In a much-watched case coming out of Florida, on May 15, 2012, the U.S. Court of Appeals for the Eleventh Circuit reinstated a bankruptcy court judgment (which had been reversed by the district court) avoiding liens on assets of debtor-subsidiaries and providing for the lender-beneficiaries' disgorgement of $421 million that had been paid to the lenders. As a result of the decision, lenders who make loans to troubled borrowers and accept payoffs of loans from troubled borrowers may bear an increased burden in investigating the sources of funds that are used for the payoff and expected to be used for future loan repayments.
In June 2005, TOUSA, Inc., a large U.S. homebuilder, entered into a joint venture with a third party to acquire homebuilding assets then owned by Transeastern Properties, Inc. Certain lenders (the "Transeastern Lenders") provided unsecured financing to TOUSA to acquire those assets. TOUSA's subsidiaries were not obligors or guarantors of the Transeastern acquisition debt (but were guarantors of TOUSA's other financing arrangements). In October 2006, the Transeastern Lenders alleged that TOUSA had defaulted under the loan documents, and demanded payment. The parties negotiated a settlement under which TOUSA agreed to pay more than $421 million to the Transeastern Lenders.
TOUSA did not have a source of funds to make the settlement payment, so TOUSA and certain of its subsidiaries (the "Conveying Subsidiaries") obtained $500 million of loans from two sets of lenders (referred to in the opinion as the "New Lenders") to make the settlement payment. The loans were secured by first and second liens on the assets of TOUSA and the Conveying Subsidiaries, and the loan agreements required that the proceeds of the loans be used to make the settlement payment to the Transeastern Lenders. TOUSA's subsidiaries owned most of the enterprise's assets and accounted for the vast majority of its revenue. The loans closed, and the settlement payment was made to the Transeastern Lenders through a TOUSA subsidiary that was neither a Conveying Subsidiary nor the new Transeastern joint venture.
The Transeastern settlement occurred just as the U.S. economy was heading into the deepest recession in 70 years, and the homebuilding industry was the hardest hit of all. TOUSA and the Conveying Subsidiaries filed bankruptcy petitions within six months of the Transeastern settlement. The Committee of Unsecured Creditors (the "Committee"), as representative of the bankruptcy estates, pursued litigation against the New Lenders and the Transeastern Lenders to avoid the transfer of liens to the New Lenders and to recover the value of the liens from the Transeastern Lenders. The Committee sought to avoid the transfer under Bankruptcy Code § 548(a)(1)(B), which generally permits a bankruptcy estate to avoid a transfer to the extent that it was made while the debtor was insolvent (under one of various tests) and without "reasonably equivalent value."
The bankruptcy court found that TOUSA and the Conveying Subsidiaries were insolvent at the time of the transaction and the district court and Eleventh Circuit accepted that finding. Thus, the focus of the analysis was on whether the Conveying Subsidiaries received reasonably equivalent value and from whom the avoidable transfer could be recovered.
The Committee pointed to the transaction as one providing no real benefit to the Conveying Subsidiaries. According to the Committee, the transaction was orchestrated solely for the benefit of the Transeastern Lenders. Among the consequences of the transaction were that unencumbered assets of the Conveying Subsidiaries were suddenly subject to a lien and that an unsecured obligation owed to the Transeastern Lenders by TOUSA (which was mired in financial woes) was transferred into a secured obligation owed to the New Lenders by the Conveying Subsidiaries.
In contrast, the Transeastern Lenders cited – and the district court accepted (but the bankruptcy court and the Eleventh Circuit dismissed) – a number of "indirect" or "soft" benefits as constituting reasonably equivalent value. For instance, the Transeastern Lenders alleged that significant value was attributable to tax benefits relating to the transaction, elimination of litigation with the Transeastern Lenders and continuing access to TOUSA corporate services, such as payroll and purchasing functions. The Transeastern Lenders also noted that failure to satisfy the Transeastern Lenders would have resulted in a default under TOUSA's other financing facilities – which were guaranteed by the Conveying Subsidiaries – and therefore argued that the Conveying Subsidiaries experienced significant benefit as a result of delaying an imminent bankruptcy filing. The Eleventh Circuit made short work of this argument, quoting another decision for the proposition that "'[a] corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it.'"
Having affirmed the bankruptcy court's finding that the New Lenders did not provide reasonably equivalent value to the Conveying Subsidiaries, the Eleventh Circuit focused on the party from whom the Committee could recover. The Committee sought to recover from the Transeastern Lenders pursuant to Bankruptcy Code § 550(a)(1), which generally permits the bankruptcy trustee (or, in this case, the Committee) to recover property subject to a fraudulent transfer, or the value thereof, from the initial transferee of the transfer or "the entity for whose benefit such transfer was made." The Eleventh Circuit easily affirmed the bankruptcy court's finding that the grants of the liens to the New Lenders were for the benefit of the Transeastern Lenders, noting that the loan documents explicitly "required that the proceeds of the loans secured by the liens be transferred to the Transeastern Lenders."
Although the Eleventh Circuit's decision in TOUSA involved some unique facts, it illustrates some of the risks inherent in transactions involving troubled borrowers, especially where new guarantors and pledgors do not directly benefit or where the effect of the transaction is transforming unsecured debt into secured debt. The scrutiny will come from creditors' committees and others whose fees are paid by the estate and who have little (if anything) to lose from challenging the transaction.
Perhaps most significantly, the Eleventh Circuit's analysis suggests that a creditor cannot limit its exposure by maintaining willful blindness regarding the source of funds used to pay an obligation. While the court dismissed concerns that its ruling would open payment recipients to "extraordinary" exposure, it explicitly noted, "It is far from a drastic obligation to expect some diligence from a creditor when it is being repaid hundreds of millions of dollars by someone other than its debtor."
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