On May 15, 2012, in a much-anticipated opinion¹ in the TOUSA, Inc. (“TOUSA”) bankruptcy cases, the U.S. Court of Appeals for the Eleventh Circuit (the “Circuit Court”) affirmed the widely criticized ruling of the U.S. Bankruptcy Court of the Southern District of Florida (the “Bankruptcy Court”)², which had avoided certain liens as fraudulent transfers and ordered the Transeastern Lenders to disgorge more than $400 million of loan proceeds. The decision of the Bankruptcy Court had been previously overruled by the U.S. District Court for the Southern District of Florida (the “District Court”)³ as it related to the disgorgement of loan proceeds by the Transeastern Lenders. The Circuit Court’s ruling endorses a more limited reading of what constitutes “reasonably equivalent value” within the meaning of fraudulent conveyance law and expands the scope of the parties subject to fraudulent conveyance claims. Both rulings have significant implications for the lending community.

Background
TOUSA was a residential homebuilder in certain states, including Florida and Texas. TOUSA had many subsidiaries, which actually owned most of the assets of the group. TOUSA had financed its activities through the issuance of more than $1 billion of public bonds, which were unsecured but were guaranteed by several of TOUSA’s subsidiaries (the “Conveying Subsidiaries”).

In June 2005, TOUSA and another partner formed a joint venture to acquire certain homebuilding assets in Florida. The joint venture financed the acquisition with the proceeds of loans made by a group of lenders known as the “Transeastern Lenders.” The loans to the joint venture were guaranteed by TOUSA but not by any of the Conveying Subsidiaries. The joint venture defaulted on the loans, and the Transeastern Lenders sued TOUSA under its guaranty. TOUSA agreed to settle the litigation by paying the Transeastern Lenders $421 million. TOUSA financed the settlement with the proceeds of new first- and second-lien loans (the “New Loans”) made by a group of mostly new lenders (the “New Lenders”) to TOUSA and the Conveying Subsidiaries. The loans were secured by liens on all of the assets of TOUSA and the Conveying Subsidiaries. The new loan agreement required that the proceeds of the New Loans be used to fund TOUSA’s settlement with the Transeastern Lenders.

The residential real estate market continued to deteriorate after the New Loans were made, and within six months of the making of the New Loans, TOUSA and the Conveying Subsidiaries filed for bankruptcy. The official Committee of Unsecured Creditors (the “Committee”) then brought an action against the New Lenders to avoid the New Loans and the liens granted thereunder as fraudulent transfers and against the Transeastern Lenders to recover the amounts paid to the Transeastern Lenders with the proceeds of the New Loans.

The Bankruptcy Court held that, among other things, the Conveying Subsidiaries did not receive reasonably equivalent value in connection with the liens they granted to secure the New Loans, and such liens were therefore avoidable as fraudulent transfers. In addition, the Bankruptcy Court held that the Transeastern Lenders were entities “for whose benefit” the Conveying Subsidiaries had granted liens under Section 550(a) of the Bankruptcy Code, thereby requiring the Transeastern Lenders to disgorge the loan proceeds they had received.

Reasonably Equivalent Value
The Committee argued in the Bankruptcy Court case that the Conveying Subsidiaries were insolvent when the liens were granted, had unreasonably small capital and/or were unable to pay their debts when due. The Transeastern Lenders seemingly did not contest such arguments, which then required the Bankruptcy Court to determine whether or not the Conveying Subsidiaries received reasonably equivalent value in exchange for granting the liens.

The Transeastern Lenders argued that the Conveying Subsidiaries did receive reasonably equivalent value in the form of indirect benefits, such as preventing a default against TOUSA under the $1 billion bond debt that was guaranteed by the Conveying Subsidiaries. The Bankruptcy Court held that “value” was the equivalent of “property” under Section 548 of the Bankruptcy Code and that in order for the Conveying Subsidiaries to receive property, they had to receive an “enforceable entitlement to some tangible or intangible article,” such as cash. Because the Conveying Subsidiaries did not receive any such “property,” the Bankruptcy Court concluded that they did not receive reasonably equivalent value.

The District Court held that, as a matter of law, the Bankruptcy Court had applied too narrow a definition of “value,” citing, in part, the U.S. Court of Appeals for the Third Circuit’s decision In re R.M.L., Inc., 92 F.3d 139 (3d Cir. 1996)⁴, which held that the “mere opportunity to receive an economic benefit in the future constitutes “value under the [Bankruptcy] Code.” The District Court found economic benefit in the Conveying Subsidiaries’ opportunity to avoid bankruptcy, continue as going concerns and ability to make future payments to creditors as evidence that the Conveying Subsidiaries received reasonably equivalent value.

The Circuit Court, in reversing the District Court, expressly declined to adopt the definition of “value” proffered by the Bankruptcy Court or the District Court and, in particular, whether the possible avoidance of bankruptcy can constitute “value.” In the opinion of the Circuit Court, the question of “value” is a factual analysis. The Circuit Court found that the Bankruptcy Court had determined as a factual matter that even if all of the “purported benefits” of the transaction were considered, the Conveying Subsidiaries did not receive reasonably equivalent value, and the Circuit Court would not overturn the decision of the Bankruptcy Court unless the decision was clearly erroneous. The Circuit Court also concluded that the record supported the findings of the Bankruptcy Court that the bankruptcy of the Conveying Subsidiaries was inevitable and that the obligations incurred by the Conveying Subsidiaries in connection with the New Loans “far outweighed any perceived benefits.” In reaching its conclusion, the Circuit Court discounted the argument of the Transeastern Lenders that they could not be held accountable for failing to foresee the collapse of the residential real estate market.

