Under Section 502(b)(2) of Title 11 of the U.S. Bankruptcy Code, upon a party-in-interest's objection to a creditor's claim, a bankruptcy court must "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."

In In re Oakwood Homes Corp., the 3rd U.S. Circuit Court of Appeals examined and interpreted this provision in determining whether the two lower courts erred by discounting the principal component of certain interest-bearing claims to present value after having disallowed the post-petition interest portion of the claims. Judge Franklin S. Van Antwerpen wrote for the majority, and found such "double discounting" to be impermissible and inequitable. Judge D. Brooks Smith dissented, although he agreed that such "double discounting" is impermissible.

On Nov. 15, 2002, Oakwood Homes Corp. filed its petition for relief under Chapter 11 of the Bankruptcy Code. Prior to filing its petition, Oakwood was in the business of building and selling prefabricated homes. Oakwood's subsidiaries often extended credit to homebuyers through long-term mortgage arrangements, and then securitized and sold these mortgages to certain trusts established for this purpose. To raise money to pay Oakwood for the mortgages, the trusts issued and sold certificates: Those who purchased the certificates were entitled to receive periodic payments of principal and interest.

Certain low-priority certificates and the holders of these certificates were at the center of the controversy that arose in Oakwood Homes. Distributions on these certificates were controlled by pooling and service agreements, which identified the distribution dates for the periodic payments of principal and interest to each class of certificate holder. In order to make the low-priority certificates more marketable, Oakwood guaranteed the trusts' payments of principal and interest on these certificates.

The funds for distribution from the trusts to the certificate holders came from the payments that individual mortgagors made on their respective mortgages. As mortgagors began defaulting on their respective mortgage payment obligations to the trusts, the trusts were in turn unable to make good on their obligations to pay the certificate holders. As a result, Oakwood was compelled to file its Chapter 11 petition.

JP Morgan, representing the holders of these low-priority certificates, filed proofs of claim representing $400 million in claims consisting of $116 million in future shortfalls of the trusts' payment of principal; $1 million in shortfalls of the trusts' payment of pre-petition interest; and the remaining $283 million representing future shortfalls in unmatured post-petition interest. These proofs of claim were based on Oakwood's guaranty of the trusts' obligations.

U.S. Bank, the indenture trustee for the holders of certain more senior notes, objected to JP Morgan's claims, alleging that such claims should not include post-petition interest; and the remaining claims for the post-petition principal payments should be discounted to present value as of the petition date. The U.S. Bankruptcy Court for the District of Delaware agreed, disallowing all unmatured post-petition interest and discounting to present value all future principal payments owing to the low-priority certificate holders. On appeal, the district court affirmed.

3rd Circuit Analysis

JP Morgan argued that the bankruptcy court had erroneously discounted the principal component of the claims to present value after having disallowed the post-petition interest portion of the claims at issue. On the other hand, U.S. Bank argued that the clear and unambiguous language of Section 502(b) calls for such discounting.

That section instructs a court to "determine the amount of such claim . . . as of the date of the filing of the petition," regardless of whether the court has already reduced the claim by disallowing post-petition interest under Section 502(b)(2). Because the principal payments were to be made over time, U.S. Bank argued that they should be reduced to present value as of the date of Oakwood's petition. U.S. Bank also argued that Section 502(b)(2) was really not even relevant to the discounting issue, because the claims arose under Oakwood's guarantee as opposed to an obligation to pay separable principal plus interest.

The court first determined that the fact that the claims arose from Oakwood's single guarantee did not change the underlying economic nature of the certificate holders' transaction and the trusts' payment obligations, which consisted of separable principal and interest. In short, Oakwood essentially stepped into the shoes of the trusts with respect to the obligation to make payments of principal and interest.

The court then analyzed whether Section 502(b) requires discounting the principal component of those claims after the interest component has already been disallowed under Section 502(b)(2). The court disagreed with the lower courts' conclusion that the language of Section 502(b) is clear and unambiguous, finding most significant the fact that Section 502(b) speaks of determining the "amount" of a claim "as of the date of the filing of the petition," while other sections of the Bankruptcy Code utilize the term "value as of" a certain date to effectuate a discounting to present value.

The court of appeals then looked to the interplay between sections 502(b) and 502(b)(2), noting that the bankruptcy court had treated separately the facets of its ruling dealing with these provisions. The court looked first to the legislative history of Section 502(b), which emphasizes two principles.

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 irrefutable presumption that the discounting rate and the contractual interest rate (even a zero interest rate) are equivalent.

Relying on this legislative history, the court held that to the extent the Bankruptcy Code contemplates discounting claims to present value, such discounting is not permitted where the claim for interest has already been disallowed under Section 502(b)(2).

Explaining its rationale and that of the legislative history, the court found it irrelevant whether a court disallows unmatured interest under Section 502(b)(2) or discounts the entire amount (i.e., principal plus interest) to present value under Section 502(b), as long as the court does not do both. While recognizing that future liabilities must be reduced in some way to reflect the time value of money, the court stated that "once unmatured interest has been disallowed, discounting the remainder of the claim to present value would inequitably twice penalize the creditor." The court stated that Congress intended to recognize that the creditor realize the benefit of its bargain while at the same time avoid any windfall to the creditor.

The court also found "highly significant" the distinction between interest-bearing and non-interest-bearing debt, with any discounting to present value generally occurring in instances of non-interest-bearing debt, e.g., deferred compensation payments, non-interest-bearing leases, and non-interest-bearing unfunded pension liabilities. The court rejected the district court and U.S. Bank's reliance on In re Loewen Group Int'l Inc., where the debt in question was non-interest bearing, as opposed to the low-priority certificate holders' interest-bearing debt in Oakwood Homes.

The Oakwood Homes court found that even the Loewen court understood this distinction when it concluded that "it was economically appropriate to discount the non-interest-bearing claims because the parties had bargained to receive less than the face value of the notes by not building interest into the bargain."

Judge D. Brooks Smith dissented in this opinion. Although he agreed with the majority that both disallowing post-petition interest and discounting the claim to present value would be impermissible "double discounting," he disagreed with the majority's analysis of the structure of the underlying transaction. The dissent argued that the majority - as well as the lower courts - had mischaracterized the trusts' future obligations as separable principal and interest obligations, which led to a misapplication of Section 502(b)(2).

Instead, the dissent would have found that the nature of the securitization and guarantee process in Oakwood's case gave rise to claims that were based on non-interest bearing future obligations. In short, Smith would have considered the whole periodic payment stream on the certificates to be a non-interest bearing obligation that should be reduced to present value under Section 502 of the Bankruptcy Code, and he would not have disallowed any portion of that payment stream.

Although in all other cases, his dissent would have reached generally the same result as had the majority of the court, Smith's rationale would have signaled bad news for JP Morgan. Smith noted that JP Morgan had not appealed the district court's affirmance of the bankruptcy court's ruling disallowing any claim for post-petition interest. Accordingly, he would have let stand the ruling that post-petition "interest" be disallowed, while affirming the district court's decision to discount to present value the remaining portion of the future payments (that portion identified by the lower courts as the "principal" portion).

Conclusion

Under the Oakwood Homes rationale, courts within the 3rd Circuit may not discount the principal of interest-bearing claims to present value after disallowing the portion of the claims representing unmatured interest. The result makes sense and, but for JP Morgan's decision not to appeal every aspect of the lower court's decision, would have been effectively the same under the majority's or the dissent's analysis.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Matthew E. Hoffman practices in the area of business reorganization and financial restructuring. Hoffman is admitted to practice in Pennsylvania and New Jersey.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.