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District Court Quashes Bankruptcy Court’s Fraudulent Transfer Decision in the TOUSA, Inc. Case

03.17.11

In a recent decision of significant relevance to secured lenders, the United States District Court for the Southern District of Florida (the “District Court”)1 quashed the portion of the controversial 2009 decision of the Bankruptcy Court for the Southern District of Florida (the “Bankruptcy Court”) in In re TOUSA, Inc. (Official Comm. of Unsecured Creditors v. Citicorp N.A., Inc.)2 which had (a) avoided, as fraudulent transfers under section 548 of the Bankruptcy Code, both liens granted by certain subsidiaries (the “Conveying Subsidiaries”) of TOUSA, Inc., (“TOUSA”) to “New Lenders” to secure loans (the “New Loans”) made to TOUSA and the Conveying Subsidiaries, and the proceeds of such loans that were used to fund the repayment of defaulted antecedent indebtedness owed by TOUSA and a subsidiary to certain lenders (the “Transeastern Lenders”) and (b) required the Transeastern Lenders to disgorge as much as $420 million in such repayments plus interest under section 550(a) of the Bankruptcy Code.

The District Court's decision is a welcome result for lenders to complex corporate enterprises generally, because it overturns a bankruptcy court decision that had raised a specter of concern among the lending industry. Lenders had worried that they might have to disgorge payments received in repayment of a debt owed only by a parent and one subsidiary with funds obtained by new loans secured by assets of not only the parent, but also of subsidiaries that were neither obligors on, nor grantors of the liens securing, the antecedent debt. 

The District Court reached its decision by interpreting certain key elements of a fraudulent transfer claim in a manner that is favorable to lenders. The ruling interprets the meaning of “reasonably equivalent value” in a broad manner following case law that holds that such “value” may include indirect economic benefits, and recognizes that such “value” need not be mathematically quantifiable and should not be viewed from the perspective of hindsight. Thus, a borrowing entity receives reasonably equivalent value if it borrows funds for the principal purpose of curing defaults on a debt of an affiliate, so long as the borrower had a reasonable expectation that it would receive economic benefit from the transaction, including the ability to avoid cross-defaults to the borrowing entity’s own debt obligations and to improve its own prospects of avoiding bankruptcy.

The District Court provides further comfort to lenders in holding that section 548 did not apply since the repayment was not a transfer of “property” of the subsidiary debtors because those debtors did not “control” how the proceeds of the new loan were to be disbursed. Moreover, the fact that the New Loans were secured by liens on assets of the subsidiaries did not render the lender an entity “for whose benefit” the liens were granted. The delinking of the liens and the repayment meant that the lender could not be strictly liable under section 550(a). As a “subsequent transferee” of the new loan proceeds, the defense of good faith under section 550(b) is available to the lender. Contrary to the holding of the Bankruptcy Court, the District Court held that good faith did not require that the lender investigate the impact of the transfer of the liens or proceeds of the new loan on the subsidiary borrowers.

Background

TOUSA, and its subsidiaries were in the business of designing, building and marketing residential properties. In June 2005, TOUSA and a subsidiary, Tousa Homes LP (“Homes”), entered into a joint venture to acquire certain Florida properties owned by Transeastern Properties, Inc. (“Transeastern”). The acquisition was funded by a loan (the “Transeastern Loan”) made under a credit agreement with the Transeastern Lenders. The Conveying Subsidiaries were neither obligors nor collateral grantors under the Transeastern Loan. Shortly after the Transeastern transaction, the housing market began to deteriorate. TOUSA and Homes brought an action against Deutsche Bank Trust Companies Americas (“DBTC”), as administrative agent for the Transeastern Lenders, seeking a determination that they were not obligated to the Transeastern Lenders under outstanding completion and carve-out guaranties.  Thereafter, in November 2006, DBTCA commenced litigation against TOUSA and Homes seeking repayment of the Transeastern Loan and damages for various breaches by TOUSA and Homes of the completion and carve-out guaranties. TOUSA then entered into an agreement with, among others, the Transeastern Lenders by which TOUSA agreed to pay approximately $420 million to the Transeastern Lenders in settlement of the Transeastern Loan. 

