The pendulum has swung again in the TOUSA, Inc. case, as the Eleventh Circuit recently overturned the decision of the United States District Court for the Southern District of Florida and affirmed the 2009 bankruptcy court opinion ordering the disgorgement of $403 million plus interest from lenders to the TOUSA parent, on the theory that such transfers were fraudulent as to certain TOUSA subsidiaries (the “Conveying Subsidiaries”).1 Quieted for a time by the district court ruling, the concerns for commercial lenders raised by the bankruptcy court ruling have returned, now supported by the precedential weight of a circuit court opinion. Following the Eleventh Circuit’s opinion, lenders should continue to review the solvency of each borrower and credit-support party in a proposed transaction, but focus more clearly on the benefits those entities receive relative to the debts incurred or collateral transferred. Similarly, creditors receiving large payments from debtors – especially financially troubled debtors – must likewise consider whether fraudulent transfer liability could result.
TOUSA’s Subsidiaries Grant Liens in Connection with Loans Used to Satisfy Debts of Parent
TOUSA, Inc. and its subsidiaries were homebuilders marketing homes under a variety of brand names. In June 2005, TOUSA entered into a joint venture to acquire certain properties owned by Transeastern Properties, Inc. in Florida. To fund this purchase, TOUSA and its joint venture subsidiary entered into a credit agreement (the “Transeastern Loan”) for third party funding with certain lenders (the “Transeastern Lenders”). The Conveying Subsidiaries were not involved in the loan – neither directly borrowing under the loan, guaranteeing the loan, nor pledging collateral in connection with the loan. With the turn in the housing market, the joint venture ran into hard times, and litigation ensued between TOUSA and the Transeastern Lenders.
TOUSA ultimately entered into a settlement agreement resolving this litigation (the “Transeastern Settlement”), agreeing to pay approximately $420 million to the Transeastern Lenders. To finance this payment, TOUSA and the Conveying Subsidiaries, as borrowers, entered into the First Lien Facility and the Second Lien Facility (collectively, the “New Loans”). Using the proceeds of the New Loans, TOUSA and the Conveying Subsidiaries (although not obligated under the initial Transeastern Loan) satisfied the Transeastern Settlement by paying approximately $420 million to the Transeastern Lenders in July 2007. The Conveying Subsidiaries pledged substantially all of their assets to secure repayment of the New Loans. The Conveying Subsidiaries did not retain any of the proceeds advanced under the New Loans.
The New Loans Cannot Prevent Bankruptcy, and Give Rise to Post-Petition Litigation
In January 2008, TOUSA and the Conveying Subsidiaries ultimately filed for bankruptcy protection, and the creditors’ committee commenced an adversary proceeding seeking to unwind the Conveying Subsidiaries’ obligations under the New Loans and to recover the amounts paid to the Transeastern Lenders. The committee alleged that the Conveying Subsidiaries did not receive reasonably equivalent value for the liens granted under the New Loans and the funds transferred to the Transeastern Lenders, as the Conveying Subsidiaries were never obligated under the initial Transeastern Loan that was satisfied from the proceeds of the New Loans. The committee also sought to recover from the Transeastern Lenders the value of the transfers made in connection with the New Loans, on the theory that the Transeastern Lenders were the direct transferees of the proceeds of the New Loans (paid in satisfaction of the settlement), and were also the “entities for whose benefit” the liens were transferred by the Conveying Subsidiaries.2
The Bankruptcy Court Rules Against the Lenders
In a 182-page opinion, the bankruptcy court ruled in the committee’s favor, finding that the New Loans could be avoided as a fraudulent transfer because the Conveying Subsidiaries – which the court found to be insolvent at the time of, or as a result of, the New Loans – did not receive reasonably equivalent value in exchange for the obligations incurred and liens granted under the New Loans. The bankruptcy court relied on a narrow definition of “value,” including “only ‘property’ and ‘satisfaction or securing of a present or antecedent debt of the debtor.’” As a result, the bankruptcy court rejected the defendants’ argument that the Conveying Subsidiaries received indirect value from the New Loans by potentially avoiding default and bankruptcy through satisfaction of the Transeastern Lenders’ claims, which – though not a direct obligation or guaranty of the Conveying Subsidiaries – could have triggered cross-default provisions in more than $1 billion of separate obligations that had been guaranteed by the Conveying Subsidiaries. In the alternative, the bankruptcy court found that any indirect value that the Conveying Subsidiaries may have received under this theory was still not “reasonably equivalent” when weighed against the scope of the more than $400 million transfers made in connection with the New Loans.
The bankruptcy court also found that the Transeastern Lenders were “entities for whose benefit” the transactions in connection with the New Loans were made, such that the estate could recover the amounts paid to the Transeastern Lenders. With prejudgment interest, this resulted in a total disgorgement of more than $480 million. The Transeastern Lenders argued that the transactions made in connection with the New Loans must be separated – into the granting of the liens, the loaning of the funds, and the subsequent transfer of the funds to the Transeastern Lenders. The bankruptcy court refused to separate the transfer as suggested by the Transeastern Lenders, however, finding that the New Loans as a whole were taken for the express purpose of paying the Transeastern Lenders.
