In a 113-page decision (click here to read decision) that is sure to be applauded by lenders and bond traders alike, Judge Alan S. Gold of the United States District Court for the Southern District of Florida, in overturning a Bankruptcy Court opinion that has caused lenders much concern, has issued a stern ruling that provides a bulwark against efforts by creditors and trustees in bankruptcy to expand the scope of the fraudulent conveyance provisions under the Bankruptcy Code. Judge Gold’s decision in 3V Capital Master Fund Ltd. v. Official Committee of Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 10-60017-CIV (S.D. Fla. Feb. 11, 2011) should be met with relief among lenders and other creditors of troubled companies, particularly companies with subsidiary borrowers and guarantors on cross-company debt obligations. Although the TOUSA decision does not necessarily break new ground, it restores balance to fraudulent conveyance jurisprudence by overturning Bankruptcy Court precedent that drew into question long-standing assumptions by lenders regarding the application of fraudulent conveyance statutes to common commercial transactions.
TOUSA, Inc. is a large homebuilder with operations in numerous states and numerous subsidiaries. As its business expanded, TOUSA issued various series of unsecured bonds totaling approximately $1.06 billion, all of which were guaranteed by various subsidiaries (the Subsidiaries). The bond documents were abundantly clear that, although the bonds were issued by TOUSA, the payments would be made from the consolidated assets of TOUSA and its subsidiaries. In addition, TOUSA had an $800 million revolving credit facility, under which numerous of the Subsidiaries were also borrowers and had pledged substantial assets to the revolving lenders. In addition to being borrowers, the assets of the various Subsidiaries were relied upon to determine the borrowing base under the revolving credit facility. The revolving credit facility was the sole source of operating financing for all of the TOUSA entities. Each of the bond indentures and the revolving credit facility documents had a provision giving rise to an event of default upon entry of a judgment in excess of $10 million against TOUSA.
In 2005, TOUSA, through a subsidiary, entered into a joint venture with another entity to acquire the home-building assets of Transeastern Properties, Inc, a leading developer in Florida. As part of that transaction, the joint venture borrowed approximately $675 million from various lenders (the Transeastern Lenders) that was guaranteed by TOUSA. The guarantee included not only the repayment of the outstanding debt, but also the completion of work on various Transeastern projects as well as the full repayment of the debt if the joint venture entity filed for bankruptcy protection. As a result of the housing industry downturn, the joint venture failed. In December of 2006, the Transeastern Lenders commenced litigation against TOUSA and the borrowers, seeking not only repayment of the outstanding loan amounts, but also damages on account of the performance aspect of the guarantee. TOUSA management estimated that the scope of these damages could exceed $2 billion. TOUSA’s exposure under the Transeastern guaranty thus had the potential to give rise to an event of default under the bond indenture and the revolving credit facility, thus triggering the guaranties and direct obligations of the various Subsidiaries.
In an effort to resolve the Transeastern issue, TOUSA entered into settlement agreements under which TOUSA became the sole owner of the joint venture and certain assets of the joint venture were sold (the proceeds from which entered TOUSA’s consolidated cash management system). This transaction resulted in an increase of TOUSA’s borrowing base under the revolving credit facility of approximately $150 million. TOUSA agreed to pay the Transeastern Lenders approximately $421 million to resolve their claims. In order to satisfy the claims of the Transeastern Lenders, TOUSA obtained $500 million (the New Loans) from new lenders which nonetheless included many of the Transeastern Lenders (the New Lenders), under which various Subsidiaries, who were also subsidiary borrowers under the revolving credit facility and guarantors of the bonds, were also borrowers. With the consent of the revolving facility lenders, the assets of these Subsidiaries were pledged as collateral for the loans provided by the New Lenders. The proceeds from the New Loans were then paid to satisfy the settlement amount owed to the Transeastern Lenders. Importantly, the funds from the New Lenders and those paid to the Transeastern Lenders never flowed through any of the Subsidiaries.
