The United States Court of Appeals for the Eleventh Circuit (the “Eleventh Circuit”) has reinstated the controversial 2009 decision of the United States Bankruptcy Court for the Southern District of Florida (the “Bankruptcy Court”) that required a group of lenders to disgorge $421 million as fraudulent conveyances under sections 548 and 550 of the Bankruptcy Code. In a prior client alert, we informed you of the 2011 decision of the United States District Court for the Southern District of Florida (the “District Court”) which had reversed the Bankruptcy Court’s decision.
The Eleventh Circuit agreed with the Bankruptcy Court’s assessments that (i) operating subsidiaries that had guaranteed the obligations of their parent, TOUSA, Inc. (the “Conveying Subsidiaries”), did not receive reasonably equivalent value in exchange for the liens granted to secure those guarantees and (ii) lenders that were paid with proceeds of loans secured by such liens were entities “for whose benefit” those transfers were made. The Eleventh Circuit remanded to the District Court for further proceedings on the issue of remedies.
In 2005, TOUSA, Inc. (“TOUSA”) entered into a joint venture and in connection therewith incurred unsecured debt from a syndicate of lenders (the “Transeastern Lenders”). None of the Conveying Subsidiaries were involved in the joint venture and the joint venture debt was not guaranteed by any of them. Ultimately, the joint venture defaulted on the debt and on July 31, 2007, TOUSA entered into a settlement (the “Settlement”) with respect to the joint venture debt, pursuant to which TOUSA was be required to pay more than $421 million to the Transeastern Lenders. To finance the settlement, TOUSA entered into two new term loan facilities with a new lender group (the “New Lenders”): a $200 million first lien facility and a $300 million second lien facility (collectively, the “Settlement Financing”), both of which were secured by first and second liens, respectively, on the assets of both TOUSA and the previously uninvolved Conveying Subsidiaries.
After TOUSA’s bankruptcy filing, the Official Committee of Unsecured Creditors (the “Committee”) in the bankruptcy proceedings sought to avoid the obligations to and liens granted in favor of the New Lenders in connection with the Settlement Financing and to recover the $421 million paid to the Transeastern Lenders as fraudulent transfers under the Bankruptcy Code. The Bankruptcy Court agreed with the Committee, granting avoidance of both the liens granted to the New Lenders and recovery of the payments made to the Transeastern Lenders in connection with the Settlement. The District Court reversed on appeal, but the Eleventh Circuit, after looking closely at all the evidence that was presented to the Bankruptcy Court, reversed the District Court and reinstated the Bankruptcy Court decision.
THE OPPORTUNITY TO AVOID BANKRUPTCY DOES NOT CONSTITUTE REASONABLY EQUIVALENT VALUE
The Transeastern Lenders argued that the Settlement Financing “allowed the Conveying Subsidiaries to escape the ‘existential threat’ of the likely bankruptcy” that would have ensued had the Settlement not been consummated. The Eleventh Circuit held that the opportunity to avoid bankruptcy “does not free a company to pay any price or bear any burden” and that the Bankruptcy Court had properly considered the evidence before it in determining that the transaction merely delayed the inevitable and that there was no chance of a positive return. Accordingly, the Conveying Subsidiaries did not receive reasonably equivalent value in granting the liens.
LIENS WERE TRANSFERRED FOR THE BENEFIT OF THE TRANSEASTERN LENDERS
The Transeastern Lenders next argued that they were not entities “for whose benefit” the Conveying Subsidiaries had granted the liens and accordingly they could not be liable under Bankruptcy Code section 550, which permits recovery from parties for whose benefit fraudulent transfers are made. Finding that the “Conveying Subsidiaries transferred liens to the New Lenders, who transferred funds to the Transeastern Lenders”, the Eleventh Circuit determined that the Transeastern Lenders were in fact entities for whose benefit the transfers were made.
Finally, the Eleventh Circuit flatly rejected arguments that the decision would impose extraordinary diligence obligations on the part of creditors accepting repayment from parties other than their debtor, stating that “[i]t 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 full effect of this decision is yet uncertain. Lenders have long been aware of the dangers of “upstream” guarantees in the bankruptcy context, and in response savings clauses have become standard practice, along with solvency representations made by borrowers and guarantors alike at the time of the initial guarantee. The decision of the Bankruptcy Court called into question the efficacy of these traditional safeguards, although, the Eleventh Circuit did not specifically address the issue. For existing transactions, there is likely little more that a creditor can do, as most documents do not place restrictions on sources for payment. Additional practical protective measures that may be taken by lenders in the wake of this decision have been elusive but may include a requirement that payments made after a predetermined period of credit deterioration be permitted only if accompanied by a solvency opinion or certificate with respect to any paying entity. Accordingly, creditors should continue to include traditional safeguard provisions while understanding that the relative strength of savings clauses remains unresolved in many U.S. Courts.