In a thorough appellate decision, a United States District Court in Florida has reversed the portion of a Bankruptcy Court’s determination that the repayment of over $400 million in loans was a fraudulent transfer. As discussed in more detail below, the decision is significant in the context of complex, multiple entity structures in determining (i) which affiliated entity (or unpaid creditors of that entity) can recover a transfer and (ii) what constitutes reasonably equivalent value for the transfer. This decision is instructive for both evaluating future risks on existing loans related to financially troubled entities as well as structuring new loan transactions and litigation settlements.
Factual Background and Bankruptcy Court Trial
In 2005, a wholly owned subsidiary of TOUSA and Falcone/Ritchie LLC formed a joint venture to acquire the home-building assets of Transeastern, a leading developer in Florida. By mid to late 2006, there were defaults on the credit agreements related to the joint venture and certain land option agreements. Various state court litigation ensued which resulted in litigation settlements in mid-2007. As part of the settlement TOUSA became the sole owner of the joint venture. A closing occurred on July 31, 2007 in which over $400 million of new loans were used to fund the settlements which include repayment of some existing loans related to the joint venture. The new loans, unlike the pre-settlement Transeastern loans, named TOUSA subsidiaries as "Subsidiary Borrowers" and required them to pledge their assets as security. The TOUSA board and the officers and directors of all the Subsidiary Borrowers executed formal resolutions approving the obligations under the new loans as being in the best interest and for the benefit of each of the entities. The new loans provided TOUSA with $476,418,784 to settle the Transeastern debts; $426,383,828 of that amount went to the Transeastern lenders to pay off their loans.
The Florida housing market deteriorated further thereafter and on January 29, 2008, TOUSA and most of its subsidiaries filed Chapter 11 cases. An unsecured creditors committee was formed and in July, 2008 consisting of the indenture trustees for six major issuances of over $1 billion of bond debt, bondholders and trade creditors. The Committee brought an adversary proceeding on behalf of certain "conveying" TOUSA subsidiaries to avoid the July 31, 2007 related transactions as fraudulent transfers under Sections 544 and 548 of the Bankruptcy Code. The Committee contended, among other things, that the conveying subsidiaries did not receive reasonably equivalent value for the new loans to finance the Transeastern settlement because they were not defendants. Because the transfers occurred more than 90 days before the Chapter 11 filings, the transfers were outside the non-insider preference window for Section 547 of the Bankruptcy Code. A bench trial on the adversary proceeding was held in the Bankruptcy Court in July, 2009. Expert testimony played a key role in the trial.
In October 2009, the Bankruptcy Court issued an opinion in favor of the Committee as plaintiff. In particular, the Bankruptcy Court found that the conveying subsidiaries did not receive reasonably equivalent value for the pledging of their assets for the new loans, because the conveying subsidiaries received "no direct benefits" and the value those particular subsidiaries received "was minimal and did not come anywhere near the $403 million of obligations they incurred." (2/11/11 District Court Opinion, p. 37). The Bankruptcy Court also held that the Transeastern lenders were entities "for whose benefit" the new loans were incurred. Therefore, pursuant to section 550(a)(1) of the Bankruptcy Code, the Bankruptcy Court ordered the Transeastern lenders to disgorge $403 million and pay prejudgment interest on the full amount of that disgorgement.
The Appeal and Appellate Ruling
An appeal to the District Court followed. The lenders sought a stay pending appeal and had to post large bonds or cash to obtain that stay.
On February 11, 2011, the District Court issued a stern decision reversing parts of the Bankruptcy Court’s opinion as it relates to the Transeastern lenders. Other appeals related to other aspects of the transaction and trial are still pending. Because the Bankruptcy Court adopted the Committee’s factual finding verbatim, the District Court relaxed the standard for review of those findings, and determined that remand was unnecessary.
In its opinion, the District Court focused its analysis on:
(1) whether the Transeastern lenders can be compelled to disgorge to the conveying subsidiaries funds paid by TOUSA to satisfy a legitimate, uncontested debt, where the conveying subsidiaries did not control the transferred funds, and
(2) whether the Transeastern lenders are liable for disgorgement as the entities "for whose benefit" the conveying subsidiaries transferred the liens to the new lenders, where the Transeastern lenders received no direct and immediate benefit from the lien transfer.
(2/11/11 District Court Opinion, at p. 42).
