A recent decision from the United States District Court for the Southern District of Florida (the "Court") [1] reversed a controversial 2009 decision from the Bankruptcy Court in the litigation styled Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc. [2] The Bankruptcy Court decision avoided as fraudulent transfers the liens and underlying debt obligations incurred by certain TOUSA subsidiaries (the "Conveying Subsidiaries") in connection with $500 million of secured loans from a syndicate of lenders (the "New Lenders") made six months prior to the bankruptcy filing of TOUSA and its subsidiaries. [3] The proceeds of the loan from the New Lenders (the "New Loan Proceeds") were used to settle litigation with a group of TOUSA's existing lenders (the "Existing Lenders"). The Bankruptcy Court avoided the guaranties and liens provided by the Conveying Subsidiaries to the New Lenders, ordered that the Existing Lenders repay to the TOUSA estate over $400 million received in settlement of their litigation with TOUSA and ordered the disgorgement of principal, interest and fees paid to the New Lenders.

On appeal, the District Court reversed the Bankruptcy Court's order that the Existing Lenders repay the amount received from the New Loan Proceeds. The District Court's decision only relates to the liability of the Existing Lenders. The New Lenders appealed separately the Bankruptcy Court's order avoiding the guaranties and liens given by the Conveying Subsidiaries to the New Lenders and ordering the disgorgement of principal, interest and fees paid to the New Lenders. Lenders and the bankruptcy bar are awaiting the outcome of the New Lenders' pending appeal to understand the full extent of the burdens and risks (discussed herein) created by the Bankruptcy Court's opinion.

Due Diligence Standard

One of the most important aspects of the District Court's decision for commercial lenders is the rejection of the Bankruptcy Court's conclusion that the Existing Lenders acted in bad faith and were grossly negligent in accepting repayment from TOUSA of their undisputed indebtedness. Describing the due diligence standard established by the Bankruptcy Court as "patently unreasonable and unworkable," [4] the District Court reasoned that "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." [5] The District Court held that holders of valid existing debts should not be held to such an investigatory duty.

Co-Borrowers Do Not Have a Right to Recover Funds

The District Court also rejected the Bankruptcy Court's holding that the Conveying Subsidiaries had a property interest in the New Loan Proceeds and could recover the property from the Existing Lenders. The District Court applied a control test and found that since the Conveying Subsidiaries lacked the ability to control the use of the New Loan Proceeds, which were within the control of TOUSA alone, the New Loan Proceeds were not property of the Conveying Subsidiaries. The District Court held that the status of the Conveying Subsidiaries as co-borrowers alone was insufficient to trigger a direct transfer. The District Court's ruling appears to put to rest the idea that any co-borrower could demand turnover of loan proceeds that were used by another borrower.

Recognition of Indirect Benefits as Reasonably Equivalent Value

The District Court also considered whether the Conveying Subsidiaries received reasonably equivalent value for the granting of liens to the New Lenders. The District Court rejected as too narrow the Bankruptcy Court's holding that reasonably equivalent value requires tangible property to be received in exchange for any transfer. The District Court affirmed the position taken by courts throughout the country that "indirect benefits" are an important element of the reasonably equivalent value calculus. The District Court reasoned that "[a]n 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." [6] Importantly, the District Court held that such value must be measured as of the time of the transfer and not with the benefit of hindsight. Based on the foregoing, the District Court found that the settlement with the Existing Lenders conferred reasonably equivalent value on the Conveying Subsidiaries by enabling the enterprise to avoid defaulting on over $1 billion in bond debt and revolving loan payments. As a result, the enterprise was able to make over $65 million in revolver payments after the settlement, which in turn enabled the enterprise to continue operating as a going concern until the real estate industry subsequently collapsed in a manner unforeseen at the time of the settlement.

Unresolved Issues

It is important to note that the following controversial holdings of the Bankruptcy Court have not been overruled and remain precedent [7] pending the New Lenders' appeal:

  1. The enforceability of routine "savings clauses," which provide that the obligations and liens are deemed to be reduced to the extent necessary to prevent the insolvency of each obligor.
  2. The validity of a solvency analysis that compares the sum of the market value of all outstanding debt and equity securities to the face amount of liabilities.
  3. The validity of the "identity of interest" doctrine that treats closely related subsidiaries, under certain circumstances, as consolidated entities for the purposes of evaluating reasonably equivalent value.
  4. The validity of a contemporaneously issued solvency opinion from a restructuring advisory firm on the issue of the solvency of the enterprise.

 Until these issues are decided, commercial lenders should continue to take a closer look at the financial condition of any subsidiary guarantor. Taking such preventative steps as identifying the solvency of each subsidiary and limiting the guaranty to an amount that does not render the subsidiary insolvent may prove invaluable in the event of a bankruptcy. Likewise, it may behoove commercial lenders to examine existing facilities that feature subsidiary guarantees to determine whether such facilities might benefit from a modification of guaranty liability of subsidiary guarantees to prevent a fraudulent conveyance finding. Lastly, commercial lenders should analyze each subsidiary's solvency to determine whether that subsidiary's guaranty may later be characterized as fraudulent due to the insolvency of the subsidiary rather than analyzing the corporate family as a whole.