In order to fund the payment of the settlement amount, on July 31, 2007, TOUSA and the Conveying Subsidiaries borrowed a total of $500 million pursuant to a $200 million First Lien Term Loan Facility and a $300 million Second Lien Term Loan Facility (collectively, the “New Loan Agreements”).3 Pursuant to the New Loan Agreements, TOUSA and the Conveying Subsidiaries granted liens on their assets and the Conveying Subsidiaries became “Subsidiary Borrowers” under the New Loan Agreements. In exchange for the liens, the New Lenders advanced the New Loan proceeds which were used, in large part, to repay the Transeastern Loan. The Conveying Subsidiaries authorized TOUSA to act as their agent for the purpose of funding the Transeastern settlement. 

The housing market declined precipitously thereafter following a tightening of credit markets in August 2007 and on January 29, 2008, TOUSA and the Conveying Subsidiaries filed for bankruptcy protection.

The Bankruptcy Court Decision

The Creditors Committee appointed in the TOUSA cases (the “Committee”) commenced an adversary proceeding seeking, among other things, to avoid the Conveying Subsidiaries’ liens and obligations under the New Loans and recover the proceeds of the New Loans paid in settlement of the Transeastern Loans. In an 182 page decision that adopted 92% of the Committee’s Proposed Findings of Fact and Conclusions of Law (a process sharply criticized by the District Court), the Bankruptcy Court found, among other things, that the Conveying Subsidiaries were insolvent at the time of, or were rendered insolvent by, the July 31 Transaction, and were left with unreasonably small capital as a result of such transaction and that the payment to the Transeastern Lenders could be avoided as a fraudulent transfer because the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for the transfer to the Transeastern Lenders of the New Loan proceeds and the grant of the liens and the incurrence of obligations under the New Loan Agreements.

In addition to avoiding the liens granted and obligations undertaken by the Conveying Subsidiaries as Subsidiary Borrowers under the New Loan Agreements as fraudulent transfers vis a vis the Transeastern Lenders and disgorgement of the settlement payment made to the Transeastern Lenders (plus interest), the Bankruptcy Court (i) avoided the liens granted the New Lenders against the assets of the Conveying Subsidiaries, (ii) deducted from the disgorged funds, for the benefit of the estate, fees paid to the New Lenders and the amount of any diminution in value of the Conveying Subsidiaries since the closing of the New Loans, and (iii) returned to the New Lenders any balance of the disgorged funds after such deductions.

The District Court Decision

The District Court in rendering its opinion considered the legal conclusions of the Bankruptcy Court de novo and applied the clearly erroneous standard to its findings. The District Court held that certain evidence was “clearly and erroneously ignored” by the Bankruptcy Court4 and that the “findings and legal conclusions were neither ‘logical’ nor ‘consistent with the equitable concepts underlying bankruptcy law.’”5 The District Court held that the Bankruptcy Court erred as a matter of law in holding that (i) the payment by TOUSA of the proceeds of the New Loans to the Transeastern Lenders was a transfer of an interest in property of the Conveying Subsidiaries subject to section 548 of the Bankruptcy Code, (ii) the Conveying Subsidiaries did not receive reasonably equivalent value for the transfer of such proceeds or the grant of the liens, (iii) the Transeastern Lenders were (a) direct transferees of the New Loan proceeds, or (b), entities “for whose benefit” the liens were granted to the New Lenders, within the meaning of section 550(a) of the Bankruptcy Code, and (iv) the Transeastern Lenders, as recipients of payment on an outstanding debt, should have done diligence with respect to the source of payment of the antecedent debt and “knew or should have known that TOUSA and the Conveying Subsidiaries were insolvent on January 31, 2007, or were precariously close to insolvency and manifestly were to be left with inadequate capital.”6

The District Court’s decision did not address the portion of the Bankruptcy Court’s decision appealed by certain New Lenders, since that appeal is pending before a different District Court Judge, Judge Adalberto J. Jordan. Judge Jordan gave each party, intervenor and amicus curiae in those appeals until March 15, 2011, to file a supplemental brief not exceeding 15 pages addressing the potential effect that the District Court’s opinion and reasoning would have on the New Lenders’ appeals. Since those appeals present other distinct issues including, dicta in the Bankruptcy Court’s decision that “fraudulent conveyance savings clauses” are void as against public policy, it is not known what impact the District Court’s decision will have on such appeals.

