Third Circuit Says No to Double-Discounting

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 claim...as
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).
</p><p>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 <i>In re Oakwood Homes
Corp.</i>, 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).

</p><p><b>Background and Facts</b>
</p><p> 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.
</p><p>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.
</p><p>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.
</p><p>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.
</p><p><b>Analysis on Appeal</b>
</p><p> 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 claim...as 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.
</p><p>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.
</p><p>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.
</p><p>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.
</p><p>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, <i>bankruptcy operates as the acceleration of
the principal amount of all claims</i> against the debtor. One unarticulated
reason for this is that <i>the discounting factor for claims</i> after the commencement
of the case <i>is equivalent to [the] contractual interest rate on the claim</i>.
Thus, this paragraph <i>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.</i>" 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.

</p><p>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
</p><p>In reaching its conclusion, the Third Circuit addressed the holding in<i> In
re Loewen Group International Inc.</i>, 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 <i>Loewen</i> from Oakwood's
case. The fundamental distinction between both cases was that the debt instruments
and debt obligations at issue in <i>Loewen</i> were noninterest-bearing, whereas
in Oakwood's case the debt was interest-bearing. The <i>Loewen</i> 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."
</p><p><b>The Dissent</b>

</p><p>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).
</p><p>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.
</p><blockquote>&nbsp;</blockquote>

<hr>
<h3>Footnotes</h3>

<p> 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.</p>