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In re TOUSA: Eleventh Circuit Reinstates Bankruptcy Court’s Controversial Fraudulent Transfer Ruling
Practical Law Legal Update 8-519-4980 (Approx. 6 pages)
In re TOUSA: Eleventh Circuit Reinstates Bankruptcy Court’s Controversial Fraudulent Transfer Ruling
by PLC Finance and Practical Law Bankruptcy & Restructuring
| Published on 17 May 2012 • USA (National/Federal) |
In a blow to lenders, the Eleventh Circuit Court of Appeals reversed a district court ruling and affirmed the decision of a bankruptcy court in In re TOUSA that liens granted by TOUSA's subsidiaries to secure TOUSA's debt constituted fraudulent transfers under section 548 of the Bankruptcy Code. The Lenders' appeal to a prior ruling by the bankruptcy court that questioned the enforceability of saving clauses, which was stayed pending the Eleventh Circuit's decision, may now proceed.
On May 15, 2012, the US Court of Appeals for the Eleventh Circuit reversed the order of the US District Court for the Southern District of Florida (District Court), affirming the liability findings of the US Bankruptcy Court for the Southern District of Florida (Bankruptcy Court) in Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc. (In re TOUSA, Inc.). The case was remanded to the District Court for further proceedings concerning remedies, including avoidance of certain TOUSA subsidiaries' guaranties and related collateral grants, and recovery of the settlement plus prejudgment interest from the Transeastern Lenders.
Background
In June 2005, a TOUSA subsidiary entered into a joint venture (the Transeastern Joint Venture) which was partially funded by loans from the Transeastern Lenders. Due partly to losses resulting from a poor housing market, the Transeastern Joint Venture defaulted on its obligations under the Transeastern Joint Venture loans in September 2006. The Transeastern Lenders then sued TOUSA for repayment and damages under the associated loan agreements (the TL Litigation).
On July 31, 2007, TOUSA and certain subsidiaries (Conveying Subsidiaries) borrowed $500 million from certain first and second lien lenders (the Lenders) to finance a settlement with the Transeastern Lenders in connection with the TL Litigation. TOUSA agreed to use $420 million of proceeds from the loans to pay the settlement to the Transeastern Lenders and secured the loans with all of its assets, including those of the Conveying Subsidiaries. After their financial condition continued to worsen, TOUSA and its subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code on January 29, 2008.
In the bankruptcy proceedings, the Official Committee of Unsecured Creditors (Committee) filed an adversary proceeding claiming that the $420 million payment to the Transeastern Lenders constituted a fraudulent transfer under section 548 of the Bankruptcy Code because the Conveying Subsidiaries did not receive reasonably equivalent value for the significant obligations that they incurred. On October 13, 2009, the Bankruptcy Court issued its decision agreeing with the Committee that the transfer was fraudulent and ordered the Transeastern Lenders to pay back any principal, interest, costs, expenses and fees gained. This decision sent shock waves through the lending community and three lender groups appealed separately, including the Transeastern Lenders.
On February 11, 2011, the District Court issued an opinion in the Transeastern Lenders' appeal, quashing the Bankruptcy Court's decision as it related to the Transeastern Lenders on the basis that many of the Bankruptcy Court's findings and conclusions were "clearly erroneous." This opinion did not address the validity of savings clauses and solvency issues. Those issues may be decided in the Lenders' appeals, which are currently stayed in the District Court.
On March 8, 2011, the Committee appealed the District Court's decision in the Transeastern Lenders' case to the Eleventh Circuit. The District Court stayed the Lenders' appeal until resolution of the Committee's appeal to the Eleventh Circuit.
For a full discussion of the background of this case, see Practice Note, In Dispute: TOUSA.
For more information on the Bankruptcy Court's and the District Court's decisions, see Legal Updates, FL Bankruptcy Court Finds TOUSA Loans Fraudulent Transfers and TOUSA: Bankruptcy Court's Fraudulent Transfer Decision Quashed by District Court.