The District Court found disgorgement and liability were not appropriate on either of these issues. .As to the direct transfer theory, the District Court noted that the new loan funds were paid directly by TOUSA to the Transeastern lenders and that the conveying subsidiaries in whose name the adversary proceeding was brought by the Committee never "received the proceeds of the New Loans, or had the power to distribute them, or designate who would receive the loan proceeds." Those subsidiaries did not exercise any actual control over the property transferred and could not use the loan proceeds for their own purposes. Accordingly, pursuant to Eleventh Circuit precedent, no interest in property of the subsidiaries was transferred and therefore, none could be recovered as a fraudulent transfer under the direct transfer theory of liability.
The District Court then examined the issue of "reasonably equivalent value" with respect to the subsidiaries as a condition precedent of determining whether there could be a recovery from the Transeastern lenders under the Committee’s second theory. If the subsidiaries received reasonably equivalent value, the transaction could not be avoided, and accordingly, there could be no recovery from the Transeastern lenders as parties for whose benefits the transfer was made. The District Court held that the Bankruptcy Court "erred as a matter of law and fact in refusing to recognize as reasonably value the indirect benefit to the subsidiaries from the entire transaction." Among other points, the District Court held that the Bankruptcy Court committed legal error in holding that the avoidance of default and bankruptcy by the subsidiaries was not as a matter of law cognizable "value" within the meaning of Section 548 of the Bankruptcy Code. The District Court rejected the limited dictionary definition of property adopted by the Bankruptcy Court to test whether the subsidiaries received reasonably equivalent value and following Second, Third and Seventh Circuit precedents, held that "value" includes direct and indirect, tangible and intangible benefits, stating:
Contrary to the Bankruptcy Court’s legal conclusion, 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 provided to be short lived, may considered in determining reasonably equivalent value. And expectation, such as in this case, that a settlement which would avoid default and produce a strong synergy for the enterprise, would suffice to confer "value" so long as that expectation was legitimate and reasonable.
(2/11/11 District Court Opinion, p. 73).
In addition, the District Court found that the Bankruptcy Court erred in failing to consider "the totality of the circumstances" in measuring reasonably equivalent value. The key inquiry for the Court was 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.
In the TOUSA case, the subsidiaries’ survival was tied to the outcome of the Transeastern litigation, although they were not parties, through their pre-existing guaranties under the TOUSA loans, which guarantees would have been triggered by a judgment in excess of $10 million against TOUSA. The District Court held that the elimination of this threat constituted an enormous economic benefit to the subsidiaries. In addition, Bankruptcy Court erroneously "patently ignored" evidence of economic financial dependence of the subsidiaries on the viability of the TOUSA enterprise as a whole. The District Court concluded that the subsidiaries received reasonably equivalent value.
The District Court also pointed out that the bondholders, who made up the Committee, were given notice in the prospectuses given to them with the bond offerings that TOUSA was a highly integrated and consolidated enterprise before investing in TOUSA and repayment of the bond debt was dependent generally on the integrated nature of the company and the cash flow of the subsidiaries in particular.
Finally, the District Court analyzed Bankruptcy Code Section 550’s provision that allows recovery from a third party "for whose benefit" the transfer was made. The paradigmatic example of such an entity is a guarantor whose liability is reduced when a transfer is made in satisfaction of the guaranteed obligation. The Court held that the provision was not applicable where the benefit is not the immediate and necessary consequence of the initial transfer, but rather flows from the use to which the transferee puts it.
The District Court chastised the Bankruptcy Court for its finding that the Transeastern lenders acted in bad faith in accepting repayment of their debt: "The net result of the Bankruptcy Court’s improper finding is to impose extraordinary duties of due diligence on the part of creditors accepting repayment -- duties that equal or exceed those imposed on lenders in extending credit in the first place." (2/11/11 District Court Opinion, p. 103).
Where multiple entities, some of which may be or may become insolvent, are involved, considerable thought needs to be given to the structuring and documentation of any loan or settlement transactions and the flow of funds, guarantees and collateral pledges to effectuate the same. While the District Court in TOUSA reversed the fraudulent transfer judgment as to the repaid joint venture lenders on these particular facts (which decision may still be appealed to the Eleventh Circuit Court of Appeal), the state law and Bankruptcy Code fraudulent transfer risks in these kinds of situations need to be carefully considered both for future loans and settlements and future disputes regarding existing loans.