Notwithstanding the resolution of the Transeastern matter, TOUSA and the majority of its subsidiaries filed for bankruptcy in January of 2008. The official committee of unsecured creditors of TOUSA (the Committee) sued the Transeastern Lenders and the New Lenders on behalf of the Subsidiaries, arguing that the transactions described above constituted a fraudulent conveyance, avoidable under section 548 of the Bankruptcy Code. That section of the Bankruptcy Code allows the avoidance of “any transfer … of an interest of the debtor in property, or any obligation incurred by the debtor …, if the debtor voluntarily or involuntarily … received less than a reasonably equivalent value in exchange for such transfer or obligation” and was either insolvent at the time of the transfer, was engaged in a business for which the debtor had unreasonably small capital, or intended to incur, or believed that it would incur, debts beyond its ability to pay. 11 U.S.C. § 548(a)(1)(B). The Committee argued that the entire approximately $421 million could be recovered from the Transeastern Lenders as “the entity for whose benefit” the alleged fraudulent transfer had occurred under section 550(a)(1) of the Bankruptcy Code. 11 U.S.C. § 550(a)(1). Essentially, the Committee argued that because the Subsidiaries were not party to the original Transeastern loan transactions, they did not receive “reasonably equivalent value” for agreeing to be borrowers and pledging their assets to secure the New Loans which were used to satisfy TOUSA’s obligations to the Transeastern Lenders, that the Subsidiaries entry into the New Loans and pledge of their assets was a fraudulent transfer, and therefore that the entire $421 million paid to the Transeastern Lenders in settlement should be disgorged and returned to the Subsidiaries’ bankruptcy estates.
The Bankruptcy Court’s Opinion
In a long and detailed opinion, the Bankruptcy Court administering the TOUSA bankruptcy proceeding agreed. Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc. (In re TOUSA, Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009). The Bankruptcy Court found that the Subsidiaries did not receive reasonably equivalent value in exchange for pledging their assets to the New Lenders, that any value they did receive was far less than the loan obligations they assumed, that the Subsidiaries receive no direct benefits from the transaction and received minimal indirect benefits because, ultimately, the Subsidiaries were required to file for bankruptcy protection and could have found an alternative source of financing if TOUSA filed bankruptcy or could not borrow under the revolving credit facility. In reaching this decision, the Court took an extremely narrow, almost mathematical, view of “reasonably equivalent value.” The Bankruptcy Court found that the Transeastern Lenders were entities “for whose benefit the transfer was made” and ordered the disgorgement of $403 million in principal plus interest on the full amount disgorged.
District Court’s Reversal and Quashing of Bankruptcy Court Decision
In an unusually strident decision, Judge Gold quashed the Bankruptcy Court’s order relating to the Transeastern Lenders and declared the Bankruptcy Court’s imposition of remedies as null and void, rather than reversing and remanding the Bankruptcy Court’s decision. Although much of the Bankruptcy Court’s decision was factual — containing voluminous analysis regarding the testimony of various experts — Judge Gold found that the clearly erroneous standard for overturning those aspects of the Bankruptcy Court’s decision, generally a higher burden for appellants, could be relaxed because the Bankruptcy Court had adopted the findings of fact proposed by the Committee verbatim. Judge Gold then carefully and methodically picked apart the Bankruptcy Court decision.
(i) The Direct Fraudulent Transfer Theory
With regard to the Bankruptcy Court’s finding that the transfer of the loan proceeds to the Transeastern Lenders was a direct fraudulent transfer, Judge Gold noted that the funds in question were never in control of the Subsidiaries on behalf of which the Committee was suing. In order to be a fraudulent transfer, a transfer must involve property in which the debtor holds an interest. The Eleventh Circuit has adopted a “control” test to determine whether the debtor has an interest in property, requiring an analysis of the entire circumstances of the transaction regarding whether the debtor had both the power to designate who receives the funds and the power to actually disburse the funds. Nordberg v. Sanchez (In re Chase & Sanborn Corp.), 813 F.2d 1177 (11th Cir. 1987). Under the New Loan, the Subsidiaries had neither, as the loan proceeds were to be paid directly to the Transeastern Lenders. The Bankruptcy Court completely disregarded this test and, according to Judge Gold, clearly erred by doing so. Moreover, Judge Gold found that the evidence clearly showed that the Subsidiaries never had any control over the proceeds from the New Loan and, therefore, the transfer of the loan proceeds to the Transeastern Lenders was not avoidable as a “direct” transfer.
(ii) The Nature of the Subsidiaries’ Property Interest
The Bankruptcy Court also found that the Subsidiaries had a property interest in the New Loan proceeds, but that interest was minimal because they were “forced” to turn the proceeds over to the Transeastern Lenders. Judge Gold noted that, if there was a property interest in the loan proceeds, the use of the loan proceeds was irrelevant for determining the value received by the Subsidiaries. Moreover, the record established that the officers and directors of the Subsidiaries had determined that the settlement and the related transactions were in the best interests of the entire TOUSA enterprise, and therefore the Subsidiaries were not “forced” to do anything. Judge Gold also agreed with the Transeastern Lenders that, if the property interest of the Subsidiaries in the funds transferred to the Transeastern Lenders was minimal, then the “reasonably equivalent value” the Subsidiaries were required to receive in order to part with that property interest need only be “minimal,” rather than equivalent to the $403 million ultimately received by the Transeastern Lenders.