A discussion of the key elements of the District Court’s decision follows:

The Transfer of the New Loan Proceeds to the Transeastern Lenders Was Not Avoidable Under Section 548 Since it was Not Property of the Conveying Subsidiaries

The District Court noted that whether the transfer of the New Loan proceeds to the Transeastern Lenders was avoidable as a fraudulent transfer under Section 548 of the Bankruptcy Code turns on the question of whether the New Loan proceeds were “property” of the Conveying Subsidiary. Under Eleventh Circuit precedent, a transfer is avoidable under Section 548 of the Bankruptcy Code only if the debtor had the requisite  “control” over the property transferred.7 Under the control test, the particular debtor had to have the power to designate which party would receive the funds and the power to actually disburse the funds.8 The District Court determined that the Bankruptcy Court could not find that the Conveying Subsidiaries received the proceeds of the New Loan, or had the power to distribute them or designate who was to receive the funds, since the record established that the power lay exclusively with TOUSA as provided in the New Loan Agreements, which required that TOUSA pay the funds to the Transeastern Lenders. Accordingly, the District Court held that the Bankruptcy Court erred in holding that the Transeastern Lenders were “direct transferees” of property of the Conveying Subsidiaries since the Conveying Subsidiaries never had any “property interest” in the New Loan proceeds and, consequently, the payment of those proceeds by TOUSA (who the District Court held controlled the transfer) was not a transfer by the Conveying Subsidiaries to the Transeastern Lenders subject to avoidance under Section 548.

The Conveying Subsidiaries Received Reasonably Equivalent Value Through Indirect Intangible Economic Benefits

The District Court next considered whether the Conveying Subsidiaries received reasonably equivalent value for either (a) the transfer of the New Loan proceeds to the Transeastern Lenders (assuming for such purpose that the Conveying Subsidiaries had a property interest in the New Loan proceeds as the Bankruptcy Court had held) or (b) the grant of the liens on their assets to the New Lenders. The District Court noted that even if the Bankruptcy Court was correct that the Conveying Subsidiaries had a “minimal” interest in the New Loan proceeds, the Bankruptcy Court erred in concluding that such transfer was avoidable under Section 548 because the Committee failed to carry its burden of proving that the respective debtors received less than a reasonably equivalent value in exchange for the transfer.

First, the District Court held that the Bankruptcy Court erred by not finding reasonably equivalent value when it found that the Conveying Subsidiaries had a minimal property interest in the proceeds of the New Loans, and in not measuring “reasonably equivalent value” received against the Conveying Subsidiaries’ “minimal interest” in the New Loan proceeds.9 Second, the District Court held that the Bankruptcy Court erred as both a matter of law and fact in refusing to recognize as reasonably equivalent value the indirect benefits received by the Conveying Subsidiaries on account of the July 31 Transaction.

The District Court also determined that the Bankruptcy Court committed legal error in holding that “avoidance of default and bankruptcy by the Conveyance Subsidiaries” is “not property and, therefore, is not cognizable as ‘value’.”10 The Bankruptcy Code does not define “reasonably equivalent value” but does define “value”.  The Bankruptcy Court, therefore, looked to the definition of “value” in Section 548(d)(2)(A), which term includes “property, or satisfaction or securing of a present or antecedent debtor of the debtor,”11to determine whether value had been given. Since no antecedent debt of the Conveying Subsidiaries was being satisfied or secured, the Bankruptcy Court focused on the term “property” and relied on the definition of “property” in Webster’s Dictionary “to conclude that the Conveying Subsidiaries could not have received ‘property’ unless they obtained some kind of enforceable entitlement to some tangible or intangible article.”12 The District Court held that the Bankruptcy Court committed legal error in relying on that definition, citing numerous cases which support a “broad” definition of “property” as used in the Bankruptcy Code that may include indirect economic benefits both tangible and intangible.13

