CORPORATE UPDATE

Fraudulent Transfers in the TOUSA Bankruptcy

A Florida bankruptcy court recently handed down a decision in the TOUSA bankruptcy that has a potentially significant impact on commercial lending in general, but particularly when the financing is provided to a company in financial difficulty and is guaranteed by one or more subsidiaries. In Official Committee of Unsecured Creditors of TOUSA v. Citicorp North America (In re TOUSA, Inc.), 2009 WL 3261963, Adv. No. 08-1435 (Bankr. S.D. Fla. Oct. 13, 2009), a Florida bankruptcy court invalidated on fraudulent transfer grounds the liens granted in favor of lenders who provided $500 million of new financing to TOUSA, Inc. (“TOUSA”). The court further ordered certain other lenders that had received the proceeds of the new loans to repay the amounts received to the bankrupt estate.

Three aspects of the court’s analysis may be particularly troubling to lenders. First, the court found that the new lenders did not take the liens securing the new loans they were providing in good faith and therefore failed to qualify for the good faith safe harbor to fraudulent transfer actions found in Section 548(c) of the Bankruptcy Code. Second, the court rejected the application of certain savings clauses included in the relevant loan documents that were designed to reduce the amount of the obligations secured by the liens to the extent necessary to prevent the obligor’s insolvency and thereby insulate the transaction from fraudulent transfer attack. Finally, the court held that, in addition to forfeiting all fees paid in connection with the transaction, the new lenders were also liable for the diminution of value of the collateral securing the new lenders’ liens during the period between when the liens were granted and the date such liens were invalidated. Each of these issues is discussed in more detail below.

Factual Background

TOUSA, a national homebuilder based in Florida, experienced substantial growth during the housing boom, but had fallen on hard times. In connection with its expansion, it issued approximately $1 billion of bond debt, for which both it and certain of its subsidiaries (the “Conveying Subsidiaries”) were liable. During this expansion period, TOUSA had entered into what the court described as a “disastrous business venture” in 2005 (the “Transeastern Joint Venture”). Because TOUSA had guaranteed certain of the Transeastern Joint Venture’s debts, the holders of such debt made demand on TOUSA for repayment and, ultimately, TOUSA agreed to settle these claims for $421 million. In order to fund this settlement, TOUSA borrowed $500 million on July 31, 2007 from certain new lenders (the “July 31 Transaction”). Even though the Conveying Subsidiaries were not obligated on the Transeastern Joint Venture’s debt, they nevertheless became borrowers under the new loan and granted the new lenders liens on substantially all of their assets to help resolve TOUSA’s liabilities on the Transeastern guaranty.

In the subsequent bankruptcy proceedings for TOUSA and the Conveying Subsidiaries, the Official Committee of Unsecured Creditors (the “Committee”) sought to avoid as fraudulent transfers the liens granted by the Conveying Subsidiaries to the new lenders securing the $500 million new loan and to recover more than $421 million of the proceeds of the new loan that was paid to the lenders of the Transeastern Joint Venture. Ultimately, the bankruptcy court ruled that the July 31 Transaction was a fraudulent transfer because the Conveying Subsidiaries were insolvent and did not receive reasonably equivalent value in connection with the new financing. Thus, the court ordered the liens to be avoided and the cash paid to the joint venture’s lenders disgorged. The court also ordered that the new lenders and others return all fees paid in connection with the loan and that the new lenders also replenish the estate for the diminution of the value of the Conveying Subsidiaries’ property since the liens were granted.

Lenders Must in Good Faith Analyze the Borrower’s Solvency

In many ways, the fraudulent conveyance question in TOUSA was not a particularly novel one. Lenders have long been concerned about fraudulent conveyance risk when a subsidiary is providing a guaranty for a parent company’s debt, particularly if the guaranty is secured by the subsidiary’s assets. In TOUSA, the court found that the Conveying Subsidiaries received no direct benefit from the transaction, and negligible indirect benefit. As a consequence, the new lenders sought refuge in the “good faith” safe harbor of Section 548(c) of the Bankruptcy Code. Section 548(c) generally provides that a transferee that takes for value and in good faith may retain its interest in property to the extent that it actually gave value. 11 U.S.C. § 548(c).

As a preliminary matter, the court noted that the good faith exception did not apply because the new lenders did not give the Conveying Subsidiaries any value in exchange for the liens granted by the Conveying Subsidiaries. Moreover, the court stated that even if value had been provided to the Conveying Subsidiaries when they encumbered their property, the new lenders would not meet the good faith requirement because the evidence overwhelmingly indicated that the new lenders knew (or should have known) that the Conveying Subsidiaries were insolvent. Given the court’s findings that the new lenders had not provided value to the Conveying Subsidiaries and that there were clear indications of their insolvency, the court held that the new lenders were on notice as to the avoidability of these transfers and therefore failed to meet the good faith requirements of Section 548(c).

