On May 15, 2012, the U.S. Court of Appeals for the Eleventh Circuit issued a significant opinion regarding fraudulent transfer claims. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA), 680 F.3d 1298 (11th Cir., 2012). The TOUSA opinion is particularly important to the distressed investing and lending communities, especially those who provide “rescue funding” to financially troubled companies in an effort to avoid bankruptcy.
In particular, the Eleventh Circuit held that subsidiaries of a borrower did not receive reasonably equivalent value in exchange for liens that the subsidiaries granted to lenders to secure in excess of $400 million in debt. The funds that were lent to the borrower were used to repay pre-existing debt owed to another lending group. Therefore, the liens could be avoided as a fraudulent transfer under §548(a)(1) of the Bankruptcy Code.
In addition, and perhaps more importantly, the court determined that the lenders who received the proceeds of the new loan were entities “for whose benefit” the liens were transferred within the meaning of §550(a)(1) of the bankruptcy code and were not, as they claimed, subsequent transferees of the loan proceeds. Consequently, the court concluded that the lenders who received the proceeds of the new loan could be liable to disgorge the funds they received.
TOUSA was a large, Florida-based homebuilder. TOUSA’s subsidiaries owned most of the assets and generated virtually all of the revenue of the consolidated enterprise. In June 2005, TOUSA entered into a joint venture with Falcone/Ritchie to purchase the assets of Transeastern Properties. The joint venture was funded by the “Transeastern Lenders.” As the housing market collapsed, the joint venture failed and TOUSA defaulted on its obligations to the Transeastern Lenders.
After litigation commenced, TOUSA and the Transeastern Lenders agreed to a $421 million settlement. To finance the settlement, TOUSA obtained two new loan facilities from Citicorp North America. As part of the new loan facilities, TOUSA caused its subsidiaries to grant liens on their previously unencumbered assets to secure the new loans even though the subsidiaries were not obligors or guarantors of the outstanding debt. While the new loan facilities explicitly required the new funds to be used to pay the settlement, the funds were first transferred to a wholly owned subsidiary of TOUSA, and were then paid to the Transeastern Lenders.
Six months after the financing transaction closed, TOUSA and the subsidiaries filed for bankruptcy protection in the Southern District of Florida. The Official Committee of Unsecured Creditors filed an adversary proceeding seeking to avoid the liens as fraudulent conveyances under §548(a)(1)(B) and to recover, under §550(a)(1), the amount of the loan proceeds from the Transeastern Lenders, as the entities “for whose benefit” the transfer was made. The committee argued that the transaction was a fraudulent transfer because the subsidiaries were insolvent when the transaction occurred and did not receive reasonably equivalent value in exchange for the issuance of the guaranties and the liens.
The Transeastern Lenders argued that the transaction should not be voided because the subsidiaries did receive reasonably equivalent value in the form of various intangible benefits, primarily the benefit of avoiding immediate default and bankruptcy. In essence, the lenders argued that in exchange for the liens, the subsidiaries were afforded the opportunity to avert bankruptcy and that opportunity constituted reasonably equivalent value.
Alternatively, the Transeastern Lenders argued that even if granting the liens did not constitute reasonably equivalent value, they could not be liable to disgorge the loan proceeds as entities for whose benefit the transfer was made because they were subsequent transferees of the loan proceeds from TOUSA, not entities that benefited immediately from the transfer under §550(a)(1).
Lower Court Decisions
The Bankruptcy Court, in Official Committee of Unsecured Creditors of TOUSA v. Citicorp, 422 B.R. 783 (Bankr. S.D. Fla. 2009), held that the transaction was a fraudulent transfer because the subsidiaries did not receive reasonably equivalent value for the lien transfers. The court applied a narrow definition of “value” and held “the Conveying Subsidiaries could not receive ‘property’ unless they obtained some kind of enforceable entitlement to some tangible or intangible article.” The court also found that even if it recognized the intangible benefits alleged by the Transeastern Lenders as legally cognizable, their value would still fall short of “reasonably equivalent value.”