The District Court next considered the Bankruptcy Court’s further conclusion that “value” does not include economic “benefits” unless they are mathematically quantifiable. After reviewing the case law in a number of other circuits as to what constitutes reasonably equivalent value, the District Court concluded that “the weight of authority supports the view that indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise’s rehabilitation, and to avoid bankruptcy, even if it provided [sic] short lived, may be considered in determining reasonable [sic] equivalent value. An expectation, such as in this case, that a settlement which would avoid default and produce a strong synergy for the enterprise, would suffice to confer ‘value’ so long as that expectation was legitimate and reasonable.”14

The District Court indicated that the Bankruptcy Court also erred by failing to consider the “'totality of the circumstances' in measuring reasonable equivalency.”15 The District Court found the facts in the TOUSA case evidenced that indirect economic benefits were received by the Conveying Subsidiaries because if the transfers did not take place, the Conveying Subsidiaries would have faced a chapter 11 filing since “[t]he Conveying Subsidiaries’ very existence was contractually tied through their pre-existing guarantees”16of the Revolver and bond debt which would have gone into default if an adverse judgment in excess of $10 million were obtained by the Transeastern Lenders. As the District Court pointed out, without the Transeastern Loan settlement, the Revolver and bond debt would likely have gone into default since at least $421 million was owed to the Transeastern Lenders and, not only had the Transeastern Lenders’ action survived a motion to dismiss, but TOUSA’s management had been advised by their experts and counsel that there was substantial risk of such a judgment and a more favorable settlement was not possible. The District Court further held that the fact that the July 31 Transaction did not assure long term viability for either TOUSA or the Conveying Subsidiaries is not controlling but “it is enough that the July 31 Transaction left the Conveying Subsidiaries in a better position to remain as going concerns than they would have been without the settlement.”17

The District Court further determined that the Bankruptcy Court committed clear error in finding that the indirect benefits to the Conveying Subsidiaries had little or no value, because the Bankruptcy Court’s conclusion that the Conveying Subsidiaries did not need the Transeastern Loan settlement was contradicted by the following: (a) the Conveying Subsidiaries depended on the viability of the TOUSA enterprise as a whole as evidenced by the fact that the TOUSA Revolver was their primary source of liquidity and (b) based on their guaranty of the bond debt alone, the Conveying Subsidiaries would have had to line up hundreds of millions of dollars in alternative financing and negotiated forbearance and subordination agreements with six different groups of bond holders in addition to the secured Revolver lenders. Moreover, the District Court noted that if, as found by the Bankruptcy Court, the Conveying Subsidiaries were insolvent at the time of the July 31 Transaction, then the Conveying Subsidiaries would not have been able to obtain financing of their own.18

The Transeastern Lenders Were Not Entities “For Whose Benefit” the Liens Were Granted to the New Lenders and Were Not Subject to Disgorgement of the Value of such Liens Under Section 550

The District Court also held that the Bankruptcy Court erred in compelling the Transeastern Lenders to disgorge the value of the liens granted under section 550 of the Bankruptcy Code “as entities for whose benefit” the liens to the New Lenders were granted. The District Court first noted that since the predicate for recovery under section 550 is the existence of a fraudulent transfer under section 548, it was not necessary to consider whether the Transeastern Lenders were entities “for whose benefit” the liens to the New Lenders were granted because the District Court had already concluded that the Conveying Subsidiaries had received reasonably equivalent value for the July 31 Transaction and therefore, the transfer of the New Loan proceeds to the Transeastern Lenders could not be avoided under section 548. Nonetheless, anticipating that its decision would be appealed to the Eleventh Circuit, the District Court went on to hold that even if its conclusion as to the existence of reasonably equivalent value is  overturned and the transfer of the New Loan proceeds is adjudged avoidable under section 548, the Conveying Subsidiaries could not recover from the Transeastern Lenders since the Transeastern Lenders were not entities “for whose benefit” the liens had been granted.

