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 In The Daily Deal Eric Goodison, a partner in the corporate department at Paul, Weiss, Rifkind, Wharton & Garrison LLP, examines the emergence of original issue discounts and the leveraged bank loan market.
The leveraged bank loan market has had many new developments over the past few years, including the issuance of leveraged bank loans at a discount to par, or what the market refers to as original issue discount, or OID. Lenders need to understand that in most cases the lender will not be able to claim the entire par amount of these OID loans in a bankruptcy proceeding of the borrower that occurs prior to the scheduled maturity of the loan.
Arrangers of leveraged bank loans have had the ability to make borrowers issue loans with OID for several years. While not commonly used, this was often a feature of the market flex provisions agreed to by the borrower and the arrangers when the arrangers committed to provide the leveraged bank loans.This market flex provision allowed the arranger to increase the yield earned by participating lenders if necessary for the arrangers' syndication effort to clear the market. This increase in yield could take the form of either an increase in interest rate or as OID. Before the second half of 2007, it was rare to see leveraged bank loans issued with OID, since most deals cleared the market without any need for upward pricing flex.
When the credit markets, including the leveraged bank loan market, collapsed in the second half of 2007, many of the arrangers had to offer leveraged bank loans at a significant discount to the market. While a substantial portion of this was market discount and not OID, the economics--to the ultimate lenders--were the same as if they'd been OID loans. The result of this market discounting is that in new leveraged bank loan financings, lenders are now often demanding OID rather than an increase in stated interest rates. Accordingly, today it is not uncommon to see new leveraged bank loans issued to lenders with OID. The bankruptcy treatment of OID is analogous to the treatment of loans issued at par with a higher interest rate. For example, on a loan issued at par with a stated maturity of five years, and where the borrower is subject to a bankruptcy proceeding after three years, the lenders generally could not, on the filing date of the bankruptcy, claim the interest still to be paid for the fourth and fifth years of the stated term. However, any interest accrued but not paid before commencement of the bankruptcy case generally should be allowed as a claim. The U.S. Bankruptcy Code treats OID in a similar fashion. OID at the time a loan is made is treated as unearned interest and not as principal. The OID is amortized over time. Accordingly, in the example above, if the loan had been issued with OID and a lower interest rate rather than at par, the OID would amortize over the life of the loan. On the bankruptcy commencement date, three years worth of OID would have been amortized and should be allowed as a claim in the borrower's bankruptcy proceeding. However, the unamortized OID on the commencement date generally will not be allowed as a claim in the borrower's bankruptcy proceeding. The leading case in this area is from the Second Circuit, In re Chateaugay Corporation from 1992. In that case, the Second Circuit held that unamortized OID on outstanding bonds at the commencement of a bankruptcy case is unmatured interest and accordingly not allowed as a claim. The court also held that the proper way to calculate unamortized interest is by the constant interest method rather than straight line. This means the amount of OID amortized in each period increases over time. Because the Chateaugay case involved unsecured bonds and not secured bank loans, and because there were no cases ruling on secured bank loans with OID, some practitioners argued that secured bank loans could be distinguished from unsecured bonds and be allowed as a claim for 100% of par. In November 2007, a bankruptcy court ruling made clear that there is no basis for this distinction. In the Solutia bankruptcy, the court said: "The underlying fact that the obligation is secured does not change this fact. There are not apparent bankruptcy policy reasons to be found in the legislative history, [Bankruptcy Code] and the relevant case law to warrant a different treatment for unsecured and secured OID." Original issue discounts and the leveraged bank loan market It should be noted that the Solutia court ultimately established the bondholders' claim at $210 million--less than the $223 million par amount of the bonds and substantially less than the $271 million the bondholders were claiming. While the bondholders had appealed the court's decision, the parties ultimately settled the claim at $220 million. While not directly decided by the court in the Solutia case, the secured status of a leveraged bank loan should make a difference if the loan is over secured. Lenders under an over secured loan are generally entitled to post petition interest during the pendency of the borrower's bankruptcy proceeding. Because unamortized OID is treated as unmatured interest, lenders of an over secured loan issued with OID should be able to claim the accretion of that OID during the pendency of the borrower's bankruptcy proceeding. Lenders in leveraged bank loans issued with OID should understand that the OID will be treated as unmatured interest and not as principal. In a bankruptcy of the borrower, only the amortized portion of the OID will be allowed as a claim by the lender. This result does not change if the loan is secured. Eric Goodison is a partner in the corporate department at Paul, Weiss, Rifkind, Wharton & Garrison LLP, with expertise in structuring, negotiating and consummating leveraged financings for all types of borrowers. Categories Deal Video
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