In the Matter of PENGO INDUSTRIES, INC., Pengo Finance,
N.V., Debtors.
TEXAS COMMERCE BANK, N.A., Indenture Trustee, Appellee,
v.
Dr. Seymour LICHT, and Official Committee of Unsecured
Creditors of Pengo Industries, Appellants.
No. 91-1769.
United States Court of Appeals,
Fifth Circuit.
June 12, 1992.
Rehearing Denied July 10, 1992.
Richard H. Kuh, Edgar H. Booth and Donald L. Kuba, Warshaw, Burstein, Cohen, Schlesinger & Kuh, New York City, for Official Committee.
Edward L. Rothberg, Weycer, Kaplan, Pulaski & Zuber, Houston, Tex., for Texas Commerce Bank.
Appeals from the United States District Court for the Northern District of Texas.
Before GOLDBERG, DUHE, and BARKSDALE, Circuit Judges.
GOLDBERG, Circuit Judge:
A company finds itself unable to meet its debt obligations. Its bondholders fear bankruptcy, with its inherent delays, costs, and complications. But perhaps the company can work out its financial problems before capitulating to the bankruptcy courts. The company proposes an exchange: Bondholders can tender an old bond and receive a new bond of equal face value, but on tеrms more favorable to the company. The incentive for the bondholder is two-fold: an increased likelihood that the company can meet its obligations on the new bonds and the avoidance of bankruptcy proceedings. Although many bondholders do exchange their old bonds, the company nevertheless lands in bankruptcy court. The issue then becomes the amount of the new bondholder's claim against the debtor: Is it the full face value of the new bond or is it some lesser, discounted amount reflecting the fair market value of thе old bond at the time of the exchange?
This particular query has fascinated not only creditors of companies engaging in consensual workouts, but also bankruptcy commentators and practitioners: Whether a face value exchange of debt instruments in a consensual out-of-court workout creates original issue discount that constitutes unallowable "unmatured interest" under section 502(b)(2) of the Bankruptcy Code. We affirm the district court and hold that such an exchange does not generate "unmatured interest."
I. BACKGROUND
The Pengo companies manufacture equipment for the petroleum industry, explosives, rubber products and earth-boring augers and teeth. In late 1988 and early 1989, involuntary petitions for relief under Chapter 11 of the Bankruptcy Code were filed against Pengo Industries, Inc. and its subsidiary, Pengo Finance, N.V. (collectively, "Pengo"). The Official Unsecured Creditors Committee and Dr. Seymour Licht, an individual creditor, objected to two proofs of claim filed by Texas Commerce Bank National Association ("TCBNA") on behalf of the holders of two securities, the Class A and Class B debentures. TCBNA served as indenture trustee for holders of Class A and Class B debentures.
Back in 1980, Pengo Finance issued $22,500,000 of 8 1/2% convertible debentures due in 1995. The public purchased these Old Debentures for the full face amount of $1,000 each. Neither Pengo Finance, nor Pengo, the guarantor, could make interest payments to the Old Debenture holders in 1983. Pengo merely accrued the interest expense on its books. Several years later, in 1985, a standstill agreement between Pengo and its senior secured lenders required an exchange offer as part of an out-оf-court workout designed to enable Pengo to restructure its indebtedness. In the First Exchange Offer, Pengo Finance offered to exchange one 0% $500 face amount Class A debenture and one 0% $500 face amount Class B debenture for each 8 1/2% $1,000 face amount Old Debenture. Each participating Old Debenture holder received two New Debentures with a total face value of $1,000 for each of their Old Debentures with a face value of $1,000. The Old Debentures were subordinated to payment in full of the New Debentures. And, while the Old Debentures mature in 1995, the New Debentures matured in 1991. The Old Debentures could be redeemed for Pengo's common stock at a much less favorable rate than that for the New Debentures. About $13,205,000 of the Old Debentures--58.7% of the issue--were exchanged for the same face amount of New Debentures. Although holders of the New Debentures waived the payment of past due interest on the Old Debentures, Pengo remained in default on the Old Debentures outstanding after the exchange because it continued to fail to make interest payments.
The reorganization plan plaсed all unsecured creditors into a single class, which included holders of both Old and New Debentures. Those creditors will share in a limited distribution. Since the total claims of the unsecured creditors exceed the amount of the limited distribution, the amount of the New Debenture holders' claims directly alters the funds available to all other unsecured creditors.