The District Court observed that section 550(a) distinguishes between (1) initial transferees and their “beneficiaries” (which are strictly liable) and (2) immediate and mediate transferees of the initial transferee (i.e., subsequent transferees) that have the benefit of defenses under section 550(b)(1) and (2) of the Bankruptcy Code. Only a person who receives a benefit from the initial transfer can be an entity for whose benefit the initial transfer was made and not someone who receives a benefit as the result of a subsequent transfer. The District Court noted that since the liens were initially transferred to the New Lenders (who exercised control over the liens), the New Lenders were the initial transferees and, since at all times the liens remained with the New Lenders, the Transeastern Lenders could not be “subsequent transferees.” The Bankruptcy Court’s theory had been that the Transeastern Lenders were beneficiaries of the lien “transfers” because the liens facilitated the New Loans which funded the payment of their Settlement. The District Court disagreed, concluding that for purposes of section 550(a)(1), the “benefit” must derive from the transfer itself and not the “use” to which it was put by the initial transferee.19 The District Court concluded that because the Transeastern Lenders were subsequent transferees of the New Loan proceeds that were backed by the liens (and not transferees of the liens themselves), the Transeastern Lenders were not entities for whose benefit the liens were granted.

The District Court further held that not only did the Bankruptcy Court err in finding strict liability under section 550(a)(1), but also to the extent that the Transeastern Lenders were subsequent transferees, the Committee was precluded from recovering under section 550(a)(2) by virtue of section 550(b)(1), which precludes recovery from “a transferee that takes for value, including satisfaction...of a[n]...antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided,” or by virtue of section 550(b)(2) which precludes recovery from ‘any immediate or mediate good faith transferee of such transferee.’”20 The District Court concluded that remand to consider the status of the Transeastern Lenders as a “transferee” was unnecessary since if the Transeastern Lenders could be considered the “immediate transferee of the proceeds” they nevertheless were a transferee that took “for value”, i.e., the payment of a valid, antecedent debt of TOUSA, and there was insufficient evidence to prove that the Transeastern Lenders acted in bad faith. Thus, there was no basis for recovery of the New Loan proceeds from the Transeastern Lenders under section 550(a)21and the Bankruptcy Court’s order that the Transeastern Lenders disgorge the New Loan proceeds was overturned.

Reversal of “Bad Faith” Finding and Suggested Due Diligence Requirement

The District Court also held that the Bankruptcy Court erred in concluding that “it is ‘bad faith’ for a creditor of someone other than the debtor to accept payment of a valid, tendered debt repayment outside of any preference period, through settlement or otherwise, if the creditor does not first investigate the debtor’s internal refinancing structure and ensure that the debtor’s subsidiaries had received fair value as part of the repayment, or that the debtor and its subsidiaries, in an enterprise, were not insolvent or precariously close to being insolvent.”22 The District Court held that such "standard is patently unreasonable and unworkable” and observed  that “the Bankruptcy Court’s improper finding [would] impose extraordinary duties of due diligence on the part of creditors accepting repayment-duties that equal or exceed those imposed on lenders extending credit in the first place” where “the Transeastern Lenders, as recipients of a debt payment had no reason or legal duty to conduct such extraordinary due diligence with respect to the provenance of the funds with which they were being repaid.”23 Had the Bankruptcy Court’s standard  applied, it would severely limit lending to distressed companies since, if a lender determined through such diligence that (i) a debtor’s subsidiaries would not receive reasonably equivalent value as a result of the repayment or (ii) the debtor and its subsidiaries were insolvent or to be rendered insolvent, the likely result would be that there could be no refinancing or settlement and the debtor and its subsidiary guarantors would have to file for relief under the Bankruptcy Code.

The District Court's decision clarifies numerous issues with respect to the application of sections 548 and 550 of the Bankruptcy Code to the avoidability of liens granted by subsidiaries of multi-tiered corporate enterprises for loans obtained to repay valid, antecedent indebtedness of the parent and an affiliate that was not secured by such liens and the recoverability of proceeds of new loans secured by such liens. Nonetheless, the decision does not address parts of the Bankruptcy Court’s decision that are the subject of the appeal by the New Lenders currently pending before a different District Judge. We will have to await that decision and potentially the determination of an appeal to the Eleventh Circuit of both decisions before the chapter is closed on the TOUSA litigation.