Significantly, based on evidence submitted during the trial, the Bankruptcy Court concluded that the benefit of avoiding bankruptcy could not constitute significant value because the filing was “inevitable” and that entering into the transaction was more harmful than an immediate bankruptcy. The court also held that the Transeastern Lenders were “entities for whose benefit” the liens were transferred under §550(a)(1) and could be subject to recovery actions. Therefore, the court held that the Transeastern Lenders must disgorge $403 million plus prejudgment interest.
On appeal, the District Court, in 3V Capital Master Fund v. Official Comm. of Unsecured Creditors of TOUSA, 444 B.R. 613, 680 (S.D. Fla. 2011), reversed the Bankruptcy Court, holding that the Bankruptcy Court defined “value” too narrowly. The District Court found that indirect benefits received by the subsidiaries, including the ability to avoid bankruptcy, continue as a going concern and make payments to creditors constituted reasonably equivalent value. Moreover, the District Court held that those indirect benefits did not need to be quantified to establish reasonably equivalent value.
Furthermore, the District Court held that the Transeastern Lenders could not, as a matter of law, be liable as “entities for whose benefit” the transfers were made, because they were subsequent transferees of the proceeds of the new loans and not immediate beneficiaries of the transfer of the liens. Subsequent transferees are not covered by §550(a)(1).
Eleventh Circuit Decision
The Eleventh Circuit reversed the District Court. In its decision, the Eleventh Circuit sidestepped the legal issue of whether the possible avoidance of bankruptcy can confer “value” for purposes of the reasonably equivalent value test of §548 of the Bankruptcy Code. Rather, the court canvassed the record presented at trial and concluded that the Bankruptcy Court had ample grounds to conclude that even if it recognized all the intangible benefits asserted by the lenders, the TOUSA subsidiaries did not receive reasonably equivalent value in exchange for granting the liens. The Eleventh Circuit made clear that “not every transfer that decreases the odds of bankruptcy for a corporation can be justified” and cautioned that “the opportunity to avoid bankruptcy does not free a company to pay any price or bear any burden.”
Turning to the second issue, the Eleventh Circuit found that because they received the proceeds of the loans that were secured by the avoided liens, the Transeastern Lenders were entities “for whose benefit the transfers were made” (as opposed to secondary transferees) and, therefore, were liable under §550 (a)(1). The Eleventh Circuit rejected the argument that the Transeastern Lenders were subsequent transferees of the loan proceeds because the funds they received were first transferred to a wholly owned subsidiary of TOUSA before being transferred to the lenders.
The court noted that “[a]lthough the funds technically passed through a TOUSA subsidiary, this formality did not make the Transeastern Lenders subsequent transferees of the funds because TOUSA never had control over the funds.” The court was also unsympathetic to the argument that its broad reading of §550(a)(1) could result in expanding the potential pool of entities that could be liable for a fraudulent conveyance. The court tersely dismissed this concern by noting that “every creditor must exercise some diligence when receiving payment from a struggling debtor.”
The TOUSA decision is another cautionary warning to creditors and lenders that there are significant risks associated with extending credit and obtaining liens to secure debt issued to a struggling business and its subsidiaries. Although the basic theories underlying the TOUSA decision are not novel, the decision underscores the need to conduct extensive financial and legal due diligence regarding the financial condition of the enterprise as a whole and the likely impact that the proposed financial restructuring will have on the business. Lenders facing situations similar to those in TOUSA should assure themselves that a bankruptcy filing is not inevitable, notwithstanding the extension of new credit to stave off a bankruptcy in the hope that the borrower can successfully restructure its business.
Kenneth A. Rosen is a member of Lowenstein Sandler and chair of the firm’s bankruptcy, financial reorganization and creditors’ rights department. Paul Kizel is a member of the firm. Elie J. Worenklein, an associate at the firm, contributed to this article.