The money trail
As of 2006, TOUSA, Inc. (“TOUSA”) was the thirteenth largest homebuilder in the country and was growing rapidly. In order to finance its advancement, as of July 2007, TOUSA had borrowed approximately $1.061 billion of bond debt (in the form of unsecured public bonds that were guaranteed by certain of TOUSA’s subsidiaries (the “Conveying Subsidiaries”)) and $224 million in a revolving loan (for which TOUSA and the Conveying Subsidiaries were jointly and severally liable).
In addition, in June 2005, TOUSA had entered into a joint venture to acquire certain assets from Transeastern Properties, Inc. In order to fund this acquisition, TOUSA assumed debt from a group of lenders (the “Transeastern Lenders”) which was guaranteed by the Conveying Subsidiaries. By October 2006, TOUSA defaulted on its debt obligations to the Transeastern Lenders. As a result, the Transeastern Lenders sued TOUSA for damages of over $2 billion. In July 2007, TOUSA settled its disputes with the Transeastern Lenders for more than $421 million. To finance the payment of the settlement, TOUSA incurred more debt from a syndicate of new lenders (the “New Lenders”) consisting of a $200 million loan secured by a first-priority lien on the assets of TOUSA and the Conveying Subsidiaries and a $300 million loan secured by a second-priority lien on the assets of TOUSA and the Conveying Subsidiaries. The proceeds of the loans from the New Lenders were used to pay TOUSA’s settlement with the Transeastern Lenders (the foregoing, the “Transaction”).
Six months following the Transaction, TOUSA and the Conveying Subsidiaries filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. Thereafter, the Official Committee of Unsecured Creditors (the “Committee”) filed an adversary proceeding to avoid the liens granted to the New Lenders and to recover the payments made to the Transeastern Lenders as fraudulent transfers under section 548(a)(1)(B) of the Bankruptcy Code.
For value or not for value, that is the question
In short, the Committee alleged that the Conveying Subsidiaries were insolvent at the time the Transaction occurred, had unreasonably small capital, or were unable to pay their debts when due. More importantly, the Committee argued that the Conveying Subsidiaries did not receive reasonably equivalent value for the granting of the liens to the New Lenders or the subsequent payment made to Transeastern (collectively, the “Transfers”). The Transeastern Lenders and New Lenders argued that the Conveying Subsidiaries received reasonably equivalent value for the Transfers in that the payments to the Transeastern Lenders, which was facilitated by the granting of the liens to the New Lenders, among other things, allowed the Conveying Subsidiaries to avoid defaulting on its obligations arising in connection with the joint venture financing and a likely bankruptcy. Alternatively, the Transeastern Lenders argued that even if the granting of the liens to the New Lenders constituted a fraudulent conveyance, the payments made to the Transeastern Lenders could not be avoided because they were subsequent transferees of the loan proceeds that were obtained by TOUSA from the New Lenders.
After extensive litigation, the Bankruptcy Court, in a lengthy decision, held that the Transfers indeed constituted fraudulent conveyances. In essence, the Bankruptcy Court held that the Conveying Subsidiaries did not receive reasonably equivalent value for the transfers and that the delay of the bankruptcy filing conferred no benefit. The Eleventh Circuit upheld this finding noting that the “opportunity to avoid bankruptcy does not free a company to pay any price or bear any burden” and that not every transfer that decreases the odds of a filing can be justified. This directly contradicted the holding of the District Court, which held that both tangible and intangible forms of “value” should be considered when considering whether a transfer constitutes a fraudulent conveyance.
The Eleventh Circuit also sided with the Bankruptcy Court, against the contrary holding by the District Court, holding that (i) the Conveying Subsidiaries did not receive reasonably equivalent value for the transfers, and (ii) the Transeastern Lenders were entities for whose benefit the liens were granted. First, the Eleventh Circuit explained that the benefits conveyed the Conveying Subsidiaries clearly outweighed any perceived benefits they received, concluding that a transaction that simply extends the life of a corporation does not necessarily lead to the conclusion that such transaction is beneficial. Of prime importance is the Eleventh Circuit’s insistence that the Lenders were required to consider the sources of repayment of lent funds, and the possible consequences of that lending on the financial viability of the entity assuming a debt obligation. As the Eleventh Circuit held, “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.”
What is a lender to do?
This ruling clearly weakens the lender protections for parties that make loans to distressed companies and imposes some level of due diligence to determine the source of funds used for repayment of those obligations. Notably, the Eleventh Circuit did not delineate the level of due diligence required, leaving this to another day.
While TOUSA is only the law within the Eleventh Circuit, and other circuits, notably the Second and Third Circuits, have taken arguably contrary views on the value of indirect, intangible, benefits as they relate to defending against a fraudulent conveyance action, lenders should consider taking steps to avoid TOUSA-like issues:
- Lenders should consider discounting (or not over-rely on) the value of upstream guarantees, and the security interest securing such guarantees where the guarantor will not receive any portion of loan proceeds.
- TOUSA may make it more likely that courts will invalidate upstream guaranties given by subsidiaries for the benefit of a parent borrower where only an indirect benefit can be shown. Lenders should structure a transaction to ensure that at least some direct, tangible, benefit is given to the subsidiary. Further, the loan documents should recite and acknowledge the benefits or consideration received at each subsidiary level.
- Borrowers should consider simplifying, or consolidating, their corporate structures where other considerations would permit.
- Lenders should conduct independent financial analysis of each party to confirm that each guarantor is solvent at the time it gives its guarantee. Depending on transaction size and value, consider requiring an independent solvency opinion. Lenders must look at the value received by each entity and at its individual solvency rather than the borrower group as a single economic unit.
- Parties should include a “savings clause” in the guarantee limiting the liability of each guarantor to the largest amount that will still leave the guarantor solvent. The Bankruptcy Court invalidated such clauses in its decision, but the Eleventh Circuit has not yet weighed in on this issue to date.
A copy of the Eleventh Circuit’s decision is available at: