The United States Court of Appeals for the Eleventh Circuit issued its much anticipated decision in the TOUSA, Inc. bankruptcy cases on May 15, 2012.  The decision provides an ominous reminder to Lenders to carefully assess the value of accepting asset pledges or guarantees from borrowers’ subsidiaries, sometimes referred to as upstream guarantees.  TOUSA should also give creditors pause in accepting payments for existing obligations from the proceeds of transactions that may later be avoided as fraudulent transfers in violation of the bankruptcy code.

On July 31, 2007, TOUSA, Inc. reached an agreement to settle existing obligations to various lenders (“Previous Lenders”) with financing from new lenders (“New Lenders”).  The New Lenders secured the new loans with liens on the assets of TOUSA’s subsidiaries (“Conveying Subsidiaries”).  The loan agreement with the New Lenders required that the funds be used to pay the Previous Lenders.  Six months after this payment, however, TOUSA and its subsidiaries filed for bankruptcy.  The Committee of Unsecured Creditors of TOUSA filed proceedings against the New Lenders to avoid the liens as fraudulent transfers and against the Previous Lenders to recover the value of the loans.

In a stunning decision, the United States Bankruptcy Court for the Southern District of Florida, Fort Lauderdale Division, granted both requests.  The court ruled that the granting of the liens by the Conveying Subsidiaries to the New Lenders were fraudulent transfers under Section 548(a)(1) of the bankruptcy code, finding that the Conveying Subsidiaries did not receive value “reasonably equivalent” to the liens.  It therefore avoided the liens held by the New Lenders.  Because the loan agreements required the loans be used to pay the Previous Lenders, the court further held that the Previous Lenders were the entities “for whose benefit” the transfer was made, and ordered them to disgorge the loan proceeds to the bankruptcy estate under Section 550(a)(1) of the bankruptcy code.

Both groups of lenders appealed the decision to the United States District Court for the Southern District of Florida.  The court overturned the bankruptcy court’s decision and held that the intangible value the Conveying Subsidiaries received in the form of “opportunity to avoid bankruptcy, continue as going concerns, and make further payments to their creditors” was not disproportionate to the value of the liens held by the New Lenders.  It also ruled that because Previous Lenders were “subsequent transferees” and not “immediate beneficiaries” of the new loan agreements, the Previous Lenders could not have been the entities “for whose benefit” the transfer was made and did not have to return the proceeds.

The Eleventh Circuit reversed the district court and reinstated the bankruptcy court’s decision.  It noted that the bankruptcy court previously conducted a detailed factual analysis of the purported intangible benefits of the transaction and found that in total, the tangible and intangible benefits of the new loans did not confer a ‘reasonably equivalent value’ to the value of the liens held by the New Lenders.  Additionally and perhaps further alarming to creditors, although the court acknowledged that “immediate beneficiaries” are the “paradigmatic case” of “entities for whose benefit” a transfer was made, it held that “when a debtor transfers a lien to a lender who proceeds to transfer funds to the creditor,” the creditor can be liable.  The court therefore regarded the Previous Lenders’ status as a subsequent transferee to be merely a “formality” because the new loan agreements required the debtors (TOUSA and the Conveying Subsidiaries) to wire the funds to the Previous Lenders immediately upon receipt of the proceeds from the New Lenders. 

The TOUSA ruling provides at least two cautionary notes to lenders.  First, it shows that lenders must be especially diligent when relying on upstream pledges or guarantees.  They must ensure that subsidiary corporations are either solvent or are receiving value that is no doubt “reasonably equivalent” to the value of the loan, because bankruptcy courts have wide discretion to make those determinations.  Also, creditors should be wary when debtors satisfy their obligations with proceeds from new transactions.  If the new transaction is avoided in bankruptcy and found to be made for the benefit of the new creditor, the paid off creditor could be forced to disgorge proceeds.