Can Warrants Be Deemed "Original Issue Discount" and Disallowed as Unmatured Interest?

Treatment of Unmatured Interest
In general, a creditor is not entitled to interest that matures post-petition. Section 502(b)(2) of the Bankruptcy Code provides:

(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if [an] objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that—
* * *
(2) such claim is for unmatured interest. . . .

11 U.S.C. § 502(b)(2).

Simply put, section 502(b)(2) requires a court to disallow a claim to the extent that the claim is for “unmatured interest.”

Congress did not define the term “unmatured interest,” and courts have given the term its plain meaning. E.g., In re Lamarre, 269 B.R. 266, 267 (Bankr. D. Mass. 2001). According to Black’s Law Dictionary, “interest” is

[t]he compensation fixed by agreement or allowed by law for the use or detention of money, or for the loss of money by one who is entitled to its use; [especially], the amount owed to a lender in return for the use of borrowed money.

Black’s Law Dictionary 935 (10th ed. 2014).

Interest is the cost of borrowing money. Moreover, Black’s Law Dictionary defines “mature” to mean “to become due” and a “matured claim” as “a claim based on a debt that is due for payment.” Black’s Law Dictionary 301, 1126 (10th ed. 2014).

Therefore, “unmatured interest” is the cost of borrowing money that is not yet due and payable. This definition is consistent with the legislative history of section 502(b)(2), and—in general—the courts have adopted the definition or a similar one. E.g., Joyce v. Fid. Consumer Disc. Co. (In re Joyce), 41 B.R. 249, 255 (Bankr. E.D. Pa. 1984) (citing H.R. Rep. No. 95-595, at 353 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6308).

The legislative history of section 502(b)(2) illustrates two types of “unmatured interest”:

1. “postpetition interest that is not yet due and payable” and

2. “any portion of prepaid interest that represents an original discounting of the claim, yet would not have been earned on the date of the bankruptcy.”

H.R. Rep. No. 95-595, at 352 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6308.

In general, parties agree on whether an amount is interest and when it is due and payable. When they disagree, however, OID is often involved. OID is interest. LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378, 380–81 (2d Cir. 1992). Therefore, like all other interest, OID is a cost of borrowing money. OID is the difference between the stated principal of a loan and the proceeds that the borrower received. Id. at 380.

For example, if a debtor borrows $1 million, but the stated principal of the loan is $1.5 million, there is $500,000 of OID. OID results when a borrower borrows the stated principal of a loan and pays interest that has neither accrued nor been earned with some of the stated principal.

This is why the legislative history of section 502(b)(2) refers to “any portion of prepaid interest that represents an original discounting of the claim.” Accordingly, section 502(b)(2) requires a court to disallow prepaid interest that “represents” OID—not OID that is “represent[ed]” by prepaid interest. Said differently, section 502(b)(2) is concerned about the prepaid interest the lender possesses, not the corresponding OID.

This distinction is important if a borrower prepays with property—for example, a warrant—and it is due and payable when the loan is made. That is what happened in Baxano.

Baxano Surgical
Baxano Surgical, Inc., a Chapter 11 debtor, borrowed about $7.6 million from a lender. The contract governing the loan required the debtor to provide the lender with a warrant—that is, an option to buy stock in the debtor at a fixed price. In essence, the debtor prepaid for the loan with property. The warrant was not “unmatured interest” because the contract required the borrower to issue the warrant when the loan was made—well before the debtor filed its petition for relief under the Bankruptcy Code.

By an objection to a sale of substantially all of the debtor’s assets, a complaint, and an amended complaint, the committee alleged that (i) part of the stated principal of the loan was consideration for the warrant and not an advance, (ii) the warrant reduced the proceeds of the loan by an amount equal to the value of the warrant when the borrower issued the warrant to the lender, (iii) there was OID equal to the difference between the stated principal of the loan and the reduced proceeds of the loan, (iv) part of the OID was “unmatured interest,” and (v) section 502(b)(2) required the court to disallow any claim to the extent that the claim is for the OID that is “unmatured interest.”

The lender countered that there was no OID because (i) the borrower received all of the stated principal, (ii) the warrant was nonmonetary interest, and (iii) that interest was due and payable when the loan was made. Therefore, while the committee and the lender agreed that there was interest equal to the value of the warrant, they disagreed on the interest’s form—OID or the warrant itself.

The answer is important because—unlike the warrant—the alleged OID was not due at any particular time. OID is disguised principal. Therefore, OID and principal are fungible—that is, indistinguishable and indivisible. For this reason, OID matures as principal matures. Despite that, the courts have held that for purposes of section 502(b)(2), OID matures at a constant rate. E.g., In re Solutia Inc., 379 B.R. 473, 486 (Bankr. S.D.N.Y. 2007). In other words, OID is amortized, and unamortized OID is unmatured. LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378, 380 (2d Cir. 1992). It follows that if the interest was the warrant, then the interest was matured because it was due and payable when the loan was made, and if the interest was OID, then the interest was unmatured to the extent that it had not been amortized.

The Importance of the Parties’ Intent Rather Than Tax Code Characterization
The problem with the committee’s argument is that it ignored the purpose of the warrant. The stated principal amount was advanced because the borrower needed more liquidity. In exchange, the borrower was required to pay interest—that is, the cost of borrowing. It did so by granting a security interest in substantially all of its assets to the lender and issuing the warrant to the lender.

