Wednesday, May 30, 2012

Tousa: A Cautionary Tale for Lenders

On May 15, 2012, the Eleventh Circuit Court of Appeals issued its long-awaited decision in the In re: Tousa, Inc.  fraudulent transfer litigation.  The Court affirmed the Bankruptcy Court holding that the “Transeastern Lenders” received fraudulent transfers when Tousa, Inc., the parent company paid a settlement of $421 million dollars to the Transeastern Lenders which was funded by a loan from “the New Lenders” secured primarily by the assets of several Tousa subsidiaries, “Conveying Subsidiaries,” who were not themselves legally obligated to the Transeastern Lenders.

The Tousa decision is a cautionary tale.  Companies that are dealing with troubled debtors who are receiving repayment of substantial debts will have to be wary and exercise due diligence and consider their potential exposures for fraudulent transfers after this decision.

At trial, the Bankruptcy Court ruled the subsidiaries did not receive reasonable equivalent value in exchange for the liens to secure the loans from the New Lenders and the Transeastern Lenders were entities for whose benefit the Conveying Subsidiaries transferred the liens and liable for repayment of the funds under 11 U.S.C. §550(a)(i).  Before being affirmed by the Eleventh Circuit, the decision of the Bankruptcy Court was widely criticized in the blogosphere and reversed by the District Court.

Prior to the bankruptcy Tousa, Inc. had issued in excess of $1 billion dollars of public bonds which were unsecured but guaranteed by certain of its subsidiaries.  Tousa also had a line of credit administered by Citicorp secured by the subsidiaries’ assets.  Under both obligations, it would be an event of default if Tousa or any of its subsidiaries suffered an adverse judgment in excess of $10 million.

In 2005, Tousa entered into a joint venture to acquire assets known as the Transeastern Assets.  This joint venture was separately funded with debt from the Transeastern Lenders but none of the subsidiaries were obligated on that debt.  The joint venture eventually defaulted and the Transeastern Lenders sued Tousa.  Tousa entered into a $420 million dollar settlement with the Transeastern Lenders which Tousa funded with new debt guaranteed and secured by the Conveying Subsidiaries.  Under the loan documents, the loan proceeds had to be paid to the Transeastern Lenders.

In the Bankruptcy Court litigation, the Committee alleged that the transfer was fraudulent as to the Conveying Subsidiaries because they were rendered insolvent by the liens and did not receive reasonably equivalent value.  The Committee further contended that the Transeastern Lenders were entities for whose benefit the transfer, i.e. the granting of the liens, occurred.

The Transeastern Lenders (and the New Lenders who intervened) argued that the Conveying Subsidiaries received reasonably equivalent value, particularly the economic benefit of avoiding a default and bankruptcy.  Other benefits included a higher debt ceiling, tax benefits, elimination of adverse effects of the litigation and that their parent company, which provided them with centralized administrative services, would continue to survive.  The Transeastern Lenders further argued that they were not entities for whose benefit the transfer was made because they were subsequent transferees.

The Eleventh Circuit held that the Bankruptcy Court’s findings of fact (after a thirteen day trial and the admission of over 1,800 exhibits) were not clearly erroneous when the Court found that the Conveying Subsidiaries did not receive reasonably equivalent value and the Transeastern Lenders were entities for whose benefit the liens were transferred.

The Court’s recitation of the facts is fascinating, particularly the discussion of the economic conditions that existed as of July 2007, when the Transeastern settlement was reached.  The Transeastern Lenders attempted to argue that it was the Lehman Brothers tsunami that caused Tousa’s inevitable demise and not conditions as they might have existed in July, 2007.  The contrary findings by the Bankruptcy Court were upheld on appeal.

As to the legal issue under 11 U.S.C. §550, the Transeastern Lenders argued that they could not be liable because the loan proceeds benefited Tousa as they passed through a Tousa subsidiary (a title company) before they were transferred to the Transeastern Lenders.  The court rejected that argument as a technicality because the Tousa subsidiary never had control over the funds and was required, under the loan documents, to disburse immediately to the Transeastern Lenders.

The Transeastern Lenders also argued that the expansive reading of §550(a) and the definition of an entity for whose benefit a transfer was made would drastically expand the potential pool of entities that could be liable.  However the Court found that those concerns were unsubstantiated.  The Eleventh Circuit may have created a new legal standard 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.”  Slip Op at 39.  The Eleventh Circuit remanded on the issue of remedies.

Eckert Seamans Cherin & Mellott, LLC

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