On May 15, 2012, the United States Court of Appeals for the Eleventh Circuit decided Senior Transeastern Lenders et al. v. Official Committee of Unsecured Creditors (In re TOUSA, INC., et al.), No. 11-11071 (11th Cir. 2012), a decision with potentially significant implications for commercial lenders. Reversing a prior decision of the District Court for the Southern District of Florida (which in turn reversed an earlier decision of that district’s bankruptcy court), the Eleventh Circuit held that liens granted by subsidiaries of a borrower to refinance obligations owed to the borrower’s lenders constituted fraudulent transfers within the meaning of section 548 of the Bankruptcy Code and that the proceeds paid to the borrower’s lenders, as the ultimate beneficiaries of the refinancing, were subject to disgorgement. Under TOUSA, it emerges that lenders that were repaid on account of valid, antecedent loans with funds from a new loan secured by liens granted by the borrower’s subsidiaries can have fraudulent transfer liability to the subsidiaries’ estates.
The TOUSA decision significantly expands the potential pool of entities that could be held liable for a fraudulent transfer. As a practical matter, the TOUSA decision may be read to impose significant due-diligence requirements on creditors accepting repayment of a debt, particularly from a borrower known to be in financial distress.
Background
In 2005, TOUSA, Inc., a homebuilding enterprise, entered into a joint venture to acquire homebuilding assets owned by Transeastern Properties, Inc. To finance the joint venture, TOUSA borrowed approximately $400 million from a group of lenders (the “Transeastern Lenders”). By the end of 2006, the joint venture had failed, and TOUSA defaulted on its obligations to the Transeastern Lenders. In July 2007, in settlement of litigation claims asserted against it, TOUSA repaid the Transeastern Lenders in full. To repay this debt, TOUSA obtained approximately $500 million in new financing provided by new lenders (“New Lenders”) and secured by liens on the assets of TOUSA and certain of its subsidiaries, referred to in the opinion as the Conveying Subsidiaries.
In January 2008, following the collapse of the U.S. housing market, TOUSA and its homebuilding subsidiaries filed for bankruptcy relief. The Official Committee of Unsecured Creditors (“Committee”) filed a lawsuit on behalf of the Conveying Subsidiaries against the New Lenders and the Transeastern Lenders. The Committee asserted, inter alia, fraudulent transfer claims and sought to avoid the liens held by the New Lenders and recover the funds paid to the Transeastern Lenders.
In October 2009, following a lengthy trial, the Bankruptcy Court for the Southern District of Florida: (i) avoided the New Lenders’ liens on the Conveying Subsidiaries’ assets because the Conveying Subsidiaries did not receive “reasonably equivalent value” in exchange for the liens; (ii) held that the Transeastern Lenders were liable as entities “for whose benefit” the transfer of the liens was made; and (iii) held that the Transeastern Lenders were “direct transferees” of the new loan proceeds from the Conveying Subsidiaries. The Transeastern Lenders were ordered to disgorge more than $403 million in loan proceeds and almost $80 million in prejudgment interest.
On appeal, in a strongly worded 113-page opinion, the United States District Court for the Southern District of Florida quashed the order of the Bankruptcy Court with respect to the Transeastern Lenders, finding that the Bankruptcy Court’s decision was “clearly erroneous.” The District Court held that the Conveying Subsidiaries received reasonably equivalent value in exchange for the liens that they granted to the New Lenders, such that the transfer of those liens to the New Lenders was not fraudulent and could not be avoided under the Bankruptcy Code. The District Court also held that the liens were not transferred for the benefit of the Transeastern Lenders (but rather, for the benefit of the new lenders under the refinancing), and therefore the proceeds of the new loans could not be recovered from them under the Bankruptcy Code.
Circuit Court Decision
On further appeal, the Eleventh Circuit reversed the District Court’s decision, holding that the Bankruptcy Court did not clearly err when it found that the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for granting liens to the New Lenders. The Eleventh Circuit also held that the bankruptcy court correctly ruled that the Transeastern Lenders were entities “for whose benefit” the liens were transferred and the proceeds of the new loans that were transferred to the Transeastern Lenders could be subject to disgorgement.
