On May 15, 2012, the Eleventh Circuit Court of Appeals upheld a ruling by the U.S. Bankruptcy Court for the Southern District of Florida, which required certain lenders to return $403 million in prepetition payments they had received from TOUSA, Inc. because the new loan TOUSA obtained to make those payments was a fraudulent transfer. The Eleventh Circuit’s decision raises serious questions regarding whether lenders whose loans are paid off in a refinancing may be forced to disgorge or return funds to a debtor if the refinancing loan is later found to be avoidable under the bankruptcy code. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA, Inc.), Case No. 11-11071 (11th Cir. May 15, 2012).
TOUSA was a large homebuilder that, through its various subsidiaries, operated throughout the United States. In June 2005, TOUSA and a subsidiary guaranteed a loan made by the Transeastern Lenders to a joint venture operated by the subsidiary and a third party. The loan from the Transeastern Lenders was not secured or guaranteed by TOUSA’s other subsidiaries. In January 2007 the Transeastern Lenders alleged that TOUSA was in default of its obligations and owed the Transeastern Lenders over $2 billion.
In June 2007 TOUSA reached settlement agreements with, among others, the Transeastern Lenders, and agreed to pay those lenders $421 million. TOUSA financed this payment through a new loan from another syndicate of lenders. Many members in the new syndicate were also Transeastern Lenders. Because of TOUSA’s deteriorating financial condition, the new lenders required that the new loan be secured and guaranteed by certain TOUSA subsidiaries that were not obligated to the Transeastern Lenders. The new lenders also required that proceeds of the new loan be used to pay the Transeastern Lenders. On July 31, 2007, a subsidiary of TOUSA received the proceeds of the new loan and immediately paid $421 million to the Transeastern Lenders. Six months later, TOUSA and the subsidiaries which guarantied the new loan filed chapter 11 cases.
The creditors’ committee appointed in the subsidiaries’ bankruptcy cases sought to avoid the liens securing the new loan as fraudulent transfers under bankruptcy code section 548, and to recover damages from the Transeastern Lenders under bankruptcy code section 550(a)(1). Section 548 provides, among other things, that a debtor may avoid any transfer where the debtor (1) received less than reasonably equivalent value, and (2) was insolvent at the time of, or was rendered insolvent by, the transfer. Section 550(a)(1) permits a debtor to recover damages for a fraudulent transfer from “the initial transferee of such transfer or the entity for whose benefit such transfer was made . . . .”
After a lengthy trial, the bankruptcy court found that the liens granted by the subsidiaries to secure the new loan were fraudulent transfers, because the subsidiaries did not receive reasonably equivalent value and were insolvent at the time they granted the liens. The bankruptcy court also determined that the liens were issued for the benefit of the Transeastern Lenders – notwithstanding that they secured obligations to the new lenders – and accordingly the Transeastern Lenders were liable for damages resulting from those liens.
On appeal by the Transeastern Lenders and the new lenders, the U.S. District Court for the Southern District of Florida reversed the bankruptcy court on both points. The district court found that the new loan allowed TOUSA to settle with the Transeastern Lenders, which avoided an event of default under other TOUSA debt agreements and provided TOUSA and its subsidiaries the opportunity to avoid bankruptcy. Without quantifying the value of this opportunity, the district court determined that it constituted reasonably equivalent value for the liens granted by the subsidiaries. Moreover, the district court determined that the liens were for the benefit of the new lenders, not the Transeastern Lenders, and therefore the Transeastern Lenders could not be liable under section 550(a)(1). We have previously discussed the district court’s decision, as well as the consequences to lenders of both the bankruptcy court’s and district court’s interpretation of “reasonably equivalent value” in the context of a refinancing loan, in detail here.
On further appeal from the district court, the Eleventh Circuit reinstated the bankruptcy court’s decision on both counts. The Eleventh Circuit found that the liens were granted for the benefit of the Transeastern Lenders – and accordingly that the Transeastern Lenders could be held liable as an initial transferee under section 550(a)(1) of the bankruptcy code – because (1) the new loan required TOUSA to use the loan proceeds to pay the Transeastern Lenders, and (2) TOUSA needed the new loan to have funds to pay the Transeastern Lenders the amounts due under their settlement. The Court dismissed the Transeastern Lenders’ argument that they were not initial transferees of funds from the New Lenders because the funds flowed to the Transeastern Lenders through a TOUSA subsidiary, rather than directly from the New Lenders. Rather, in determining that the Transeastern Lenders were initial transferees, the Court adopted what it referred to as a “flexible, pragmatic” approach to the overall refinancing transaction that focused on the fact that TOUSA never had control over the funds used to pay the Transeastern Lenders, and TOUSA was contractually required to use those funds to immediately pay the Transeastern Lenders. The Court did not expressly find that the structure of the refinancing transaction was influenced or designed by the Transeastern Lenders or indicate whether any such determination would have been relevant to its analysis.
The Eleventh Circuit’s decision raises serious questions for a large segment of the credit market. Taken on its face, the Eleventh Circuit’s reasoning may mean that a lender whose loan is refinanced – regardless of whether the lender consents to the refinancing – may be liable if the refinancing loan requires that the proceeds be used to pay off existing debt and the refinancing loan is subsequently deemed to be a fraudulent transfer. This is troubling, as companies often obtain secured debt (including debt secured by operating subsidiaries) to refinance unsecured holding company debt that is maturing at a time when the company is no longer investment grade or is otherwise unable to refinance on an unsecured basis. Under the Eleventh Circuit’s decision, the existing holding company lenders may be at risk of liability if, even years after the refinancing, the company files a chapter 11 case and the refinancing loan is deemed to be a fraudulent transfer
The Eleventh Circuit’s opinion is fairly brief, and it is possible that its interpretation of bankruptcy code section 550 is not so broad. The Court noted that the new lenders included some Transeastern Lenders, and “these lenders essentially converted their unsecured loans to the [joint venture] into secured loans to TOUSA and the [subsidiaries]”. The Court’s decision could be limited to these facts and to similar circumstances where a refinancing is in actuality the same lenders improving their collateral or priority at the expense of other creditors.
The Court did not expressly limit the reach of its opinion in that way, however, and did not seem concerned that its decision should be limited. Rather, the Court put the onus on all creditors, including trade and other non-lender creditors, to “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 the debtor,” to determine whether payment is being made from proceeds of a loan that may be a fraudulent transfer. While that statement could be reasonable in light of the record before the Eleventh Circuit – where the Transeastern Lenders appear to have had insight into the new loan’s terms and TOUSA was on the verge of bankruptcy – it is troubling as a general proposition. Creditors often have little to no ability to perform diligence on the origins of the funds being paid to them. Moreover, requiring all creditors to perform this diligence would impose significant friction costs on doing business with any company suffering financial uncertainty.
Furthermore, lenders generally cannot block a borrower from repaying its obligations to them, including through proceeds of a new loan. If, as is often the case, a lender is unable to refuse payment from a borrower, the lender may be left in the untenable position of being exposed to potential fraudulent transfer liability for years after its loan has been repaid without any ability to protect itself or preserve its rights against the borrower. This result could have significant consequences for credit markets.
The Eleventh Circuit’s TOUSA decision raises important questions regarding lenders’ exposure to fraudulent transfer liability in circumstances where their loans have been refinanced. It is unclear what steps lenders may take to avoid this risk absent covenants in their loan documents that permit the lenders to affect the terms on which their loans are refinanced, including at maturity. Going forward, lenders may need to consider protective covenants designed to address this issue.
Cadwalader will discuss those mechanisms in future analysis of this important decision.