Contributed by Debra A. Dandeneau.
Yesterday, the United States Court of Appeals for the Eleventh Circuit upheld the decision of the Bankruptcy Court for the Southern District of Florida holding that liens granted by subsidiaries of a borrower to refinance obligations owed to the borrower’s lenders constituted fraudulent transfers under section 548(a)(1) of the Bankruptcy Code with respect to those lenders. In reversing the district court’s decision, the Eleventh Circuit held that the bankruptcy court did not clearly err when it found that subsidiaries of TOUSA (referred to in the opinion as the “Conveying Subsidiaries”) that granted liens to new lenders to refinance obligations of existing lenders (referred to in the opinion as the “Transeastern Lenders”) did not receive reasonably equivalent value in exchange for the granting of such liens. The Eleventh Circuit also held that the bankruptcy court correctly ruled that the Transeastern Lenders were entities “for whose benefit” the liens were transferred under section 550(a)(1) of the Bankruptcy Code.
The Eleventh Circuit’s decision, as well as the earlier decisions by the district court and bankruptcy court, discuss the factual background of the case in detail. In essence, after TOUSA defaulted on approximately $2 billion of debt owed to the Transeastern Lenders, it entered into a series of agreements to address the default. Among other things, TOUSA entered into new second and first lien credit facilities and used $421 million drawn under the new credit facilities to repay, in part, amounts owed to the Transeastern Lenders. The new credit facilities were secured, among other things, by liens on the assets of the Conveying Subsidiaries; the Conveying Subsidiaries, however, had not been liable under the debt owed to the Transeastern Lenders.
After TOUSA and the Conveying Subsidiaries filed for chapter 11 protection, TOUSA’s unsecured creditors’ committee commenced an action challenging the liens granted to the new lenders as fraudulent transfers under section 548(a)(1) of the Bankruptcy Code because, it claimed, the Conveying Subsidiaries had not received reasonably equivalent value in exchange for securing the new credit facilities. The unsecured creditors’ committee sought to recover the value of such liens from the Transeastern Lenders under section 550(a)(1) of the Bankruptcy Code on the ground that the Transeastern Lenders were the entities for whose benefit the liens had been granted.
Although the Conveying Subsidiaries were not obligated under the debt owed to the Transeastern Lenders, the Transeastern Lenders argued that the Conveying Subsidiaries did receive a benefit as a result of the settlements that led to, among other things, the new credit facilities and the paydown of the Transeastern Lenders’ debt. Among the benefits they asserted the Conveying Lenders received was that, in the absence of the settlement, the defaults under the Transeastern Lenders’ debt likely would have led to a judgment against TOUSA that would, in turn, have led to a cross-default on over $1 billion of debt that the Conveying Subsidiaries had guaranteed. The Transeastern Lenders also argued that, even if the Conveying Subsidiaries’ granting of the liens were avoidable under section 548(a)(1) of the Bankruptcy Code, the value of such liens could not be recovered from the Transeastern Lenders because TOUSA, not the Transeastern Lenders, was “the entity for whose benefit such transfer was made.”
The bankruptcy court adopted the arguments of the unsecured creditors’ committee, but the district court reversed the bankruptcy court’s decision.
Although the trial testimony before the bankruptcy court included testimony on the issue of whether the insolvency tests of the fraudulent transfer statute had been met, the focus of the Eleventh Circuit appeal was on the issue of whether the Conveying Subsidiaries had received “reasonably equivalent value” in exchange for granting liens on their assets to secure the new credit facilities. The Eleventh Circuit declined to weigh in on the dispute between the bankruptcy court and the district court of how narrowly “value” should be construed in the context of determining “reasonably equivalent value,” with the district court adopting a broad definition of “value” that could include the avoidance of bankruptcy. Instead, the Eleventh Circuit simply concluded that “[t]he record supports the finding by the bankruptcy court that, for the Conveying Subsidiaries, the almost certain costs of the [new credit facilities] far outweighed any perceived benefits.”