Eleventh Circuit Decision
On May 15, 2012, the Eleventh Circuit, in a blow to lenders, reversed the order of the District Court and affirmed the liability findings of the Bankruptcy Court against the Transeastern Lenders.
Indirect Benefits and Reasonably Equivalent Value
The Eleventh Circuit found that the Bankruptcy Court did not clearly err in its findings that the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for their liens, even considering all of the indirect benefits of the transaction. Therefore, it did not decide whether indirect benefits constitute value because reasonably equivalent value was not received in either case. The Eleventh Circuit cited numerous facts in the record to support the determination by the Bankruptcy Court that the costs of the transaction far outweighed any perceived benefits. The Eleventh Circuit declined to decide whether the avoidance of bankruptcy can confer "value," as the Transeastern Lenders argued.
However, the Eleventh Circuit said that the argument that the transaction provided an escape from the "existential threat" of bankruptcy which was a benefit reasonably equivalent in value to the obligations incurred under the liens, was not supported by the record. The Eleventh Circuit stated that "not every transfer that decreases the odds of bankruptcy for a corporation can be justified" and added that "the opportunity to avoid bankruptcy does not free a company to pay any price or bear any burden."
Beneficial Transferee Liability
The Eleventh Circuit also found that by the terms of the loan agreements (which required the proceeds of the loans secured by the liens to be transferred to the Transeastern Lenders), the Transeastern Lenders were entities "for whose benefit the transfer was made," rather than subsequent transferees as the Transeastern Lenders argued. The Eleventh Circuit followed the reasoning in In re Air Conditioning Inc. of Stuart, 845 F.2d 293 (11thCir. 1988) and found that the Conveying Subsidiaries transferred liens to the Lenders, who transferred funds to the Transeastern Lenders. Because the Bankruptcy Court later avoided the transfer of the liens, under section 550(a)(1) of the Bankruptcy Code, the Transeastern Lenders were entities for whose benefit the transfer was made.
The Eleventh Circuit also rejected the argument that the Transeastern Lenders benefited from a later transfer of funds rather than the initial transfer of liens. Under the facts of the case, the settlement was paid to the Transeastern Lenders from the proceeds of the new loan agreements. The funds first passed to a subsidiary of TOUSA before being paid to the Transeastern Lenders, but the subsidiary did not have control of the funds. The loan documents required the subsidiary to wire the funds to the Transeastern Lenders immediately. The Transeastern Lenders argued that this made them subsequent transferees of the funds.
However, the Eleventh Circuit rejected that argument saying that although the funds technically passed through a TOUSA subsidiary, that formality did not make the Transeastern Lenders subsequent transferees of the funds because TOUSA never had control over the funds.
Lastly the Eleventh Circuit rejected the argument that assigning liability to the Transeastern Lenders under section 550(a) of the Bankruptcy Code would drastically expand the pool of entities that could be liable for any transaction and would place "extraordinary" duties of due diligence on creditors accepting repayment. The Eleventh Circuit did not agree that the burden was undue and said "every creditor must exercise some diligence when receiving payment from a struggling debtor."
Practical Implications
Lenders are once again in an uncertain position as to whether they may employ past lending practices based on credit support from subsidiary guarantors. By overruling the District Court's decision, lenders' fraudulent transfer liability has been expanded by the Bankruptcy Court's decision well past limits set by prior precedent.
Lenders may also have to meet the heightened due diligence standard cited by the Bankruptcy Court to avoid a determination that they acted in bad faith which would deny them the benefit of the good faith defense for subsequent transferees under section 550(b) of the Bankruptcy Code.
It remains to be seen whether this decision will negatively impact distressed borrowers' ability to obtain rescue financing and instead force them into bankruptcy. In addition, creditors may now need to question the finality of debt repayments received from an affiliate guarantor of a financially troubled debtor.
The Lenders' appeal in the District Court, which was stayed pending the Eleventh Circuit's decision, may now proceed. A ruling on the enforceability of saving clauses should be forthcoming.