Third Circuit Says No to Double-Discounting

Third Circuit Says No to Double-Discounting

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It is well-established that unsecured creditors are not entitled to collect post-petition interest on their claims against a debtor. A corollary to this general rule is that bankruptcy operates as the acceleration of the principal amount of all claims against the debtor. These principles are codified in §502(b) of the Bankruptcy Code, which provides that, upon a claim being challenged, the bankruptcy court is required to "determine the amount of such of the date of the filing of the petition, and shall allow such claim in such amount except to the extent that...such claim is for unmatured interest." 11 U.S.C. §502(b), (b)(2).

The question that §502(b) does not clearly answer, however, is whether the debtor is entitled to strip such debt of post-petition interest, in addition to discounting to present value all outstanding principal, in cases where the principal on an interest-bearing debt of the debtor is unmatured as of the petition date. This was the precise issue recently addressed in In re Oakwood Homes Corp., 449 F.3d 588 (June 9, 2006), where the Third Circuit Court of Appeals held that such form of double-discounting was not warranted under §502(b).

Background and Facts

Prior to filing bankruptcy, Oakwood Homes Corp. (Oakwood), a builder and seller of prefabricated homes, extended credit to its homebuyers through long-term mortgages, which Oakwood subsequently securitized and sold to specially-created trusts known as Real Estate Mortgage Investment Conduit (REMIC) securitization trusts. In order to raise funds to create the mortgages, the REMIC trusts issued various types of certificates entitling the certificate-holders to periodic payments of principal and interest. The REMIC trusts serviced the debt owed to the certificate-holders solely through the mortgage payments made by the homebuyers. Distributions to all certificate-holders were governed by pooling and service agreements, which specified the distribution dates for principal and interest payments to each class of certificate-holders, in the order of priority.

Distributions from the REMIC trusts, however, depended on the homebuyers making their scheduled mortgage payments. At issue in the case were certain low-priority certificate holders, whom the REMIC trusts were ultimately unable to pay because of defaults by mortgage customers on their mortgage payments. Such low-priority certificate-holders had recourse not only against the REMIC trusts but also against Oakwood, which, in order to make the low-priority certificates marketable, issued guarantees on the payment obligations owed to these certificate-holders under the pertinent pooling and service agreements.

After Oakwood filed for bankruptcy, JP Morgan, as the trustee for certain low-priority certificate-holders, filed $400 million in claims against Oakwood comprised of $1 million in pre-petition interest, $116 million in future shortfalls in principal payments and $383 million in future shortfalls in interest payments that the REMIC trusts would likely not make to the low-priority certificate-holders.

U.S. Bank, as indenture trustee for certain higher-priority certificate-holders, ultimately objected to JP Morgan's claims, asserting that, pursuant to §502 of the Code, (a) the post-petition interest component of JP Morgan's claims should be disallowed and (b) the principal component should be discounted to present value as of the petition date. The bankruptcy court and the district court (on appeal) agreed with U.S. Bank's objection, resulting in the disallowance of all post-petition interest and the further discounting of the principal payments owed to the low-priority certificate-holders.

Analysis on Appeal

At the Third Circuit, JP Morgan's sole challenge was that the discounting of principal to present value, after all post-petition interest had already been disallowed, constituted double-discounting, which was not authorized by §502(b). The critical distinction pointed out by JP Morgan was that the debt owed to the low-priority certificate-holders was interest-bearing and that any discounting of principal generally occurs in instances where there is noninterest-bearing debt. U.S. Bank, on the other hand, argued that the clear language of §502(b), which instructs a court to "determine the amount of such of the date of the filing of the petition," mandated a discounting of all principal and that, in any instance, since the debt arose from a guarantee—and not from the debt instruments governing the mortgages—the total payment obligations only represented a single, future obligation owed to the low-priority certificate-holders, which warranted a discounting. The Third Circuit disagreed.

The Third Circuit first addressed the notion that the indebtedness owed on Oakwood's guarantees represented a single, future obligation. Notwithstanding U.S. Bank's arguments, the Third Circuit interpreted the underlying loan documents between the certificate-holders and the REMIC trusts as specifically breaking down the trust's payment obligations into separate principal and interest payments. In addition, the fact that Oakwood's payment obligations arose from a guarantee did not change the fundamental economic nature of these separable obligations. Rather, Oakwood simply stepped into the shoes of the REMIC trusts when making interest and principal payments to the certificate-holders.

The court then logically turned to whether the language in §502(b) required the further discounting of principal after post-petition interest had already been disallowed. The court first distinguished the language in §502(b) from the language in other sections of the Code where it is well-established that present value discounting is required. For instance, pursuant to §1129(b)(2), in cramdown situations secured creditors may receive deferred cash payments equal to the present value of their claims as of the petition date. Given that §502(b) speaks in terms of determining the "amount" of a claim "as of" the petition date, and the remainder of the Code (including §1129(b)(2)) uses the term "value, as of" to signify discounting to present value, the Third Circuit could not conclude, as the bankruptcy court and district court did, that "§502(b) clearly and unambiguously requires discounting to present value in all situations." The court essentially reasoned that the terms "amount" and "value," neither of which are defined in the Code, have different meanings.

The Third Circuit ultimately decided to examine the interplay between §502(b) and subsection 502(b)(2), which was contrary to the approach taken by the bankruptcy court, which first disallowed post-petition interest under subsection 502(b)(2) and then, without considering the economic implications of such disallowance, discounted the principal under §502(b). The Third Circuit found that such two-faceted approach contravened the legislative history of §502(b) and economic reality.

