FL Bankruptcy Court Finds TOUSA Loans Fraudulent Transfers

Practical Law Legal Update 5-500-5311 (Approx. 5 pages)

FL Bankruptcy Court Finds TOUSA Loans Fraudulent Transfers

by PLC Finance and Practical Law Bankruptcy & Restructuring

Key Litigated Issues

Fraudulent Transfers

Fraudulent transfers (or fraudulent conveyances) consist of certain transfers of a debtor's interest in property (or the incurring of an obligation) made voluntarily or involuntarily within two years before a bankruptcy filing. The law concerning fraudulent transfers serves to protect unsecured creditors by ensuring that property of the debtor is not unfairly transferred beyond their reach before the debtor files for bankruptcy.

According to Section 548 of the Bankruptcy Code, a fraudulent transfer can be avoided if it was made with actual intent to delay, hinder or defraud creditors. The property of the bankruptcy estate can then be recovered to distribute to unsecured creditors. Transfers can also be constructively fraudulent and avoided, regardless of intent, if the debtor received less than reasonably equivalent value for the transfer and was insolvent at the time of, or rendered insolvent, by the transaction (or experienced certain other states of financial distress).

For more information on fraudulent transfers, see Practice Notes, Fraudulent Conveyances in Bankruptcy: Overview and Fraudulent Conveyances: Issues and Strategies for Lenders and Private Equity Sponsors.

Savings Clauses

Limitation of liability clauses are also known as "savings clauses" because they operate to "save" a transaction, such as a guaranty, that might otherwise be entirely avoided as a fraudulent transfer. It is intended to limit liability under the guaranty to an amount that will not be avoidable as a fraudulent transfer under the Bankruptcy Code.

For an example and explanation of a Savings Clause, see Standard Clause, Savings Clause.

Background

TOUSA Inc. and its subsidiaries design, build and market houses. In June 2005, TOUSA Inc. entered into a joint venture, Transeastern Joint Venture, which was partially funded by loans from certain lenders (the Transeastern Lenders). None of TOUSA's Conveying Subsidiaries was an obligor or guarantor on this debt to the Transeastern Lenders. Due partly to losses resulting from a poor housing market, TOUSA began defaulting on its obligations under the Transeastern Joint Venture loans. The Transeastern Lenders then sued TOUSA for repayment and damages under the associated loan agreements.

On July 31, 2007, TOUSA took on $500 million of new debt to finance a settlement of about $420 million with the Transeastern Lenders in connection with its litigation over the Transeastern Joint Venture financing (the July Transaction). To complete the settlement, TOUSA borrowed $200 million under a $200 million first lien term loan credit agreement with Citicorp (Citi) as administrative agent and $300 million under a $300 million second lien term loan credit agreement with Citi as administrative agent. Citi was then replaced by Wells Fargo Bank as administrative agent for the second lien term loan facility. TOUSA also amended its revolving credit agreement with Citi as administrative agent. As part of the credit agreements, TOUSA agreed to use the cash to pay the settlement to the Transeastern Lenders and secured both loans with all of its assets, including those of the Conveying Subsidiaries (who limited their liability with a savings clause).

After its financial condition continued to worsen, TOUSA and its subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code on January 28, 2008. The creditors' committee in this case represents the interests of the unsecured creditors, primarily bondholders owed a principal amount slightly over $1 billion.

Outcome

On October 13, 2009, Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida (Court) issued an opinion that the liens granted by the Conveying Subsidiaries in connection with the loans to TOUSA were fraudulent transfers and will be avoided and all claims by the first and second lien lenders against the Conveying Subsidiaries are disallowed. The Court ordered that the first and second lien lenders pay back to the Conveying Subsidiaries' estates any principal, interest, costs, expenses and fees gained from the liens imposed on the Conveying Subsidiaries.

In addition, the Court ordered the Transeastern Lenders pay back $403 million plus prejudgment interest to the Conveying Subsidiaries' estates. The Court left open the option for the Transeastern Lenders to file a claim against TOUSA stemming from the failed joint venture financing.

In its decision, the Court also found that the security interest in the tax refund was a preference and should also be avoided and any portions paid out to the first lien lenders should be paid back (for more information about preferences, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors).

