In a recent decision, Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA, Inc.), 2012 US App. LEXIS 9796 (11th Cir. May 15, 2012), the 11th Circuit Court of Appeals overturned a district court decision which had forcefully quashed a bankruptcy court decision to avoid, as a fraudulent transfer, a $400 million settlement and loan repayment by a parent company to a group of lenders (the “Transeastern lenders”). The TOUSA parent’s settlement and loan repayment was funded with the proceeds of new loans which were secured by guarantees and liens granted by subsidiaries who were not liable for the original loan. The 11th Circuit held that, under the applicable standard of review, the bankruptcy court did not “clearly err” in finding that the subsidiaries did not receive reasonably equivalent value in exchange for the guarantees and collateral. The district court had found that the opportunity for the enterprise to avoid bankruptcy and continue as a going concern constituted reasonably equivalent value. The 11th Circuit deferred to the conclusion of the bankruptcy court that, based on the facts of the case as they existed at the time of the transaction, bankruptcy was inevitable and that the costs of the transaction to the subsidiaries outweighed the benefits by a significant margin. To support its conclusion, the court referred to numerous internal TOUSA emails and communications from around the time of the transaction, as evidence that the transaction was likely to increase the risk of bankruptcy for the enterprise in a failing real estate market and that senior management knew or should have known this. The 11th Circuit did not address the question of whether intangible benefits, such as the opportunity to avoid bankruptcy, could ever constitute reasonably equivalent value.

Importantly, the 11th Circuit also held that the Transeastern lenders were the entities “for whose benefit” the guarantees and collateral were transferred to the new lenders—and were therefore “initial transferees” for purposes of Section 550(a)(1) of the Bankruptcy Code (i.e., the avoidance recovery provision). Subsequent transferees may raise a “good faith” defense to avoidance recovery under Section 550(a), but initial transferees may not. The Transeastern lenders had apparently argued that they were subsequent transferees of the proceeds of the new loans, and that the new lenders were initial transferees of the subsidiary guarantees and liens. The 11th Circuit rejected this argument, concluding that TOUSA never had control over the proceeds of the new loans because the loan documents for the new loans required that the proceeds be used to pay the Transeastern lenders. The 11th Circuit cited to its 1988 decision in In re Air Conditioning, Inc. of Stuart as controlling precedent. In Air Conditioning, the court imposed preference liability on an undersecured creditor for liens granted by the debtor to secure a letter of credit issued in favor of the creditor during the preference period. The court found that the creditor was the entity “for whose benefit” the liens were granted to the letter of credit issuer. The 11th Circuit found the TOUSA settlement and loan repayment transaction to be factually analogous. The Transeastern lenders also raised the policy argument that this reading of Section 550(a) would impose an extraordinary due diligence obligation on creditors receiving payments. The 11th Circuit rejected this argument as unsubstantiated, while also stating that “every creditor must exercise some diligence when receiving payment from a struggling debtor”.

At first blush, this aspect of the holding appears to expand significantly the universe of potential fraudulent transfer defendants and to impose an unreasonable due diligence obligation on lenders and other creditors who receive payments. However, while this result is troubling for these reasons, it is not technically inconsistent with Air Conditioning—though the 11th Circuit certainly could have declined to extend Air Conditioning. Although lenders and other creditors who receive payments need to be cognizant of the risks raised by the TOUSA holding, the true impact of the holding will not be fully understood until the lower courts resolve the ultimate remedies to be applied to the Transeastern lenders and the new lenders. Section 550 allows only a single recovery for a fraudulent transfer. Among other remedies, the bankruptcy court avoided the guarantees and liens granted by the subsidiaries to the new lenders, and ordered the Transeastern lenders to disgorge most of the settlement and loan repayment. The Transeastern lenders argued that this constitutes a double recovery. The 11th Circuit remanded the remedies questions to the district court.

The 11th Circuit decision was issued by a panel of three 11th Circuit judges, as is common. Following the decision, the Transeastern lenders have requested a rehearing en banc before all judges of the 11th Circuit.