B.R. 549 (Bankr. S.D.N.Y. 2013), the court expanded that rationale to apply to Fair Value Exchanges. If interpreted broadly and adopted by other courts, the decision will bring certainty to the markets that OID resulting from a debt-for-debt exchange will be allowed in bankruptcy, regardless of how the exchange is structured.
A more detailed discussion of the ruling is available here.