Lender Beware: TOUSA Bankruptcy Court Holding Reinstated
Business Restructuring, Creditors’ Rights & Bankruptcy Update
Date: May 17, 2012
In October 2009, the court overseeing the TOUSA, Inc. bankruptcy cases in the Southern District of Florida (Bankruptcy Court) set off considerable alarm bells throughout the lending community when it unraveled a refinancing transaction as a fraudulent conveyance based upon, in primary part, the fact that certain subsidiaries of TOUSA, Inc. pledged their assets as collateral for a new loan that was used to repay prior debt on which the subsidiaries were not liable, and that was not secured by those subsidiaries' assets. The Bankruptcy Court's pronouncement required the disgorgement of more than $403 million in payments received by the prior lenders, and the avoidance of liens encumbering the subsidiaries' assets that were given to the take-out lenders.
On February 11, 2011, the lending community obtained short-term relief from this decision when the district court for the Southern District of Florida (District Court) reversed the Bankruptcy Court's holdings that the TOUSA subsidiaries had not received reasonably equivalent value when they pledged their assets to the new lenders and that the prior lenders were entities "for whose benefit" the liens were conveyed. As of May 15, 2012, however, lenders can no longer rest easy, as the Eleventh Circuit Court of Appeals (Court of Appeals) reversed the District Court's decision and reinstated the Bankruptcy Court's holdings on reasonably equivalent value and on the liability of the prior lenders, while remanding to the District Court for further proceedings regarding the propriety of the remedies and damages awarded by the Bankruptcy Court.
The TOUSA Bankruptcy Cases
TOUSA, Inc., together with its numerous affiliates and subsidiaries (collectively, Tousa), was a large regional residential developer and builder. In July 2007, Tousa entered into a financing arrangement with a group of lenders (New Lenders) for the purpose of funding a litigation settlement with another group of lenders (Transeastern Lenders) that had previously provided separate financing for a failed joint venture involving certain Tousa entities.
Under the new financing, a number of Tousa subsidiaries (Conveying Subsidiaries), which were not parties to the loans with the Transeastern Lenders, were named as borrowers on the New Lenders' loans. The Conveying Subsidiaries granted security interests and liens on certain of their assets as security for the new financing, and the settlement payment to the Transeastern Lenders was funded.
Not long after entering into this lending arrangement with the New Lenders, the housing market in Florida (and elsewhere) took a decided turn for the worse, freezing credit markets and drying up the pool of home buyers, which doomed Tousa.
Tousa filed for bankruptcy protection in January 2008. Shortly thereafter, an official committee of unsecured creditors (Committee) was appointed, and in July 2008, the Committee brought a lawsuit on behalf of Tousa's bankruptcy estate against a number of Tousa's prepetition secured creditors, seeking, among other things, avoidance and recovery of substantial prepetition payments and lien interests under preference and fraudulent transfer theories. Included in the action were claims brought on behalf of the Conveying Subsidiaries against the Transeastern Lenders and the New Lenders for avoidance of alleged fraudulent transfers under 11 U.S.C. ? 548 (Bankruptcy Code), as a result of the 2007 financing and settlement payments.
In its complaint, the Committee alleged that the July 2007 transaction, including the settlement payment to the Transeastern Lenders, was an avoidable fraudulent transfer because the Conveying Subsidiaries were rendered insolvent as a result of the transaction and they did not receive "reasonably equivalent value" in return.
After a 13-day bench trial involving nearly two dozen witnesses and thousands of trial exhibits, the Bankruptcy Court issued a 182-page opinion, in which it held in favor of the Committee on all claims.
Among other things, the Bankruptcy Court specifically:
- Avoided the obligations incurred by the Conveying Subsidiaries to the New Lenders (and the liens securing those obligations) as a fraudulent transfer.
- Ordered the Transeastern Lenders to disgorge the majority of the settlement payment (approximately $403 million) received by the Transeastern Lenders.
- Ordered that damages, including the transaction costs for securing the new financing, the attorneys' fees and costs in seeking to unwind the transaction, and an amount equal to the decrease in value in the liens that were granted to the New Lenders (i.e., the decrease in value of the assets) be paid from the disgorged funds prior to any of those funds being returned to the New Lenders.
In a harshly critical opinion, the District Court reversed the Bankruptcy Court's decision as to the Transeastern Lenders, holding that the transfers to the Transeastern Lenders were not avoidable under Bankruptcy Code section 548 and related provisions. First, the District Court held that the payment sought to be avoided was not a transfer of property of the Conveying Subsidiaries; thus, an essential element of Bankruptcy Code section 548 could not be met. Instead, the proceeds of the new loans were property of the parent. Moreover, with respect to the alleged fraudulent transfers arising from the granting of liens in the Conveying Subsidiaries' assets, the District Court held that the Conveying Subsidiaries received reasonably equivalent value in return by way of corresponding direct and indirect benefits in the form of averting defaults under other obligations3 and a likely bankruptcy, as well as substantial tax benefits and an opportunity to rehabilitate their businesses. The District Court neither accepted nor rejected the Bankruptcy Court's finding that the Conveying Subsidiaries were insolvent at the time of the transaction.