By recharacterizing the issuance of the warrant as a sale, the committee reimagined the loan, suggesting that the borrower prepaid interest with some of the stated principal, not the warrant. The committee also ignored the intended purpose of the warrant, which was to pay the cost of borrowing. Further, the committee ignored the contract governing the loan, whereby the lender did, in fact, advance the stated principal amount, which provided the borrower with more liquidity than if the lender had discounted the principal in exchange for the warrant. The committee argued that the parties’ intent should be ignored and that sections 1272 and 1273 of the Internal Revenue Code should govern.

The United States taxes OID as income, United States v. $315,298.52 in U.S. Currency, 2010 WL 1529402, at *1 n.2 (D. Md. Apr. 14, 2010), and section 1273(a)(1) of the Internal Revenue Code defines this OID as the excess (if any) of the stated redemption price at maturity, over the issue price. In general, the “issue price” of a “debt instrument” is the price that its first buyer paid for it. 26 U.S.C. § 1273(b)(2). Therefore, the “issue price” of a “debt instrument” is the equivalent of the proceeds of a loan. Section 1273(c)(2) includes special rules for calculating the “issue price” of a debt instrument when it and property are “issued together as an investment unit”:

(A) the issue price for [the] unit shall be determined in accordance with the rules of . . . subsection [(c)] and subsection (b) as if it were a debt instrument,

(B) the issue price determined for [the] unit shall be allocated to each element of [the] unit on the basis of the relationship of the fair market value of [the] element to the fair market value of all elements in [the] units, and
(C) the issue price of [the] debt instrument included in [the] unit shall be the portion of the issue price of the unit allocated to the debt instrument under subparagraph (B).

26 U.S.C. § 1273(c)(2).

Under the rules of section 1273, there would be OID equal to the value of the warrant (cf. Chock Full O’ Nuts Corp. v. United States, 453 F.2d 300, 304–5 (2d Cir. 1971) (discussing section 1273’s predecessor)), and section 1272(a)(1) required the borrower to report the OID as income over the life of the loan. That is, sections 1272 and 1273 require OID to be amortized even if the prepaid interest that corresponds to the OID was due and payable already. But the committee in Baxano ignored that one purpose of sections 1272 and 1273 is to distinguish between when a lender must report OID and prepaid interest as income and when OID and prepaid interest mature.

Before Congress amended section 1232—the predecessor of section 1272—in 1969, if a borrower issued a zero-coupon bond, then the borrower was required to amortize and deduct the costs of borrowing—that is, the OID—over the life of the bond, and the lender was not required to recognize any income from lending—that is, the OID—until the lender redeemed (or resold) the bond. H.R. Rep. No. 91-413, at 109 (1969), reprinted in 1969 U.S.C.C.A.N. 1645, 1757–58.

Thus, before 1969, the Internal Revenue Code did not require a lender to report OID as income until the principal matured. In fact, one argument against the amendment was that federal law should not require a lender to report OID as income until it matured. See Staffs of J. Comm. on Internal Revenue Taxation & Comm. on Fin., 91st Cong., Summary of H.R. 13270, The Tax Reform Act of 1969 61 (Comm. Print 1969) (“A bondholder should not be taxed on original issue discount until the time when he, in effect, receives it; namely, when the bond is redeemed or when he sells the bond.”). Neither section 1272 nor section 1273 dictates when OID or prepaid interest matures. Accordingly, the sections should not control when interest matures for purposes of section 502(b)(2) of the Bankruptcy Code. See Tex. Commerce Bank, N.A. v. Licht (In re Pengo Indus., Inc.), 962 F.2d 543, 546 (5th Cir. 1992) (“[T]his is not a tax case. . . . [T]he tax treatment of original issue discount does not control our inquiry, which is placed firmly within the bankruptcy framework.”).

Conclusion
Section 502(b)(2) of the Bankruptcy Code requires a court to disallow a claim to the extent that the claim is for interest that was prepaid, represents an original discounting of the claim, and did not mature—that is, become due and payable—pre-petition (or pre-confirmation, if the claim is secured).

The court should conclude that property the borrower issued to the lender is interest if the parties intended the property to be interest. The parties’ intent should be inferred from the parties’ words and contract, the parties’ actions, and the context of the loan. Cf. Cohen v. B Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 456 (3d Cir. 2006) (“[T]he characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances.”).

Once an amount is determined to be interest, a court should determine when the interest matures according to the contract. Cf. In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio. 1993) (“Prepayment amounts, although often computed as being interest that would have been received through the life of a loan, do not constitute unmatured interest because they fully mature pursuant to provisions of the contract.” (citing In re Skyler Ridge, 80 B.R. 500, 508 (Bankr. C.D. Cal. 1987), and In re 360 Inns, Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987))). In the Baxano case, it is clear that the parties intended the warrants to constitute a cost for the loan that was matured and paid as of the date of the loan transaction. There was no ruling by the court because the matter settled based on the relatively small amount at issue as compared with the administrative expenses required to litigate. However, because each case must be decided on its unique facts with the foregoing authorities applied, warrants might again be argued to constitute unmatured interest.

Keywords: bankruptcy and insolvency litigation, original issue discount, unmatured interest, warrant