(iii) Determining Reasonably Equivalent Value
The heart of Judge Gold’s opinion, and the source of the greatest opprobrium regarding the Bankruptcy Court’s opinion, overturns the Bankruptcy Court’s refusal to recognize that the Subsidiaries received reasonably equivalent value as a result of the indirect benefits realized through the settlement between TOUSA and the Transeastern Lenders. First, Judge Gold found reversible error in the Bankruptcy Court’s imposition of the burden of establishing that the Subsidiaries received reasonably equivalent value upon the Transeastern Lenders, notwithstanding clear, controlling Eleventh Circuit precedent imposing the burden on the party challenging a transaction as a fraudulent transfer to establish a lack of reasonably equivalent value. Nordberg v. Arab Banking Corp. (In re Chase & Sanborn Corp.), 904 F.2d 588 (11th Cir. 1990).
The District Court also found that “the Bankruptcy Court committed legal error in holding that the ‘avoidance of default and bankruptcy by the … Subsidiaries’ is as a matter of law ‘not property and therefore is not cognizable as ‘value’ under section 548 of the Bankruptcy Code.” The Bankruptcy Code does not define “reasonably equivalent value” and defines “value” for purposes of fraudulent conveyance as “property, or satisfaction or securing of a present or antecedent debt of the debtor.” 11 U.S.C. § 548(d)(2)(A). Referring solely to Webster’s dictionary, the Bankruptcy Court concluded that “property” included only “some kind of enforceable entitlement to some tangible or intangible article.” Relying on long-standing and extensive precedent, as well as the legislative history of the Bankruptcy Code, Judge Gold pointed out that the Bankruptcy Court’s definition of “property” was inconsistent with the expansive notion of the term under the Bankruptcy Code as well as precedent finding that “indirect benefits may take many forms, both tangible and intangible.” Indeed, the Bankruptcy Court’s decision was contrary to controlling Eleventh Circuit precedent declaring that the Bankruptcy Code “does not authorize voiding a transfer which confers an economic benefit upon the debtor, either directly or indirectly.” General Electric Credit Corp. v. Murphy (In re Rodriguez), 895 F.2d 725, 727 (11th Cir. 1990).
According to Judge Gold, “the weight of authority supports the view that indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise’s rehabilitation, and to avoid bankruptcy, even if it prov[ed] to be short lived, may be considered in determining reasonably equivalent value.” Judge Gold cited precedent from the Second, Third and Seventh Circuits. “What is key in determining reasonable equivalency … is whether, in exchange for the transfer, the debtor received in return the continued opportunity to financially survive, where, without the transfer, its financial demise would [have] been all but certain. Where such indirect economic benefits are provided, ‘the debtors’ net worth has been preserved, and the interests of the creditors will not have been injured by the transfer.’” (quoting Kipperman v. Onex Corp., 411 B.R.805, 837 (N.D. Ga. 2009)).
Judge Gold also found that the Bankruptcy Court legally erred by not considering the “totality of the circumstances” in measuring reasonable equivalency, pointing to case law from across Florida, applying the Third Circuit’s decision in Mellon Bank, N.A. v. The Official Committee of Unsecured Creditors of R.M.L., Inc. (In re R.M.L., Inc.), 92 F.3d 139 (3d. Cir. 1996). Under this standard, courts generally consider whether the transaction was at arm’s length, whether the transferee acted in good faith, and the degree of difference between the fair market value of the assets transferred and the price paid. Paraphrasing the Eleventh Circuit in Rodriguez, “the 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. Otherwise stated, but for the transfer, was there a realistic risk that the … Subsidiaries and the enterprise would not financially continue to survive?” Here, because the Subsidiaries were contractually tied to TOUSA as borrowers on the revolving credit facility and guarantors of the bond debt, and an adverse judgment against TOUSA would have resulted in an event of default under both the revolving credit facility and the bonds triggering the Subsidiaries’ obligations with regard to both, the settlement was essential to the economic viability of the Subsidiaries. Moreover, the reprieve obtained by the entire TOUSA enterprise allowed it to continue making bond payments to the very bondholders comprising the Committee, as well as to pay an additional $65 million on the revolving credit facility and obtain $150 million in availability under the revolving credit facility.
The District Court opinion also criticized the Bankruptcy Court for imposing a per se rule that indirect benefits must be quantifiable and for reviewing the question of reasonably equivalent value retrospectively, that is, in light of the fact that TOUSA and the Subsidiaries ultimately did file bankruptcy, rather than based on facts known at the time of the transaction itself. In addition, Judge Gold found reversible error in the Bankruptcy Court’s conclusion that the Subsidiaries could have survived independent of TOUSA and could have obtained independent financing, particularly in light of the fact that the Bankruptcy Court found that the Subsidiaries were insolvent at the time of the transfers.
