The U.S. Court of Appeals for the 11th Circuit recently issued its opinion in one of the largest fraudulent transfer litigations against lenders. The 11th Circuit held that in a $421 million loan transaction where subsidiaries pledged their assets to secure their parent’s debt, the bankruptcy court did not err when it found that the subsidiaries did not receive reasonably equivalent value in exchange for the liens granted. The bankruptcy court also did not err in finding that the pre-existing lenders, which received a payoff because of the new financing secured by the subsidiaries’ assets, was an entity "for whose benefit" the subsidiaries’ liens were transferred and was liable for disgorgement of the payoff. This case has far reaching implications for secured lenders.
TOUSA, a homebuilder, received approximately $500 million in first- and second-lien term debt as part of a July 31, 2007, financing transaction. These loans from so-called New Lenders were guaranteed by TOUSA’s subsidiaries (Conveying Subsidiaries) and secured by the Conveying Subsidiaries’ assets. The loan proceeds were primarily used to repay the $421 million outstanding debt incurred by an affiliate, Transeastern, that had previously settled a lawsuit with its lenders (Transeastern Lenders) and whose settlement debt had been guaranteed by TOUSA. None of the Conveying Subsidiaries had been an obligor or guarantor of Transeastern’s debt. However, an adverse judgment of that magnitude would have triggered defaults in bond debt guaranteed by the Conveying Subsidiaries and their revolving loan facility. The New Lenders’ loan agreements required that the funds be used to pay the $421 million settlement with the Transeastern Lenders. Funds were transferred from the Transeastern Lenders to a wholly-owned subsidiary of TOUSA that was not a Conveying Subsidiary, to the administrative agent for the Transeastern Lenders and finally to the Transeastern Lenders. Six months later, in January 2008, TOUSA and its subsidiaries filed for Chapter 11. The Official Committee of Unsecured Creditors (the Committee) commenced an adversary proceeding against the New Lenders and the Transeastern Lenders alleging that the transfer of liens to the New Lenders and the transfer of funds to the Transeastern Lenders were fraudulent transfers which should be avoided.
The bankruptcy court, in a 180-page opinion, agreed with the Committee that both the New Lenders and the Transeastern Lenders had received fraudulent transfers. The bankruptcy court held that the guarantees and collateral from the Conveying Subsidiaries were not issued in exchange for "reasonably equivalent value" and therefore should be avoided as fraudulent transfers. The Transeastern Lenders and the New Lenders emphasized that the crucial source of alleged value for the Conveying Subsidiaries was the economic benefit of avoiding default and bankruptcy. They unsuccessfully alleged that the opportunity to continue as a potentially profitable enterprise was reasonably equivalent in value to the Conveying Subsidiaries’ obligations incurred in the financing. Other benefits cited included a higher debt ceiling on the revolving loan, new tax benefits, the elimination of adverse business effects from the Transeastern litigation and the opportunity to retain access to various centralized services provided by TOUSA such as cash management, purchasing and payroll administration.
The bankruptcy court did not find these benefits to be reasonably equal in value to the obligations incurred. Applying a narrow definition of value, the Conveying Subsidiaries did not receive any property and therefore did not receive reasonably equivalent value. The tax benefits, property and services cited by the lenders either already existed prior to the new financing or fell short in comparison to the obligations. Further, the court concluded that the bankruptcy filing was inevitable, and therefore no value was given for avoiding bankruptcy.
The Transeastern Lenders also argued that they were not liable as entities for whose benefit the transfer was made, because they were subsequent transferees of the loan proceeds from TOUSA, not entities that benefited immediately from the transfer. The bankruptcy court held that the fraudulent transfers were incurred "for the benefit of" the Transeastern Lenders and therefore ordered the Transeastern Lenders as "transferees" of the fraudulent transfer to disgorge $403 million of the loan proceeds. The court also awarded damages to the Conveying Subsidiaries, including damages to cover the transaction costs related to the financing transaction and the prosecution of the fraudulent transfer action.
The District Court reversed, criticizing the bankruptcy court for applying a narrow definition of "reasonably equivalent value" that was "inhibitory of contemporary financing practices" and also finding that the Transeastern Lenders were not susceptible to fraudulent transfer liability.
On May 15, 2012, the U.S. Court of Appeals for the 11th Circuit reversed the District Court and reinstated the bankruptcy court’s opinion in its entirety. Using the "clearly erroneous" standard, the 11th Circuit held that the bankruptcy court’s findings of fact were not "clearly erroneous" and should not be reversed. In determining "reasonably equivalent value," it held that the element of value proposed by the New Lenders was not enough in the aggregate to constitute reasonably equivalent value. It declined to adopt either court’s definition of value or to decide whether avoiding bankruptcy could confer value, since the findings of fact concluded that even if all the benefits were recognized, they were not enough to confer reasonably equivalent value. Finally, given that the Transeastern Lenders received the bulk of the new loan proceeds, the 11th Circuit found that the loans were made "for the benefit of" the Transeastern Lenders. The case was remanded back to the bankruptcy court for consideration of the remedies.
Although the TOUSA decision was based upon findings of fact which were not typical of a cash flow loan where use of proceeds are for corporate purposes, secured lenders must be cautious when dealing with financings guaranteed by other credit parties. The solvency of each borrower and guarantor subsidiary must be evaluated. The relative value of the direct and indirect benefits received by each must be compared to the obligations and liens incurred. The 11th Circuit did not provide guidance on the amount of value to be attributed to indirect benefits. This decision may force distressed companies into Chapter 11 sooner where refinancing or distressed lending would be approved by a court. This chilling effect on out–of-court workouts will increase the cost of restructuring as chapter 11 professional and reporting fees will have to be taken into consideration. In addition, lenders receiving a "payoff" from an affiliate guarantor have to be wary of its finality. Any creditor receiving a substantial payment from a distressed entity should perform diligence and conduct a fraudulent conveyance analysis in order to reserve accordingly.
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