In its recent ruling in In re Oakwood Homes Corp., 449 F.3d 588 (3d Cir. 2006), the U.S. Court of Appeals for the Third Circuit held that §502(b) of the Bankruptcy Code does not permit a court to discount to present value the principal component of a claim for indebtedness where, pursuant to §502(b)(2), the court has already disallowed the future, unmatured interest component of the claim. In Oakwood, the Third Circuit was presented with the issue of what effect §502(b), with its provisions dealing with discounting to present value and disallowing claims based on future interest, would have on notes that had not been paid in full, nor expired, as of the debtor's petition date. In its opinion, the court presented a detailed analysis of the nature of claims based on debt instruments with interest components and the effect of §502 of the Code upon the unmatured interest portion of such claims. Finally, the court reached a conclusion that applied §502(b) in a manner consistent with, in the court's view, the economic realities of these instruments and how the Code demands they be treated.

For practitioners, however, equally as important as the substance of the Third Circuit's opinion itself is the factual and procedural history that led to, and followed, the decision. The saga of the particular noteholders' claims in the Oakwood bankruptcy illuminates the measures that need be taken on behalf of creditor-clients holding claims based on long-term indebtedness. This article will (1) discuss the Third Circuit's ruling in the Oakwood case, (2) outline the factual and procedural history of salient events that occurred before and after the Third Circuit's ruling and (3) suggest precautionary measures to be taken in future cases with respect to creditors with disputed claims during the claims objection and appeals processes.

Debtor Oakwood Homes Corp. was a manufacturer and seller of prefabricated homes. In connection with home sales, subsidiaries of Oakwood would extend mortgages to buyers of the homes and then securitize the mortgages by selling them to trusts. To acquire the necessary capital to pay for these mortgages, the trusts issued indebtedness in the form of various certificates, payable over time via periodic payments of principal and interest. Certain of these certificates, the so-called "B-2 Certificates (herein, the "Certificates")," were issued to holders represented by JPMorgan Chase Bank as trustee. These certificates were of a relatively low priority contractually in comparison with other long-term indebtedness the trusts had issued. Because the Certificates had a priority junior to other major debt tranches, Debtor Oakwood guaranteed payment of both interest and principal to the holders of these certificates.

JPMorgan filed proofs of claim on behalf of certain holders of Certificates, asserting claims of over $1 billion. These claims were based on (1) funds attributable to future shortfalls in principal payments that would not be made to the holders, (2) funds attributable to pre-petition interest payments and (3) funds attributable to future, unmatured, post-petition interest payments that would come due, but would not be paid, over the life of the certificates (terminating under their terms in approximately 2030). A trustee of certificates senior to the B-2 Certificates, U.S. Bank National Association, objected to the JPMorgan claims, arguing that (1) the portion of JPMorgan's claims based on post-petition, unmatured interest should be disallowed pursuant to §502(b)(2) of the Code and (2) the portion of JPMorgan's claims based on future principal payments should be discounted to their present value. The bankruptcy court and district court agreed with U.S. Bank's position and held that the future interest component of JPMorgan's claims should be disallowed. Further, the bankruptcy court and subsequently the district court held that the future principal component of the claims should be discounted to present value.

Approximately two months after the bankruptcy court's order disallowing the claims for unmatured interest and discounting the principal component of JPMorgan's claims, the court entered an order confirming the Oakwood liquidation plan. Pursuant to the debtors' plan, a liquidating trust was appointed to reconcile and make distributions on account of various unresolved claims. With respect to disputed claims still pending and unresolved at the time of plan confirmation, the plan provided that the liquidation trust was to establish "disputed claims reserves" so that sufficient funds would be available to pay distributions on the maximum allowable amount of unresolved claims within a given class. Thus, on account of those claims that were subject to pending objections, as well as those that had not already been allowed in a liquidated amount, the liquidation trust established reserves to cover potential distributions.

JPMorgan appealed the bankruptcy court's decision, which discounted its claims to the district court, then to the Third Circuit. While the appeals were pending, the parties continued to litigate collateral issues related to JPMorgan's claims in bankruptcy court. One issue was the effect the appeal would have on ongoing distributions pursuant to the terms of the plan. Specifically, JPMorgan requested that a reserve be established to preserve funds for JPMorgan's claims, and also that distributions to other creditors be stayed, pending the outcome of the appeal. In connection with JPMorgan's request, the court directed the debtors' estates to fund a reserve, in the amount of $61 million, to cover a distribution to JPMorgan in the event that the bankruptcy court's decision discounting its claims was overruled on appeal. However, the court conditioned its order regarding the reserve upon JPMorgan's posting of a bond in the amount of $61 million. When JPMorgan elected not to post the bond, the bankruptcy court refused to stay distributions to other creditors and also approved the setting of a $0 cash reserve to cover JPMorgan's claims.