Section 550/ “For Whose Benefit”
In a transaction that is avoided as a fraudulent transfer, Section 550 of the Bankruptcy Code permits the recovery of the value of the property transferred from an “initial” transferee or from any entity “for whose benefit” the transfer was made. The Transeastern Lenders argued that they did not receive a direct benefit from the initial grant of liens by the Conveying Subsidiaries and were therefore a subsequent transferee and outside the scope of Section 550.

The Bankruptcy Court disagreed with the Transeastern Lenders and held that the Transeastern Lenders were entities “for whose benefit” the liens were granted, that the Transeastern Lenders directly received the benefit of the New Loans and that the New Loans were made with the “unambiguous intent” that the proceeds thereof would repay the Transeastern Lenders.

In rejecting the District Court’s reversal of the Bankruptcy Court, the Circuit Court placed great emphasis on the fact that the loan agreements for the New Loans required the proceeds to be used to repay the Transeastern Lenders and that the litigation settlement expressly depended on the New Loans. The Circuit Court analogized the issue to the benefit received by a guarantor by the payment of the underlying debt of the borrower. The Circuit Court also concluded that its ruling was controlled by the Circuit Court’s prior decision in In re Air Conditioning, Inc. of Stuart, 845 F.2d 293 (11th Circuit 1988). In the Air Conditioning case, a company owed a creditor a certain sum of money. When the company fell behind on payments, the parties worked out an arrangement pursuant to which the company obtained a loan from a lender secured by a grant by the company of a security interest in a certificate of deposit and, in turn, the lender issued a letter of credit in favor of the creditor to backstop the company’s payment obligations to the creditor. When the company filed for bankruptcy shortly thereafter (and within 90 days of the grant of the security interest), the Circuit Court deemed the grant of the security interest in the certificate of deposit to be a fraudulent transfer. It further ruled that the trustee in the company’s bankruptcy case could recover the value of the certificate of deposit because the company granted the security interest therein for the benefit of the creditor.

The Transeastern Lenders argued that the ruling of the Circuit Court in TOUSA would impose an “extraordinary” duty of due diligence on the part of creditors being repaid. The District Court perhaps summed up this argument the best, stating that such a ruling “would pose an unfair burden on creditors to investigate all aspects of their debtors and the affiliates of their debtors before agreeing to accept payments for valid debts owed.” The Circuit Court was not persuaded by their argument, however, stating that “every creditor must exercise some diligence when receiving payment from a struggling debtor.” It further stated that “[i]t 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.”

Conclusion: Troubling News for the Lending Community
The Circuit Court’s opinion is, to say the least, troubling news for the lending community, both for what it did and did not do. The Circuit Court endorsed a narrow interpretation of what constitutes reasonably equivalent value under Section 548 of the Bankruptcy Code, although the Circuit Court did not actually rule on whether indirect benefits can constitute reasonably equivalent value and, if they can, what level or type of indirect benefits are required to qualify as reasonably equivalent value to withstand a fraudulent conveyance attack. Further, the Circuit Court did not rule on the validity of the fraudulent conveyance “savings clause” contained in the guaranty of the Conveying Subsidiaries⁵, a provision used by many lenders to limit the liability of a guarantor to the amount that would not render such guarantor insolvent. These questions call into doubt the validity of many upstream (and potentially cross-stream) guaranties and place a greater burden on a lender to make sure that a subsidiary guarantor is solvent or will receive a tangible benefit from loans to its corporate parent.

The Circuit Court imposed a duty on the part of a creditor being repaid a debt to conduct due diligence regarding the source of the funds for such payments. As a practical matter, it is unlikely that a creditor would refuse payment of a debt, even if its due diligence uncovers certain risks. In essence, then, the ruling means that any creditor who is repaid by funds from an insolvent entity or group of entities runs the risk of disgorgement even though such payment was made on account of antecedent debt and was received outside of the applicable preference period. Given the Bankruptcy Code provisions that allow trustees or debtors-in-possession to avail themselves of state law fraudulent conveyance statutes, the “clawback” period for these payments could be years.

¹ Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (in re: TOUSA, Inc.), Case No. 11-11071 (11th Cir. May 15, 2012).

² Official Committee of Unsecured Creditors of Tousa, Inc v. Citicorp North America, Inc. (In re: TOUSA, Inc.), 422 B.R. 783 (Bankr. S.D. Fla 2009).

³ 3V Capital Master Fund Ltd. v. Official Committee of Unsecured Creditors of TOUSA, Inc. (In re: TOUSA, Inc.), 444 B.R. 613 (S.D. Fla. 2009).

⁴ The Third Circuit hears appellate cases from Pennsylvania, New Jersey and Delaware.

⁵ The Bankruptcy Court held that such provision was unenforceable.


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