For more information, please contact:

Ezra Cohen

Atlanta

404-885-3116

Jeff Kelley

Atlanta

404-885-3383

Carolyn Richter

Atlanta

404-885-3358

John Campo

New York

212-704-6075

Dan Chambers

Orange County

949-622-2724

Richard Hagerty

Tysons Corner

703-734-4326

Jonathan Hauser

Virginia Beach

757-687-7768

Mitch Perkiel

New York

212-704-6016

Ashley Story

Raleigh

919-835-4103

Lee Stremba

New York

212-704-6143

Marty Taylor

Orange County

949-622-2718


1In re TOUSA, Inc. (3V Capital Master Fund Ltd. v. Official Comm. of Unsecured Creditors of TOUSA, Inc.), 2011 WL 522008 (S.D. Fla. 2011).

2In re TOUSA, Inc. (Official Comm. of Unsecured Creditors v. Citicorp N.A., Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009).    

3TOUSA and the Conveying Subsidiaries also entered into a refinancing of TOUSA’s revolving credit agreement between TOUSA and Citicorp N.A. (the “Revolver”) at the time of the July 2007 loan transactions.  (The transactions on July 31, 2007 are collectively referred to as the “July 31 Transaction”.)  In October 2006, many of the Conveying Subsidiaries had pledged their assets pursuant to the Revolver.  In January 2007, some of the Conveying Subsidiaries were added as Subsidiary Borrowers on the Revolver.  Many of the Conveying Subsidiaries were also guarantors of in excess of $1 billion of bond indebtedness.

42011 WL 522008 at *38.

52011 WL 522088 at *23, citing, Nordberg v. Societe Generale (In re Chase & Sanborn Corp.), 848 F.2d 1196, 1199 (11th Cir. 1988).

6422 B.R. at 205-206.

72011 WL 522008 at *23-24, citing, In re Chase & Sanborn Corp., 813 F.2d at 1181-82.

82011 WL 522008 at *24, citing, Tolz v. Barrett Bank of S. Fla. (In re Safe-T-Brake of S. Fla, Inc.), 162 B.R. 359, 365 (Bankr. S. D. Fla. 1993).  The District Court noted that control does not exist where the loan from the third party was conditioned on payment to a particular creditor.  (Howdeshell of Ft. Myers v. Dunham-Bush, Inc. (In re Howdeshell of Fort Myers), 55 B.R. 470, 474-75 (Bankr. M.D. Fla. 1985).)

92011 WL 522008 at *28. The District Court observed that the Bankruptcy Court’s reasoning was flawed in that if the Transeastern Lenders received valuable property from the Conveying Subsidiaries, then the value of the New Loan proceeds could not have been deemed “minimal” when the New Loan proceeds were previously transferred from the New Lenders to the Conveying Subsidiaries as part of the July 31 Transaction.

102011 WL 522008 at *30.

1111 U.S.C. §548(d)(2)(A).

122011 WL 522008 at *31.

132011 WL 522008 at *31-32.

142011 WL 522008 at *36.  The District Court held that “[t]he touchstone is whether the transaction conferred reasonable commercial value on the debtor.”

152011 WL 522008 at *37.

16Id.

172011 WL 522008 at *38.  The District Court further pointed out that by virtue of the July 31 Transaction the “net worth” of the Conveying Subsidiaries was preserved and imminent default averted, thereby allowing the enterprise to continue to meet its bond interest obligations and Revolver loan payments, and noted that payments in excess of $65 million were made on the Revolver that presumably benefitted the unsecured creditors.  The District Court concluded that under those circumstances no further proof of “quantification” was necessary to establish reasonably equivalent value.  2011 Westlaw 522008 at *39.

182011 WL 522008 at *41-42.  The District Court rejected the Bankruptcy Court’s conclusion that the fact that the Conveying Subsidiaries assets were not pledged to secure the Transeastern Loan meant they could have obtained alternate “stand alone” financing and noted that the same assets were already pledged under the Revolver.

192011 WL 522008 at *47.

202011 WL 522008 at *47 and *48.

21Id.

22Id.

23 2011 Westlaw 522008 at *48 and *49.

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