On appeal to the Third Circuit, JPMorgan argued that once the bankruptcy court had disallowed JPMorgan's claim for unmatured interest, §502(b) did not require the court to discount the principal component of JPMorgan's claim to its present value. In response, U.S. Bank argued that the plain language of §502(b) required such discounting, and also argued that §502(b)(2) (dealing with unmatured interest) was irrelevant because the obligation owed to JPMorgan was not separable into an interest component and a principal component. JPMorgan argued, and the Third Circuit agreed, that U.S. Bank was "double-discounting," which ran afoul of the rights for which JPMorgan and the certificate-holders had contracted, and that the Code does not countenance this result.

The Third Circuit further ruled that the interest and principal components were separable and were not merely a single future liability that should be discounted, at least not once the B-2 Certificate-holders' rights to unmatured interest had been disallowed. The court engaged in a detailed analysis of the underlying documents, §§502(b) and (b)(2) of the Code, and the legislative history pertaining thereto. The court concluded that with respect to an interest-bearing obligation such as the B-2 Certificates, §502(b) requires either disallowance of future interest or discounting the entire claim of principal plus interest to present value, but does not permit both.

The Third Circuit began its analysis by reviewing the documents supporting the claims: the Certificates themselves and the pooling and servicing agreement under which the Certificates were issued. The court reasoned that both the B-2 Certificates and the servicing agreement bifurcated the principal and interest components into separate obligations. Therefore, the court held that principal and interest in this instance did not "merely represent a singular future liability." Oakwood, 449 F.3d at 594. Since principal and interest were severable components of the claims, the court ruled, they could not be treated as part of the same, unified obligation, the entirety of which could be discounted once interest had been disallowed. The court ruled that the interest component of the B-2 Certificates made them a more valuable instrument than a non-interest-bearing debt, and to couple disallowance of unmatured interest with discounting to present value would be to treat the B-2 Certificate-holders as if the claims were based on an interest-free debt; this was not the instrument for which the holders had bargained or that the debtors had issued.

Secondly, the Third Circuit held that the statutory language of §502(b) did not require (or merit) the result advocated by U.S. Bank. The court noted that in each instance where the Code discusses discounting a claim or obligation to present value, it specifies that what is being established is the claim's or obligation's "value." In contrast, §502(b), the provision relied upon by U.S. Bank, speaks in terms of determining the "amount" of an "allowed claim" as opposed to the "value" of such claim as of the filing of the bankruptcy petition. In reliance on this discrepancy in language, the court disagreed with U.S. Bank that §502 clearly and unambiguously required discounting in all circumstances and held, "[w]e do not hold here that 11 U.S.C. §502(b) never authorizes discounting a claim to present value, but instead that the statute does not clearly and unambiguously require it for all claims evaluated under §502." Oakwood, 449 F.3d at 598.

Finding ambiguity present in the language of §502(b), the court referenced the legislative history of this provision to shed light on whether §502(b) requires a court to discount the principal component of a claim arising from an interest-bearing note to present value, after the court has already disallowed the future interest portion of the claim. The court relied on language in the legislative history dealing with discounting rates, which provides that, in instances where present-value discounting is appropriate, the proper discounting rate should be the rate of interest provided for in the instrument on which the claim is based. Therefore, for example, where a court seeks to discount an unmatured note bearing 5 percent interest, the court will combine all principal and interest payments over the life of the loan and discount the sum to present value using a discounting rate of 5 percent. See, e.g., H.R. Rep. No. 95-595, at 352-54 (1977).

The court determined that the effect of this language was that, "[t]o the extent that the Code in any way contemplates discounting to present value, such discounting is not permitted where the claim is for principal plus interest, and the interest has already been disallowed pursuant to §502(b)(2)." Oakwood, 449 F.3d at 600. The court reasoned that the intent behind using the contracted-for interest rate as the discount rate was to achieve the same economic result for discounted claims as for claims that were not discounted where the future interest component was simply disallowed. The court held that "[a]s a matter of economics, the legislative history recognizes that it is irrelevant whether a court applies §502(b)(2) to disallow unmatured interest, or discounts the entire amount (i.e., principal plus interest) to present value—as long as the court performs only one such operation and not both, the result is the same." Oakwood, 449 F.3d at 600. As a result of this analysis, the court held that the bankruptcy court had erred, and that interest-bearing debt should not be discounted to present value after unmatured interest has already been disallowed as required by Code §502(b)(2). Oakwood, 449 F.3d at 603. As a result of the Third Circuit's decision, the amount of JPMorgan's claim increased from an allowed claim of approximately $8 million to approximately $29 million.

After entry of the Third Circuit's decision, the bankruptcy court was presented with the task of allowing JPMorgan's claims in accordance with the Third Circuit's ruling. JPMorgan filed a motion in the bankruptcy court seeking an order fixing the amount of its allowed claims, without discounting. JPMorgan's motion also sought to stay further distributions to other unsecured claimants, until such time as JPMorgan had received a "catch-up" distribution. That is, while JPMorgan's appeal had been pending, the liquidation trust had been engaged in reconciling the claims of other unsecured creditors. With respect to allowed claims, the trust made distributions at the approximate rate of 47 percent of the amount of the creditors' respective claims. Thus, JPMorgan sought a stay on these distributions to any unsecured claimants (even those for whom disputed claims reserves had been established) until such time as the trust made a distribution to JPMorgan of 47 percent of its allowed claims, which could total as much as $13,744,528.19.

JPMorgan's motion was based largely on §502(j) of the Code, which provides that "if a reconsidered claim is allowed and is of the same class as [another] holder's claim, such holder may not receive any additional payment or transfer from the estate on account of such holder's allowed claim until the holder of such reconsidered and allowed claim receives payment on account of such claim proportionate in value to that already received by such other holder." 11 U.S.C. §502(j). JPMorgan argued that §502(j) required that JPMorgan be "caught up" by receiving a 47 percent distribution before any further distributions could be made to other unsecured claimants.

U.S. Bank, as well as certain creditors in JPMorgan's class under the plan that had not yet received a distribution, objected to JPMorgan's motion. These creditors were concerned with, among other things, the absence of a reserve to cover JPMorgan's distribution and the possible lack of estate resources available for distributions to be made to JPMorgan on account of its claims. The objecting creditors opposed JPMorgan's motion to the extent that any distribution made to JPMorgan would affect the funds present in the disputed claims reserves already dedicated for specific claims. Other creditors in JPMorgan's class were concerned that the assets remaining in the estates would be insufficient to provide a 47 percent distribution on account of both JPMorgan's increased claim and on the claims of remaining creditors. These creditors were further concerned that if their distributions were stayed while JPMorgan was "caught up," the requested "catch-up" payments would have to come from the reserves already dedicated for the claims of unsecured claimants.

When the bankruptcy court had originally ordered that JPMorgan's claims be discounted to present value, the court directed that a reserve be established for JPMorgan's claims, but that directive was contingent on JPMorgan's posting of an adequate bond. Had JPMorgan posted a bond as directed, the estates would have been required to establish a reserve sufficient to cover a distribution to JPMorgan on account of its undiscounted claims. JPMorgan, however, made the business decision not to post the bond. The result was that no reserve was established for the JPMorgan claims, and the other creditors in JPMorgan's class argued that they should not be penalized (by receiving a lesser distribution or having their distributions stayed) as a result of JPMorgan's conscious business decision not to post a bond.

The bankruptcy court agreed that a stay was unwarranted because JPMorgan had missed several opportunities to protect itself by posting a bond and, had it done so, the need for certain of the relief requested in JPMorgan's motion would have been averted. In accordance with the Third Circuit's decision respecting discounting, the bankruptcy court increased the allowed amount of JPMorgan's claims from $8,151,864 to $29,243,677. However, the court denied in part that portion of JPMorgan's motion that sought a stay of distributions to other unsecured creditors. Specifically, although the court ruled that undedicated cash in the estates should be used for a distribution to JPMorgan, the court also held that the liquidation trust could continue to make distributions to unsecured creditors from the disputed claims reserves. Said another way, the court denied JPMorgan's request for a stay on distributions to the extent such relief would stay distributions from the disputed claims reserves.

The bankruptcy court observed that it was likely, but not certain, that JPMorgan would eventually receive a 47 percent distribution on account of its claim. However, given that JPMorgan's distribution will come from, in the first instance, "available cash" as defined in the plan, it may take some time for JPMorgan to receive its "catch-up" distribution in full. The court noted that JPMorgan could have avoided this delay in the first instance by posting a bond sufficient to insure the trust's outlays in connection with a sufficient reserve. Had it done so, the trust could have dedicated funds in the reserve that would have been available for distribution as soon as the Third Circuit rendered its decision. The effect of the court's ruling was to leave the risk of a shortfall on JPMorgan, which is not an altogether unfair result in light of its failure to post a bond.

The history of the proceedings on JPMorgan's claims illustrates that the claims reconciliation process can be a lengthy one, especially where appeals are involved. During the time between plan confirmation and the ultimate distribution on account of an allowed claim, a bankruptcy estate's resources can change significantly in many ways. The prudent claimant will, therefore, take the steps necessary at the outset to ensure that sufficient funds are set aside to cover an eventual distribution.