The Eleventh Circuit focused first on whether the Conveying Subsidiaries received less than “reasonably equivalent value” in exchange for granting liens on their assets to secure the new loans. While the District Court had held that the term “value” must be read broadly and included intangible benefits such as allowing the debtor-subsidiaries to stave off a bankruptcy filing, the Bankruptcy Court had construed the term narrowly to require a more concrete exchange for actual value. The Eleventh Circuit declined to weigh in on the meaning of “value” in this context. Instead, the court concluded that the Bankruptcy Court did not clearly err in finding that “even if all the purported benefits of the transaction were legally cognizable, they did not confer reasonably equivalent value.” The Court thus held that “[t]he record supports the finding by the bankruptcy court that, for the Conveying Subsidiaries, the almost certain costs of the [new loans] far outweighed any perceived benefits.”
Having concluded that the Bankruptcy Court correctly found that the New Lenders’ liens on the Conveying Subsidiaries’ assets could be avoided as a fraudulent transfer under the Bankruptcy Code, the Court then reviewed the Bankruptcy Court’s holding that the value of the transfers could be recovered from the Transeastern Lenders under the Bankruptcy Code as the entities “for whose benefit such transfer was made.” The Court held that because the loan agreements for the new loans required that the proceeds be paid to the Transeastern Lenders, the Transeastern Lenders were the entities for whose benefit the liens were transferred.
The Eleventh Circuit rejected the Transeastern Lenders’ argument that the Bankruptcy Code did not permit the Committee to recover the loan proceeds from them because they benefited from a subsequent transfer of funds from TOUSA, not from the initial transfer of the liens. The loan proceeds initially were disbursed to a subsidiary of TOUSA before they were paid over to the Transeastern Lenders. The Eleventh Circuit characterized this as a “formality” and concluded that TOUSA “never had control over the funds” because the “loan documents required the subsidiary to wire the funds to the Transeastern Lenders immediately.” The Court was not persuaded by the Transeastern Lenders’ argument that such a result would drastically expand the pool of entities that could be held liable for fraudulent transfer claims on any transaction, reasoning that “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.”
Observations
The TOUSA opinion may have broad implications for lenders to struggling companies. Under TOUSA, third party recipients of funds which they are legitimately owed bear a risk of disgorgement not only if their obligor was insolvent at the time of the transfer (which the market has always understood to create a 90-day preference risk under section 547 of the Bankruptcy Code), but also if the obligor’s source of those funds, or even the source of collateral that permitted the obligor to obtain those funds, was insolvent, in which case the lenders may find themselves exposed for the much longer periods provided for fraudulent transfers under sections 544 and 548 of the Bankruptcy Code. The TOUSA decision arguably creates a legal duty to conduct extraordinary due diligence with respect to the origin and provenance of funds with which a lender is repaid. Although lenders may be advised to accept repayment even where the funds used for repayment may be deriving from an insolvent source, particularly if the alternative is not to receive repayment at all, a cloud of uncertainty may hover over the lenders’ right to the repaid monies for a period that is much longer than has been traditionally assumed to be the case.
On the other hand, fraudulent transfer cases are inherently fact-specific, and the TOUSA case is no exception. The Eleventh Circuit’s reliance on the size of the TOUSA transaction in stating that courts could expect creditors to conduct “some diligence” suggests that any diligence obligation imposed by the decision may be proportionate to the size of the transaction in question. Moreover, one gets the sense from TOUSA (and, in particular, the bankruptcy court opinion that it effectively affirmed) that the Transeastern Lenders’ intimate involvement in the refinancing transaction (to the point where certain of the Transeastern Lenders were also New Lenders) and their knowledge of the financial difficulties being faced by the entire TOUSA enterprise were substantial factors in the finding of liability against them. It seems less likely that a true third party obligee with no good faith basis to doubt the solvency of a debtor or its funding source would have gotten the same negative result.
In any event, TOUSA suggests that to the extent possible, lenders to an entity that may be struggling should pay particular attention to the source of any repayment and, if possible, attempt to ensure that the party ultimately bearing the cost of repayment is already obligated under the relevant loan. This generally will limit disgorgement risk to payments received within 90 days prior to a bankruptcy filing. If the ultimate source of payment is not so obligated, or becomes obligated only after the loan already was made, then the repayment may be at risk of being clawed back if there is a bankruptcy filing even two years or more after repayment.
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Wilamowsky-StevenThis article was originally published by Bingham McCutchen LLP.