The District Court Quashes the Bankruptcy Court Opinion
The concerns raised by the bankruptcy court opinion were temporarily alleviated when the district court quashed the bankruptcy opinion in 2011.3 The district court held that the bankruptcy court applied an unnecessarily narrow view of “reasonably equivalent value.” The district court stated that “indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise’s rehabilitation, and to avoid bankruptcy, even if it proved to be short lived, may be considered in determining reasonable equivalent value. …[T]he decisive inquiry can be simplified to whether, based on the totality of the circumstances at the time of the transfer, the result was to preserve the debtor’s net worth by conferring realizable commercial value on the debtor.” Based on this expanded definition, the district court found that the Conveying Subsidiaries had received reasonably equivalent value under the New Loans, including by avoiding the risk of default and bankruptcy.
The district court also sided with the Transeastern Lenders regarding whether they were the “entities for whose benefit” the liens were initially transferred.4 The district court separated the transactions made in connection with the New Loans into three distinct transfers: (i) the granting of loans and creation of indebtedness by the Conveying Subsidiaries and TOUSA under the New Loans, (ii) the transfer of funds to TOUSA in exchange, and (iii) the subsequent transfer by TOUSA to the Transeastern Lenders of these funds, in satisfaction of the Transeastern Settlement. Unless these transactions were collapsed into a “single integrated transaction,” which the district court held to be improper, the Transeastern Lenders were not the beneficiaries of the lien transfer, and the payment to the Transeastern Lenders by TOUSA was not a transfer by the Conveying Subsidiaries.
The Eleventh Circuit Sides with the Bankruptcy Court
The district court’s opinion was appealed to the Eleventh Circuit, which ultimately affirmed the ruling of the bankruptcy court. The Eleventh Circuit declined to decide whether the bankruptcy court’s definition of “value” was too narrow or the district court’s definition too broad. Instead, the circuit court determined that no matter the definition of “value,” the bankruptcy court was entitled to wide latitude in making factual findings. According to the bankruptcy court’s specific factual findings, which were not clearly erroneous, even if Alan Greenspan and Warren Buffett could not foresee the general economic downturn in August 2007, TOUSA’s employees and professionals recognized that the relevant TOUSA housing markets began their freefall prior to the July 2007 transaction, making a bankruptcy filing inevitable (a “slow-moving category 5 hurricane [rather] than an unforeseen tsunami”). As a result, the Eleventh Circuit found no clear error in the bankruptcy court’s alternative holding that the benefits received by the Conveying Subsidiaries – even including the indirect value of a potential financial lifeline – were not “reasonably equivalent” to the obligations incurred and assets transferred under the New Loans. In other words, bankruptcy was inevitable, and postponing the inevitable for a short period of time did not constitute reasonably equivalent value to the Conveying Subsidiaries.
The Eleventh Circuit also affirmed the bankruptcy court’s holding regarding the integrated nature of the transactions underlying the New Loans, relying heavily on the fact that the loan documents expressly required that the proceeds be used to satisfy the Transeastern Settlement. As such, the Transeastern Lenders were the “entities for whose benefit” the entire transaction had been made.
The Eleventh Circuit looked at the entirety of the transaction and noted that through the transaction, certain of the lenders “essentially converted their unsecured loans to the Transeastern Joint Venture into secured loans to TOUSA and the Conveying Subsidiaries.”
Following the Eleventh Circuit’s Opinion, Lenders Must Be Even More Cautious
The Eleventh Circuit’s opinion resurrects many of the same concerns that the bankruptcy court opinion posed for lenders and creditors. Lenders in transactions involving subsidiaries should consider the value received by, and the solvency of, each entity individually, rather than the value received by the corporate group as a whole, as the TOUSA opinions indicate that courts may reject attempts to show indirect benefit to the subsidiary resulting from value provided to the parent. On the other hand, the Eleventh Circuit did not adopt the strict definition of value proposed by the bankruptcy court, leaving open the potential that legitimate, indirect benefits can constitute value for purposes of a fraudulent-transfer analysis.
Additionally, creditors such as the Transeastern Lenders who receive large payments from financially troubled debtors should carefully consider the implications of such payments, especially where subsidiaries are involved. The Eleventh Circuit’s opinion demonstrates the level of diligence it expects in such situations: “[E]very creditor must exercise some diligence when receiving payment from a struggling debtor. It is far from a drastic obligation to expect some diligence from a creditor when it is being repaid hundreds of millions of dollars by someone other than its debtor.”
The Eleventh Circuit, like the district court, did not address the validity of fraudulent transfer “savings clauses,” which are commonly included in large loan transactions and which had been challenged by the bankruptcy court. The enforceability of these clauses therefore remains an open issue.