According to the pertinent legislative history, "§502(b) contains two principals of present law. First, interest stops accruing at the date of the filing of the petition because any claim for unmatured interest is disallowed under this paragraph. Second, bankruptcy operates as the acceleration of the principal amount of all claims against the debtor. One unarticulated reason for this is that the discounting factor for claims after the commencement of the case is equivalent to [the] contractual interest rate on the claim. Thus, this paragraph does not cause disallowance of claims that have not been discounted to a present value because of the irrebuttable presumption that the discounting rate and the contractual interest rate (even a zero interest rate) are equivalent." H.R. Rep. No. 95-595, at 352-54 (1977) (emphasis added); see also S. Rep. No. 95-989, at 62-65 (1978) (same). Notwithstanding historical debate over whether this passage in the legislative history applies to §502(b) or subsection 502(b)(2), the court concluded that, pursuant to this passage, to the extent the Code contemplates the discounting of claims to present value, such discounting is not permitted where the claim is for principal plus interest and the interest component has already been disallowed.

From an economic standpoint, the Third Circuit explained that it was irrelevant whether a court applies §502(b)(2) to disallow unmatured interest, or discounts the entire amount of the claim (including both principal and interest) to present value, as long as the court performs only one such operation. Presumably the result under either would be the same. The goal, according to the Third Circuit, is for courts to recognize what a creditor bargained for without giving the creditor a windfall. This fundamentally requires a recognition that there is a substantial difference between what lenders bargain for with respect to interest-bearing and noninterest-bearing obligations.1

In reaching its conclusion, the Third Circuit addressed the holding in In re Loewen Group International Inc., 274 B.R. 427 (Bankr. D. Del. 2002), which was the primary authority cited by U.S. Bank and relied upon by the district court below. While noting that this lower-court opinion was not binding precedent, the court nonetheless proceeded to distinguish Loewen from Oakwood's case. The fundamental distinction between both cases was that the debt instruments and debt obligations at issue in Loewen were noninterest-bearing, whereas in Oakwood's case the debt was interest-bearing. The Loewen court recognized this distinction throughout its opinion and, in fact, found that subsection 502(b)(2) did not apply. Accordingly, the Third Circuit noted that "Loewen understood the crucial economic distinction [between interest-bearing and noninterest-bearing debt], concluding that it was economically appropriate to discount the noninterest-bearing claims because the parties had bargained to receive less than the face value of the notes by not building interest into the bargain."

The Dissent

The dissent agreed with the conclusion that double-discounting of claims was not authorized by the Code, but disagreed with the majority's reasoning on how the double-discounting error occurred. According to the dissent, the apparent error (which had not been raised by JP Morgan on appeal) occurred because the parties and the courts mischaracterized the REMIC trusts' future debt obligations as including separate interest and principal. This led the courts to improperly apply subsection 502(b)(2). It appeared to the dissent, however, that the securitization and guarantee process, pursuant to the pooling and service agreements and Oakwood's guarantees, converted the original mortgage loans of the REMIC trusts (which included interest and principal) into substantially different forms of financial instruments, pursuant to which future noninterest-bearing obligations owed to certificate-holders were created. Following this reasoning, there would have been no need to apply subsection 502(b)(2) to JP Morgan's claims, and thus there would have been only a single discounting of claims pursuant to §502(b).

The dissent also found that in interest-bearing debt situations, double-discounting can be avoided if courts simply applied subsection 502(b)(2), which, according to the dissent, already implicitly provides for the acceleration of remaining principal and explicitly provides for the discounting of claims through the disallowance of unmatured interest. This conclusion avoids the dissent's primary criticism of the majority's holding. According to the dissent, the majority's finding that §502(b) does not clearly provide for discounting stretches beyond just proscribing the discounting of interest-bearing claims pursuant to §502(b) and could be interpreted as doing away with the general and well-accepted principle that noninterest-bearing debt should be discounted pursuant to §502(b). However, considering the careful distinction drawn by the majority with respect to the case law endorsing the discounting of noninterest-bearing obligations as well as the majority's proclamation that "[w]e do not hold here that 11 U.S.C. §502(b) never authorizes discounting a claim to present value," the prevailing view on discounting of noninterest-bearing debts probably remains undisturbed. Only time will tell whether the dissent's concerns were valid.



1 As a simple illustration, the Third Circuit evaluated the economics of a note with a face value of $1,000, an interest rate of 5 percent and yearly payment obligations extending over 10 years. The future value of such a note would be $1,628.89 in principal and interest. Assuming that a debtor executes this note and files bankruptcy on the date of issuance, the disallowance of post-petition interest on the note, per subsection 502(b)(2), would yield a principal claim of $1,000. Similarly, discounting the full value of the noteholder's claim ($1,628.89) to present value, using the contract rate of interest, would yield a $1,000 claim. But using the bankruptcy court's approach of first stripping the claim of post-petition interest and then discounting the principal to present value would yield a claim for $613.91. Using this scenario, the Third Circuit found that the holder of the interest-bearing note clearly bargained for $1,628.89 over time. Assuming the note had been noninterest-bearing, however, the holder would have only bargained for $1,000. Thus, the holder of the noninterest-bearing note would have been fully compensated with a claim of $613.91, because presumably he would be able to invest such amount and realize a proper return if paid ahead of time. In contrast, the holder of the interest-bearing note would only have been fully compensated by receiving $1,000, which the could have been used to realize a proper return over time.

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Saturday, July 1, 2006