After losing at the District Court, the Committee appealed to the Court of Appeals. In its decision, the Court of Appeals reversed the District Court and affirmed the Bankruptcy Court's finding that the Conveying Subsidiaries received less than reasonably equivalent value when they granted liens in their assets. Further, the Court of Appeals found that the Transeastern Lenders were entities "for whose benefit" the liens were transferred in affirming the liability of the Transeastern Lenders.
In arguing that they were not the entity "for whose benefit" the transfers were made, the Transeastern Lenders argued that such a ruling would impose "extraordinary" duties of due diligence on the part of all creditors accepting repayments, as any funds could conceivably be received by the debtor in the first instance as a result of a fraudulent conveyance. In addressing this concern, and using language that will undoubtedly be quoted in future lender liability litigation, the Eleventh Circuit stated: "But every creditor must exercise some diligence when receiving payment from a struggling debtor. 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."5
The Court of Appeals remanded to the District Court for further proceedings regarding the propriety of the remedies and damages awarded by the Bankruptcy Court. The liability of the New Lenders was not decided in this appeal.
The Broader Implications of Tousa 3: What Does the Future Hold?
Tousa 3 involved one subset of appeals arising out of multi-faceted transactions involving numerous borrower, guarantor and lender parties and replete with factual and legal intricacies and complexities. As such, its holding is, for now, limited to the precise transaction and factual findings, as upheld by one circuit court of appeals. Nonetheless, the reverberations of Tousa 3 may be substantial and the implications far-reaching.
First, the Tousa 3 opinion directly undermines the common practice of subsidiaries incurring obligations for the benefit of their parents, a practice premised in part on the theory that the total enterprise benefits from the obligations incurred by the individual members of the enterprise. Ultimately, it is likely that counsel for borrowers and guarantors will seek to exploit this holding further by attempting to use this decision to limit the liability of other affiliated corporate borrowers (i.e., parent and sister companies) and guarantors that do not directly receive benefits from financings.
Further, it is likely that Tousa 3 will be used to expand the scope of fraudulent conveyance litigation to include additional creditors as entities "for whose benefit" a transfer is made, as "every creditor must exercise some diligence when receiving payment from a struggling debtor."6
Additional ramifications will be felt if the Bankruptcy Court is ultimately affirmed on the broad range of remedies that it ordered, including, among other things, the disgorgement of the funds paid to the Transeastern Lenders, the award of damages that allowed the Committee to retain from the disgorged funds the transaction costs of entering into the financing, the costs and attorneys' fees incurred in pursuing the fraudulent conveyance claim, and the diminution in the value of the liens for the period between the transaction closing date of July 31, 2007, and October 13, 2009. Under the Bankruptcy Court's ruling, all of these costs and damages would be paid prior to returning the remaining disgorged funds to the New Lenders.
Given the broad and far-reaching implications of Tousa 3, it is likely that further appeals will be taken and, perhaps, an en banc review might be granted. Although the Eleventh Circuit's opinion is silent on the issue, it is also quite possible that if en banc review is granted, the Transeastern Lenders and the New Lenders may seek to challenge the standard of review applied by the Court of Appeals in light of the Supreme Court's decision in Stern v. Marshall, which limits the power of bankruptcy judges to enter final orders in non-core proceedings (i.e., proceedings not integrally related to the restructuring of debtor-creditor relationships).7 The Eleventh Circuit determined that the appropriate standard of review in this case was to consider whether the Bankruptcy Court's findings of fact were clearly erroneous. The Court of Appeals concluded that the Bankruptcy Court's findings of fact were not clearly erroneous and thus affirmed the Bankruptcy Court's holding that the lenders were liable. However, if by reason of the Supreme Court's decision in Stern v. Marshall, this action should be treated as a non-core proceeding, the appropriate standard of review may instead have been for the Court of Appeals to have determined if the District Court's findings of fact in favor of the lenders were clearly erroneous (or to remand to the District Court to make such findings of fact). Whether the lenders will seek to raise this issue in further proceedings before the Eleventh Circuit remains to be seen.
Until there is further clarity on all of these issues, lenders will need to be guarded with respect to transactions that involve facts similar to those present in the Tousa case.
Thompson Hine's Business Restructuring, Creditors' Rights & Bankruptcy practice group, Commercial & Public Finance practice group, and Real Estate practice group are equipped to assist lenders in structuring financing transactions to enhance protections against preference and fraudulent transfer liabilities that may arise after a borrower goes into distress.
1Official Committee of Unsecured Creditors of Tousa, Inc. v. Citicorp North America, Inc. (In re Tousa, Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009).
23V Capital Master Fund Ltd. v. Official Committee of Unsecured Creditors of Tousa, Inc. (In re Tousa, Inc.), 444 B.R. 613 (S.D. Fla. 2011).
3Tousa's operations were financed in large part by issuances of unsecured bond indebtedness and a revolving credit facility, under which most of the numerous Tousa entities were jointly and severally liable as borrowers, pledgors and/or guarantors. According to testimony at trial, had TOUSA, Inc. not settled with the Transeastern Lenders, defaults may have been triggered under the bonds and/or credit facility.
4Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re Tousa, Inc.), Case No. 11-11071 (11th Cir. May 15, 2012).
5Id. at 39.
7Stern v. Marshall, ____ U.S. ____, 131 S. Ct. 2594 (June 23, 2011).