The two proofs of claim filed by TCBNA on behalf of the holders of Class A and Class B debentures in the Pengo bankruptcy represented the full face amount of the outstanding New Debentures. TCBNA did not deduct any аmount for unamortized original issue discount. The Committee and Dr. Licht, who holds Old Debentures, objected to the amounts of the claims, arguing that the exchange created unamortized original issue discount and, thus, a portion of the claims constituted "unmatured interest" not allowable under 11 U.S.C. § 502(b)(2).1
After a hearing and upon stipulated facts, the bankruptcy court sustained the objections and reduced the New Debenture holders' two proofs of claim to eliminate what the court considered to be unamortized original issue discount--unmatured interest under section 502(b)(2). The district court reversed the bankruptcy court and held that the proofs of claim did not include a claim for original issue discount. Texas Commerce Bank Nat'l Ass'n v. Licht (In re Pengo Indus., Inc.),
II. DISCUSSION
A. "Unmatured Interest" and Original Issue Discount.
Section 502(b) of the Bankruptcy Code requires the bankruptcy court to determine the amount of a claim objected to by a party in interest under section 502(a). Congress has provided specific standards to guide the bankruptcy court in making this determination. 11 U.S.C. § 502(b)(1)-(8) (1979 & Supp.1991). One established statutory rule is that the bankruptcy court must disallow any claim "for unmatured interest." 11 U.S.C. § 502(b)(2) (Supp.1991). This rule flows from the legal principle that "interest stops accruing at the date of the filing of the petition." S.Rep. No. 989, 95th Cong., 2d Sess. 63, reprinted in 1978 U.S.C.C.A.N. 5787, 5849.
In this case, the bankruptcy rule meets an economic acronym: OID. OID--original issue discount--presents a definitional concept generally unfamiliar to those not bonded to the world of economics. As ably explained by the Second Circuit, "[o]riginal issue discount results when a [debt instrument] is issued for less than its face value. The discount, which compensates for a stated interest rate that the market deems too low, equals the difference between a [debt instrument]'s face amount (stated principal amount) and the proceeds, prior to issuance expenses, received by the issuer." LTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateaugay Corp.),
The "unmatured interest" bankruptcy rule and the economic notion of "original issue discount" intersect to form the legal nexus for our decision-making. The term "unmatured interest," which is not defined by the Bankruptcy Code, encompasses OID. The economic reality оf original issue discounting bolsters this conclusion. Chateaugay,
B. The Debt-for-Debt Face Value Exchange.
The 1980's spawned trouble--trouble for companies encumbered by massive amounts of debt. Not surprisingly, this crisis has fused into "an explosion of debt defaults, out-of-court debt restructuring and bankruptcies." Deleveraging Tool, supra, at 643. A company confronted with debt dеfault can choose to rearrange its finances out of court as an alternative to obtaining relief under the bankruptcy laws.
A debtor in financial trouble may seek to avoid bankruptcy through a consensual out-of-court workout. Such a recapitalization, when it involves publicly traded debt, often takes the form of a debt-for-debt exchange, whereby bondholders exchange their old bonds for new bonds. The debtor hopes that the exchange, by changing the terms of the debt, will enable the debtor to avoid default. The bondholders hоpe that by increasing the likelihood of payment on their bonds, the exchange will benefit them as well. The debtor and its creditors share an interest in achieving a successful restructuring of the debtor's financial obligations in order to avoid the uncertainties and daunting transaction costs of bankruptcy.
Chateaugay,
The 1989 bankruptcy court decision of In re Chateaugay created an enormous disincentive for investors to participate in consensual out-of-court restructurings and, thus, spurred movement of financially troubled companies into the bankruptcy courts. LTV Corp. v. Valley Fidelity Bank & Trust Co. (In re Chateaugay Corp.),
The Chateaugay bankruptcy court, then, faced a narrow issue, but one of national first impression: Whether a faсe value exchange of debt instruments in a consensual out-of-court workout generated original issue discount not allowed under section 502(b)(2). In Chateaugay the LTV Corporation offered to exchange $1,000 face amount of new 15% senior notes and shares of common stock for each $1,000 face amount of old 13 7/8% debentures. After the face value exchange in Chateaugay, LTV filed for Chapter 11 protection. The indenture trustees filed proofs of claim for the face value of the new notes. The bankruptcy court first held, as we do, that unamortized OID constituted "unmatured interest" under section 502(b)(2). Chateaugay,
The Committee and Dr. Licht urge this Court to endorse the Chateaugay bankruptcy court's analysis and hold that the Pengo exchange created OID measured by the difference between the face amount of the New Debentures and the value given for the New Debentures, measured by the unamortized portion of the fair market value of the Old Debentures on the exchange date. The Chateaugay decision, however, produced a swift response from commentators who aggressively scrutinized its analysis of the original issue discount question in the face value exchange context and observed its effect on consensual out-of-court restructurings. See Deleveraging Tool, supra, at 647-48; Richard L. Epling, Exchange Offers, Defaults, аnd Insolvency: A Short Primer, Bankr.Devs.J. 15, 42-47 (1991) [hereinafter Primer ]; Practitioner's Guide, supra, at 548-51; Restructuring, supra, at 669 n. 28. This is so because the decision translated, in general terms, into the rule that when a financially troubled company exchanges new debt for old debt of equal face value, exchanging holders "will have a lower claim than those who did not [exchange], even though the overall debt obligation of the company has not been altered." Deleveraging Tool, supra, at 647. Under the rationale of the Chateaugay bankruptcy court, the claim of an exchanging holder of a debt instrument in a subsequent bankruptcy proceeding equals not the face amount of the new debt instrument, but the face amount of the new debt instrument minus the value paid for the new debt instrument, measured by the unamortized portion of the market value of the old debt instrument on the exchange date. For example, if we were to follow the Chateaugay bankruptcy court rule in this case, the claims of the exchanging holders of New Debentures would not be $1,000, the face amount of the New Debentures, but about $680, the fаce amount of the New Debentures ($1,000) minus the unamortized OID (approximately $320). This illustration makes it quite understandable that creditors of financially troubled companies are eager for the courts to provide them with guidance as to the post-bankruptcy ramifications of their workout decisions.
