Pengo Industries, Inc., Matter of

• Citation: 962 F.2d 543
• Decision Date: 12 June 1992
• Docket Number: No. 91-1769,91-1769
• Parties: , 27 Collier Bankr.Cas.2d 119 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.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 543

962 F.2d 543

60 USLW 2798, 27 Collier Bankr.Cas.2d 119

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 terms 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 the 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-of-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 placed 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 amount 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.), 129 B.R. 104 (N.D.Tex.1991). ² The Committee and Dr. Licht appeal from the judgment of the district court reversing the judgment of the bankruptcy court. We review the bankruptcy court's conclusion of law de novo. Stoker v. Smith (In re Moody), No. 91-2156, Slip op. 4091, 4092 (5th Cir. Apr. 29, 1992) (citing Jordan v. Southeast Nat'l Bank (In re Jordan), 927 F.2d 221, 224 (5th Cir.1991)).

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.), 961 F.2d 378, 380 (2nd Cir.1992); see Marc S. Kirschner, Dan A. Kusnetz, Laurence Y. Solarsh & Craig S. Gatarz, Prepackaged Bankruptcy Plans: The Deleveraging Tool of the '90's in the Wake of OID and Tax Concerns, 21 Seton Hall L.Rev. 643, 648-50 (1991) [hereinafter Deleveraging Tool ]; see also Nicholas P. Saggese, Gregg A. Noel & Michael E. Mohr, A Practitioner's Guide to Exchange Offers and Consent Solicitations, 24 Loy. L.A. L.Rev. 527, 548 n. 100 (1991) ("[A] debt security is issued with OID to the extent its stated redemption price at maturity exceeds its issue price.") [Hereinafter Practitioner's Guide ]. The discount on a debt instrument, deduced from a purchase price lower than the face value of the instrument, "is 'in the nature of additional interest.' " Deleveraging Tool, supra, at 649 & n. 28 (citations omitted). The borrower amortizes the OID, "for accounting and tax purposes, over the life of the [debt instrument]," then the company pays back the face value to the holders on the maturity date. Chateaugay, 961 F.2d at 380.

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 of original issue discounting bolsters this conclusion. Chateaugay, 961 F.2d at 380, ("As a matter of economic definition, OID constitutes interest.") (citations omitted). For OID constitutes a "method of providing for and collecting what in economic fact is interest to be paid to compensate for the delay and risk involved in the ultimate repayment of monies loaned." In re Public Serv. Co., 114 B.R. 800, 803 (Bankr.D.N.H.1990). Moreover, the legislative history verifies our inclusion of OID in the category of unallowable "unmatured interest." The Senate and House Reports both state that "[i]nterest disallowed under [§ 502(b)(2) ] includes postpetition interest that is not yet due and payable, and any portion of prepaid interest that represents an original discounting of the claim, yet that would not have been earned on the date of bankruptcy." S.Rep. No. 989, 95th Cong., 2d Sess. 62, reprinted in 1978 U.S.C.C.A.N. 5787, 5848; H.R.Rep. No. 595, 95th Cong., 2d Sess. 352, reprinted in ...