It would be difficult for even a casual observer to miss the uproar caused by the 11th Circuit’s decision in TOUSA upholding a bankruptcy court decision that (i) liens granted by subsidiaries of TOUSA, Inc. to secure loans to TOUSA were avoidable as fraudulent conveyances, and (ii) the value of the liens could be recovered from a third party that received payment funded by the financing secured by the liens. What may be less clear to those watching from the sidelines is exactly what was going on and what this means for future transactions.
Although there are a myriad of convoluted facts, key points are:
- The old lenders, referred to as the “Transeastern Lenders,” made unsecured loans to TOUSA guaranteed by some of its subsidiaries to provide financing for a joint venture.
- Things did not go well. Eventually the Transeastern Lenders sued TOUSA, resulting in a settlement that required TOUSA to pay more than $421 million to the Transeastern Lenders.
- TOUSA obtained financing from the “New Lenders” to fund part of the settlement payments that was secured by first priority liens on the assets of some of its subsidiaries.
- Fast forward six months. TOUSA and its subsidiaries filed bankruptcy.
In the bankruptcies the unsecured creditors committee sought to avoid the liens granted by the subsidiaries to the New Lenders as a fraudulent conveyance, and to recover the value of the liens from the Transeastern Lenders.
In addition to proving actual intent, a fraudulent conveyance can be established by showing that (1) (i) a debtor was or became insolvent, (ii) was left with unreasonably small capital or (iii) was unable to pay its debts as they became due, and (2) did not receive “reasonably equivalent value.” The crux of the TOUSA fraudulent conveyance decision is whether the subsidiary debtors received reasonably equivalent value for granting liens to the New Lenders.
The bankruptcy court first noted that “value” is defined as “property” or satisfaction or securing of a present or antecedent debt, and then determined that the subsidiaries “could not receive ‘property’ unless they obtained some kind of enforceable entitlement to some tangible or intangible article.” None of the purported benefits met that test.
However, the bankruptcy court went on to issue findings in the alternative that, even under the broadest definition of value proposed by the Transeastern Lenders, the benefits were “well short” of reasonably equivalent value. Benefits proposed by the Transeastern Lenders included the opportunity to avoid bankruptcy, receiving control of certain property, tax benefits, avoiding the negative effects of continued litigation between Transeastern Lenders and TOUSA, TOUSA corporate services, and an enhanced revolving credit facility. The bankruptcy court was not persuaded that these benefits provided sufficient value.
The district court was the next stop. It quashed the bankruptcy court decision as it related to the Transeastern Lenders, holding that the bankruptcy court defined value too narrowly. The required value did not have to be tangible property or marketable financial value, and could include indirect economic benefits. It found that the transaction gave the subsidiaries an opportunity to avoid bankruptcy and continue as going concerns, which did not need to be quantified to establish reasonably equivalent value.
Now enters the Eleventh Circuit, reversing the district court. The court did not address the definition of value and whether the bankruptcy court’s narrow view or the district court’s broader view was the correct approach. Instead it relied on the bankruptcy court’s alternate finding that the almost certain costs of the transaction far outweighed any perceived benefits, determining that the bankruptcy court was not clearly erroneous in this finding. Unfortunately, this leaves the issue of what can constitute reasonably equivalent value totally up in the air.
Under Section 550 of the Bankruptcy Code when a transfer has been avoided, it can be recovered from an “entity for whose benefit the transfer was made.” A second important issue in TOUSA was whether the bankruptcy court properly found that the value of the liens granted to the New Lenders could be collected from the Transeastern Lenders as the “entity for whose benefit the transfer was made.” The Transeastern Lenders argued that the grant of the liens was made to the New Lenders, and the Transeastern Lenders were only subsequent transferees, not entities that benefitted from the initial transfer. However, the documentation required the subsidiaries to forward loan proceeds to the Transeastern Lenders for application to the settlement payments. Under these facts, the Eleventh Circuit agreed with the bankruptcy court that the value of the liens could be properly recovered from the Transeastern Lenders.
This state of affairs has caused substantial anxiety, both because there is now greater uncertainty about what can constitute reasonably equivalent value and because a lender (or anyone else, for that matter) receiving payments that are only indirectly involved in a fraudulent conveyance through the financing that funds the payments may be liable for a clawback.
Stay tuned for future developments. In the meantime, do not be surprised at the elaborate strategies people begin to dream up to reduce the risks of a clawback in the context of receiving a payoff of a loan or other payments from a financing that involves upstream guarantees or grants of security.