Although the lenders had obtained a solvency opinion from AlixPartners in connection with the transaction, the court was unimpressed. In fact, the court implied that the expert, as well as a number of others in the transaction including TOUSA’s then-CEO, were so financially motivated to conclude that the debtors were solvent (a condition to the transaction closing) that all of their conclusions may well have been tainted. The court was critical of the speed with which the insolvency opinion was prepared, as well as the quality of the information upon which it was based. The court noted that the information relied upon was stale and that nobody even bothered to talk to the division level personnel who could have given a first hand account of the plummeting sales pace, declining margins and other information casting doubt on the reasonableness of the business analysis underlying the solvency opinion. Further, the record was replete with emails and other documentary evidence suggesting that multiple company representatives had serious concerns about TOUSA’s ability to survive as a going concern. The company had already been required to obtain significant covenant relief with respect to its credit documents prior to the transaction in question and the business had only accelerated its decline afterward.

Three critical lessons emerge from this portion of the TOUSA opinion. First, lenders should perform their due diligence with care and should not ignore obvious warning signs that may call the borrower’s solvency into question. Second, if a lender intends to rely on a solvency opinion in making a credit decision, the lender should be sure that the compensation structure of the engagement (and the compensation of others interested in the transaction) are not structured in a manner that may taint the opinion, calling into question the independence of the opinion. Finally, lenders should carefully consider whether all appropriate information has been taken into account and whether such information is sufficiently current to justify reliance on it in reaching the solvency determination.

Savings Clauses May Not Be Effective in Bankruptcy

The issue of the debtors’ insolvency—both before and after the July 31 Transaction—was heavily contested in TOUSA and the court’s finding on this issue was critical to much of the court’s opinion. Not surprisingly, the lenders asserted that certain provisions of their loan documents, by their terms, prevented the liens from being characterized as fraudulent transfers. These “savings clauses” were specifically designed to reduce the obligations secured by the liens on the assets of the Conveying Subsidiaries to the extent necessary to prevent the insolvency of the Conveying Subsidiaries, and thereby insulate the transaction from fraudulent conveyance attack.1

The court rejected this argument for several reasons. First and foremost, the court found that savings clauses in this case had no effect at all because the Conveying Subsidiaries were already insolvent before the July 31 Transaction and received no value from that transaction, so there was no portion of the transaction subject to being “saved” by the savings clause. Second, in a rather strained reading, the court found that Section 1141(c)(1)(B) of the Bankruptcy Code prevented the enforcement of the savings clauses. That provision states that an interest of the debtor in property becomes property of the estate, notwithstanding any “provision in an agreement” that is “conditioned on the insolvency or financial condition of the debtor” and “that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.” The “interest of the debtor in property” implicated, according to the court, was the fraudulent conveyance claim itself. Third, the court found the savings clauses to be unenforceable as an impermissible attempt to contract around core provisions of the Bankruptcy Code—Section 548 in particular. Finally, the court found the savings clauses were unenforceable because multiple documents contained similar clauses (each of which said they were applied after taking into account all other obligations) making their application circular and incapable of enforcement. The court ultimately disregarded the savings clauses in the loan documents, stating that the savings clauses in this case were “too cute to be enforced.”

The Lenders Were Liable for the Diminution in Value of the Property that Was the Subject of the Avoided Liens

Based on the fraudulent transfer, the court ordered that the liens granted by the Conveying Subsidiaries be avoided and the $421 million paid to the joint venture’s lenders be disgorged. However, the court went further. The value of the underlying property subject to the liens had significantly declined as a result of continued deterioration of the residential real estate market after the liens were granted. The court found that the estate had lost the ability to dispose of the property prior to this depreciation as a result of the encumbrances, and that the new lenders should be responsible for the diminution in value. Accordingly, the court also held that the Conveying Subsidiaries were entitled to recover from the disgorged cash an amount equal to the diminution in value of the encumbered properties between the granting of the liens and the court issuing its opinion avoiding them.

CONCLUSION

Despite a likely appeal on the horizon, this case still provides insight into several key issues related to financing arrangements. Savings clauses, for example, may not be enforced in a bankruptcy proceeding, particularly if the clauses are ambiguous or difficult to enforce. In addition, lenders must conduct a diligent and thorough investigation of the borrower and its financial condition in order to rely on the good faith exception to the fraudulent transfer provisions. Lastly, lenders should be aware that if a court later unwinds a transaction on fraudulent transfer grounds, the remedies may include a requirement that the lenders reimburse the estate for any diminution in value of the collateral, in addition to the avoidance of the lien and disgorgement of fees collected in the case.

1 The savings clauses in the relevant financing documents states: “Each Borrower agrees if such Borrower’s joint and several liability hereunder, or if any Liens securing such joint and several liability, would, but for the application of this sentence, be unenforceable under applicable law, such joint and several liability and each such Lien shall be valid and enforceable to the maximum extent that would not cause such joint and several liability or such Lien to be unenforceable under applicable law, and such joint and several liability and such Lien shall be deemed to have been automatically amended accordingly at all relevant times.”