Until one month ago, the bankruptcy court's decision in Chateaugay represented the only school of judicial thought on the issue of whether a debt-for-debt face value exchange in a consensual out-of-court restructuring generatеd "unmatured interest" within the meaning of section 502(b)(2). But the Chateaugay bankruptcy and district court decisions did not reveal the complete interpretive scenario. A unanimous panel of the Second Circuit recently reversed the Chateaugay district court's judgment affirming the bankruptcy court and held, inter alia, that a face value exchange of debt obligations in a consensual workout does not generate OID. Chateaugay,
1. The Debt-for-Debt Face Value Exchange and Section 502(b)(2).
Bankruptcy policy strongly favors the "speedy, inexpensive, negotiated" adjustment of creditor-company relations afforded by out-of-court procedures. Chateaugay,
Such a rule also would "grant[ ] a ... windfall ... to holdouts who refuse to cooperate." Id. (citation omitted). The resulting dynamic is not difficult to prophesy. As the exchanging creditors' claim to a piece of the distributional рie shrinks, the corresponding portion of the pie actually recovered by the holdouts grows. Practitioner's Guide, supra, at 549-50 & n. 106. Since a rule recognizing the creation of OID in the context of a debt-for-debt face value exchange not only penalizes the exchanging creditors by revaluing their claims downward, but also rewards the non-exchanging holdouts by increasing the chance of receiving the total amount of their fully-intact claims, it "gives creditors a disincentive to cooperate with a struggling debtor." Deleveraging Tool, supra, at 658 (emphasis in original); see Practitioner's Guide, supra, at 549. We strongly disfavor a judicial interpretation of the Bankruptcy Code that contravenes the substantial Congressional policy favoring out-of-court consensual workouts. We hold, therefore, that the debt-for-debt face value exchange in the Pengo consensual out-of-court restructuring did not create "unmatured interest" in the form of original issue discount under section 502(b)(2) of the Bankruptcy Code.
2. Distinguishing Inapposite Scenarios.
As heretofore discussed, we decide only the narrow issue of whether a debt-fоr-debt face value exchange generates OID not allowed under section 502(b)(2). The parties offer cases and arguments discussing OID in contexts other than the one presented by the facts of this case. In closing, we think it is important to briefly state what this case is not about. First, we decline to consider when an original issue of debt might create a discount and, instead, appropriately confine our decision to whether the exchange of debt instruments in a consensual out-of-court restructuring creates a discount. See supra page 547 (contrasting how OID can arise when a debtor issues a debt instrument for an amount less than its face value with the suggestion that OID is generated when a debtor exchanges a debt instrument for another debt instrument of equal face value in a consensual out-of-court workout).
Next, we express no opinion as to whether a fair market value exchange creates OID not allowed under § 502(b)(2). In a "fair market value exchange," the holders exchange a debt instrument for a new debt instrument with a lower face amount. In the face value exchаnge involved in this workout, Pengo simply exchanged new indebtedness for old indebtedness with the same face amount.
We also refuse to investigate debt-for-stock exchanges and merely consider the debt-for-debt exchange presented by the facts of this case. In reducing the claims of the New Debenture holders, the bankruptcy court relied on In re Allegheny Int'l, Inc.,
Finally, this is not a tax case. We stress that the tax treatment of original issue discounting does not cоntrol our inquiry, which is placed firmly within the bankruptcy framework. The Second Circuit firmly rebuked the Chateaugay bankruptcy court for its reliance on tax cases for the proposition that a debt-for-debt exchange offer in a consensual out-of-court restructuring generates OID. Id.
III. CONCLUSION
For the foregoing reasons, we AFFIRM the judgment of the district court.
Notes
Section 502(b)(2) provides in relevant part that
if such objection to a claim is made [under § 502(a) ], the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that--(2) such claim is for unmatured interest.
11 U.S.C. § 502(b)(2) (Supp.1991).
The district court opinion contains all the stipulated facts. For an exhaustive rendition of the events invоlved in this dispute, see Pengo,
This case differs from Chateaugay in one respect. In Chateaugay the old debentures were originally issued at a discount. Because the original discount carried over from the old debt to the new debt, the Second Circuit found OID on the new debt, although no new OID was created by the face value debt-for-debt exchange. Chateaugay,
The court disrеgarded the value of the acquired stock in determining the value of the new notes; it compared the exchanged debentures with the acquired debt
The parties quarrel over whether this Court should consider certain statements contained in the Offering Circular about the reporting of interest income by holders of the New Debentures. We need not reach the issue of whether these statements are properly before this Court. Even if we resolved that issue affirmatively, we repeat that the tax treatment of a transaction does not determine its treatment in bankruptcy