(iv) Defining Parties “for whose benefit” a Transfer Occurs
Because Judge Gold determined that there was not an avoidable transfer under section 548 of the Bankruptcy Code, he was not required to address the Bankruptcy Court’s conclusions regarding whether any transfer could be recovered under section 550 of the Bankruptcy Code from the Transeastern Lenders as the party “for whose benefit” such transfer had been made. However, anticipating an appeal to the Eleventh Circuit, Judge Gold thoroughly addressed this aspect of the Bankruptcy Court decision as well. Section 550(a) of the Bankruptcy Code allows for the recovery of fraudulent transfers from three types of recipients: the direct transferee, the entity “for whose benefit such transfer was made” and a subsequent transferee. The transfer at issue in TOUSA was the transfer of liens to the New Lenders from the Subsidiaries. Judge Gold pointedly found that the Transeastern Lenders could not have been direct or subsequent transferees of this transfer, because at all times the New Lenders retained those liens.
As to the theory that the Transeastern Lenders were the party “for whose benefit” the Subsidiaries transferred the liens to the New Lenders, Judge Gold noted that the Bankruptcy Code creates a link between direct recipients and parties “for whose benefit” direct recipients receive a transfer, and as a result, only an entity who receives a benefit from the initial transfer can be an entity “for whose benefit” the initial transfer was made. As a result, a party that is a subsequent transferee cannot ever be the party “for whose benefit” a transfer is made. Here, because the “benefit” conferred upon the Transeastern Lenders (the payment of their debt) was not the “immediate and necessary consequence” of the liens granted the New Lenders, but rather the result of the manner in which the proceeds from the New Lenders were used, the Transeastern Lenders were not the party “for whose benefit” the liens had been transferred, and could not be subject to disgorgement of the loan proceeds, even if a fraudulent conveyance had occurred.
(v) Rejection of Heightened Due Diligence Requirement Imposed on Lenders
One of the most troubling aspects of the Bankruptcy Court opinion was the suggestion that lenders needed to undertake due diligence before accepting payment. Section 550(b) of the Bankruptcy Code provides that transfers cannot be recovered from recipients who receive the transfer “for value, including satisfaction of ... a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer….” 11 U.S.C. § 550(b)(1). In language that should comfort lenders, Judge Gold rejected out of hand the Bankruptcy Court’s conclusion that it is “bad faith” for a creditor of someone other than the debtor to accept payment of a valid, tendered debt repayment, through settlement or otherwise, if the creditor does not first investigate the debtor’s internal re-financing structure to ensure that the debtor’s subsidiaries have received fair value as part of the repayment, or that the debtor and its subsidiaries, as an enterprise, were not insolvent or precariously close to insolvency. In other words, Judge Gold rejected the Bankruptcy Court’s imposition of “extraordinary duties of due diligence on the part of creditors accepting repayment.” Judge Gold viewed the Bankruptcy Court’s imposition of due diligence requirements on repayment recipients as expanding the liability created under section 550 of the Bankruptcy Code from a limited remedy of recovery to the imposition of civil damages for actual wrongdoing. Thus, “if the Bankruptcy Court’s ruling were to stand, it would pose an unfair burden on creditors to investigate all aspects of their debtors and the affiliates of those debtors before agreeing to accept payments for valid debts owed.”
Although the financial community may breathe a sigh of relief that Judge Gold has overturned parts of the TOUSA decision, there is still much to play out. The Bankruptcy Court’s finding that the Subsidiaries’ incurring debt to the New Lenders is a fraudulent conveyance is still on appeal before a different District Court judge. This appeal includes the finding that the so-called “savings clause” in the guaranties, which are widely used to avoid a finding of insolvency necessary to a constructive fraudulent conveyance, are unavailing.
The TOUSA decision is a fascinating decision, not least because Judge Gold found a Bankruptcy Court decision containing extraordinary analysis of expert testimony so legally and factually deficient that he chose to quash the entire decision of the Bankruptcy Court rather than to reverse and remand. While the decision does not necessarily add to the existing body of law regarding fraudulent conveyance law — indeed, it was the Bankruptcy Court’s failure to apply existing law that led Judge Gold to reject much of the Bankruptcy Court’s decision — the detailed analysis regarding complex aspects of fraudulent conveyance claims will provide a valuable source of clarity and certainty to lenders and their counsel. The decision reaffirms what lenders and their counsel have generally understood the law regarding transactions within complex corporations to be: indirect benefits realized by affiliates through transactions that bolster the corporate well-being of the entire enterprise constitute reasonably equivalent value and can be relied upon to deflect fraudulent conveyance claims. Notwithstanding, the TOUSA saga highlights that buyers and sellers of bonds and bank claims need to take care in their trade documents as to how they apportion the risk of disgorgement. Even if TOUSA is finally quashed in all respects, this important lesson remains.