Significant in the Court's holding was its rejection of the savings clause as unenforceable. Referring to savings clauses in his opinion, Judge Olson said, "They are, in short, entirely too cute to be enforced." The decision also held that the "common enterprise" approach is inappropriate when conducting a valuation and solvency analysis of subsidiaries and the Court focused on the use of solvency opinions and the credibility of expert witnesses.

Fraudulent Transfers

The Court found that there had been a fraudulent transfer (so the liens could be avoided and the claims disallowed) because the Conveying Subsidiaries:

Did not receive reasonably equivalent value in exchange for the liens they granted.
The Conveying Subsidiaries did not receive any direct benefit because the money went to satisfy TOUSA's settlement obligation. The incidental and indirect benefits received were ruled to not be sufficient because it did not improve their day-to-day operations, nor did they gain any indirect benefit from stalling the bankruptcy of TOUSA.
Were insolvent both before and after the July Transaction.
In finding that TOUSA was insolvent before the July Transaction, the Court cited, among other factors, the poor conditions in the housing market and TOUSA's business, Citi's significant doubts about TOUSA's solvency, the deterioration in TOUSA's business as reflected in its syndication process for new loans and the large personal incentives that TOUSA's executives had for completing the deal.
AlixPartners, the company that provided a solvency opinion for Citi, also received double the amount in fees when it found TOUSA solvent before the consummation of the deal, as opposed to the lesser amount it would have received had it found insolvency. The Court also found that TOUSA was not completely honest in the financial information it provided to AlixPartners.
In addition, the creditors' committee was able to show through credible expert evidence in court that once the transaction was completed, the situation for TOUSA was dire, eventually leading to its January 2008 bankruptcy filing. The Court found the defendant's experts less reliable and credible. The Court also rejected the lenders' arguments that they acted in good faith.
The Court also rejected that the analysis of the subsidiaries' solvency in this case must be done on a "common enterprise" basis. This decision was based on several factors, including it being wrong as a matter of law, that this type of analysis lacks any roots in statutory law and the expert furnished no standard by which to tell when a complex corporate organization should or should not be considered a common enterprise.
Were left with unreasonably small capital with which to operate their businesses as a result of the July Transaction.
TOUSA and its subsidiaries were left with a large debt at a difficult time in their business after the July Transaction, including a debt capitalization ratio of 71.3%, which is higher than typical for comparable homebuilders.

The Court also held that because the security interest in the tax refund claim was perfected within the preference period and at a time when the Conveying Subsidiaries were insolvent, and that recognition of the security interest would enable the lenders to receive more than they would receive in a Chapter 7 liquidation, the security interest in the tax refund was a preference and will be avoided (§ 547(b), Bankruptcy Code).

Savings Clauses

Savings clauses purport to amend liabilities and liens to make them enforceable to the maximum extent permitted by law. However, because the Conveying Subsidiaries were insolvent at the time of the July Transaction and received no value from it, the Court held the liabilities and liens were not enforceable at all. As a result, any liability or lien would be avoidable. In this circumstance, the savings clauses have no effect at all.

The Court also gave other reasons to find the savings clauses unenforceable, including that efforts to contract around the Bankruptcy Code are invalid and, because of the circular nature of the interaction between two savings clauses, that they create unenforceable inherently indefinite contract terms. Referring to savings clauses in his opinion, Judge John K. Olsen said "They are, in short, entirely too cute to be enforced."

Practical Implications

The Court's ruling is important because until now, the enforceability of savings clauses has not been tested in the courts. Savings clauses are very common in financing transactions, and if this decision is followed by other courts, it could have a dramatic impact on guaranties in bank financings.

In addition, in connection with the analysis of reasonably equivalent value, the Court found that the Conveying Subsidiaries did not receive any direct or indirect benefits in exchange for securing TOUSA's liabilities in the July Transaction. The decision suggests that indirect benefits to a subsidiary must be more tangible than mere incidental benefits resulting from the postponement of its parent's bankruptcy.

The Court also rejected a solvency opinion due to its questionable creation, making the circumstances and process by which a solvency opinion is created more important. It also rejected the common enterprise approach in connection with the solvency analysis which means analysis may now have to be considered on a debtor-by-debtor basis.

It is likely that this decision will be appealed.

For more information on Chapter 11 bankruptcies, see Practice Note, Bankruptcy: Overview of the Chapter 11 Process.

FL Bankruptcy Court Finds TOUSA Loans Fraudulent Transfers | Practical Law