While not rejecting the view that avoidance of bankruptcy may constitute a benefit, the Eleventh Circuit noted that “not every transfer that decreases the odds of bankruptcy for a corporation can be justified.” A reversal of the bankruptcy court’s ruling would require a determination that the bankruptcy court was clearly erroneous when it found that the expected costs to the Conveying Subsidiaries from participating in the refinancing transaction outweighed the expected costs to the Conveying Subsidiaries.
At the core of the bankruptcy court’s conclusion was a determination that bankruptcy for the TOUSA enterprise, including the Conveying Subsidiaries, was “inevitable.” The Eleventh Circuit noted that, in making that determination, the bankruptcy court “based its extensive findings on a thorough review of public knowledge available before July 31, 2007; expert analysis of data available before July 31, 2007; and statements by TOUSA insiders made before July 31, 2007,” whereas the lenders only cited “the opinions of a TOUSA advisor that the company would remain viable after the transaction” and statements from TOUSA’s CEO about plans to restructure and rebuild the TOUSA enterprise. Calling on a metaphor well understood by residents of TOUSA’s home state of Florida, the Eleventh Circuit found that “the record supports a determination that the bankruptcy of TOUSA was far more like a slow-moving category 5 hurricane than an unforeseen tsunami.” Accordingly, the Eleventh Circuit concluded that the record supported the bankruptcy court’s decision that there was no chance that the Conveying Subsidiaries would see a “return on their investment” by granting liens to support the new credit facilities.
Having concluded that the bankruptcy court correctly found that the elements of a fraudulent transfer under section 548(a)(1) of the Bankruptcy were satisfied, the Eleventh Circuit turned to the issue of whether the value of the transfers could be recovered from the Transeastern Lenders under section 550(a)(1) of the Bankruptcy Code as the entities “for whose benefit such transfer was made.” The difference between finding that an entity falls under the “initial transferee” provision of section 550(a)(1), as opposed to the “subsequent transferee” provision of section 550(a)(2) is that a subsequent transferee may defend against a fraudulent transfer recovery under section 550(b)(1) of the Bankruptcy Code to the extent that it “takes for value …, in good faith, and without knowledge of the voidability of the transfer.” Such defense, however, is not available to an initial transferee.
The Transeastern Lenders argued that the entity for whose benefit the liens had been transferred was TOUSA, their borrower. The Eleventh Circuit rejected this argument, though, noting that the loan agreements for the new credit facilities required that the proceeds be paid to the Transeastern Lenders. The court also noted that the concept of a party that benefits from a transfer, even when it may not receive the transfer directly, was established by the Eleventh Circuit’s decision in In American Bank of Marin County v. Leasing Service Corp. In re Air Conditioning, Inc. of Stuart). In Air Conditioning of Stuart, the court found that an unsecured creditor could be held liable for a preference recovery under section 547(b) of the Bankruptcy Code when the debtor granted a lien on its assets to its lender in order to procure a letter of credit for the benefit of the unsecured creditor. The court rejected the arguments of the Transeastern Lenders that Air Conditioning of Stuart was distinguishable because it involved a preference and involved a letter of credit, holding that the preference in Air Conditioning of Stuart and the fraudulent transfer in TOUSA had “material similarities” and that the Transeastern Lenders did not “provide a principled basis for limiting section 550(a)(1) to factual scenarios that involve letters of credit.”
Finally, the court rejected the Transeastern Lenders’ argument that they were not the initial transferees because 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 moved by the Transeastern Lenders’ arguments that such a conclusion would be a harmful expansion of section 550(a)(1), 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.”
Because the district court had reversed the bankruptcy court’s fraudulent transfer ruling, the district court never addressed the parties’ arguments on the appropriate remedies to apply against the lenders. Accordingly, the Eleventh Circuit declined to rule on the remedies and remanded the case to the district court to consider the remedies in light of the court’s decision.
Disclosure: Although Weil is not counsel of record on the fraudulent transfer case discussed above, we do represent parties in connection with the TOUSA bankruptcy.