CLIENT ALERT: Reversal of Fortune: Lenders Beware As Eleventh Circuit Reinstates Tousa Bankruptcy Court Decision
Lenders that finance distressed companies have a renewed reason for concern. On May 15, 2012, the United States Court of Appeals for the Eleventh Circuit reversed the decision of the Southern District of Florida (the “District Court”) in In re Tousa, Inc. (“Tousa”) reinstating the bankruptcy court’s decision that the transfer of funds to a lender in connection with a financing intended to keep the distressed borrower out of bankruptcy constituted a fraudulent transfer subject to claw-back under the Bankruptcy Code.
Tousa has been followed closely by lenders and bankruptcy attorneys and with the reversal, the Eleventh Circuit cast a shadow on financing practices, swinging a $421 million pendulum back in favor of the debtor. This decision adds a new layer of risk to financing transactions involving entities that are on the brink of insolvency.
Background of the Tousa Case
In 2005, a wholly-owned subsidiary of Tousa and another entity entered into a joint venture called the Transeastern joint venture (“Transeastern”). The joint venture was unsuccessful, and Transeastern defaulted on $675 million of debt owed to the existing lenders (“Existing Transeastern Lenders”). To settle the subsequent litigation, Tousa agreed to pay the Existing Transeastern Lenders more than $421 million (the “Settlement”). The Settlement was financed by new rescue lenders (the “Rescue Lenders”) with a first-lien credit facility in the amount of $200 million and a second-lien facility in the amount of $300 million (the “July Financing”). Tousa and its subsidiaries (the “Conveying Subsidiaries”) were co-borrowers under the July Financing. This financing was secured by a lien on substantially all of the assets of Tousa and the Conveying Subsidiaries.
Six months later, Tousa and the Conveying Subsidiaries filed for relief under Chapter 11 of the Bankruptcy Code. The official committee of unsecured creditors (the “Creditors’ Committee”) appointed in Tousa then sought to avoid the obligations incurred and the liens granted by the Conveying Subsidiaries as fraudulent transfers pursuant to section 548 of the Bankruptcy Code (“Section 548”). After a 13-day trial, the bankruptcy court granted the relief sought by the Creditors’ Committee. The bankruptcy court concluded that the Conveying Subsidiaries were insolvent before and after the closing of the July Financing and were left with unreasonably small capital to operate their businesses as a result of the transaction. The bankruptcy court also held that the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for incurring such obligations and granting such liens to the Rescue Lenders. Accordingly, the bankruptcy court avoided the obligations incurred and the liens granted by the Conveying Subsidiaries and required the Existing Transeastern Lenders to disgorge more than $400 million of the loan proceeds they had received in connection with the Settlement of the Transeastern litigation.
The Existing Transeastern Lenders appealed the decision of the bankruptcy court to the District Court. The District Court quashed the bankruptcy court’s decision, finding that, as a matter of law, the bankruptcy court had defined “value” too narrowly, and held that the indirect benefits conferred on Tousa by the Existing Transeastern Lenders, including providing Tousa with an opportunity to avoid bankruptcy, could constitute “value” under Section 548. The District Court also held that the Existing Transeastern Lenders could not, as a matter of law, be liable as “entities for whose benefit” the transfers to Tousa were made because they did not benefit from the transfer of liens by the Conveying Subsidiaries. Finally, the District Court held that the Existing Transeastern Lenders were merely subsequent transferees of the proceeds backed by the liens transferred in the July Financing, not immediate beneficiaries of such transfer, and that subsequent transferees are not covered by Section 550(a)(1) of the Bankruptcy Code.
The Creditors’ Committee then appealed the decision of the District Court to the Eleventh Circuit.
The Eleventh Circuit Decision
The Eleventh Circuit focused on the bankruptcy court’s findings relating to (i) the issue of “reasonably equivalent value” and (ii) whether the funds paid to the Existing Transeastern Lenders could be recovered under the theory that the Existing Transeastern Lenders were the entities “for whose benefit such transfer was made.”
Ruling 1: The Conveying Subsidiaries Did Not Receive “Reasonably Equivalent Value” in Exchange for the Liens Granted to the Rescue Lenders
Section 548 of the Bankruptcy Code allows a court to avoid a transfer of a debtor’s interest in property if the debtor does not receive “reasonably equivalent value” in exchange. The District Court had found that the Existing Transeastern Lenders gave “reasonably equivalent value” in exchange for the funds they received in the July Financing because the money that the Rescue Lenders had provided Tousa gave Tousa the opportunity (albeit a slim chance) to avoid a bankruptcy filing. Without deciding whether providing an opportunity to avoid a bankruptcy filing constituted the provision of “value,” the Eleventh Circuit affirmed the bankruptcy court’s finding that “the almost certain costs of the transaction … far outweighed any perceived benefits.”
The basis for the Eleventh Circuit’s conclusion was the extensive evidence that the bankruptcy of Tousa was “inevitable”. The Eleventh Circuit found that the bankruptcy “was far more like a slow-moving category 5 hurricane than an unforeseen tsnunami.” The Court considered the July Financing a worthless attempt to avoid bankruptcy, failing to provide “reasonably equivalent value”. Thus, like the bankruptcy court, the Eleventh Circuit deemed the transfer of funds to the Existing Transeastern Lenders in the July Financing to be an avoidable fraudulent transfer under Section 548, thereby voiding the liens granted to the Rescue Lenders.
Ruling 2: The July Financing Funds Can be Recovered from the Existing Transeastern Lenders Because the Existing Transeastern Lenders Directly Benefited from the Rescue Financing
If a transfer is avoided under Section 548, Section 550(a)(1) of the Bankruptcy Code (“Section 550(a)(1)”) allows a court to order that the property transferred, or its economic value, be “clawed back” into the debtor’s estate from the initial transferee, or from an entity “for whose benefit such transfer was made.” An entity that is found to have “control” over a debtor’s interest in property (an “initial transferee”) is deemed to be the entity for whose benefit the transfer is made; the beneficiary entity, and not any “subsequent transferees”, is subject to claw-back under Section 550(a)(1).
Disagreeing with the District Court, the Eleventh Circuit concluded that the liens provided to the Rescue Lenders were granted “for the benefit” of the Existing Transeastern Lenders, and thus the Existing Transeastern Lenders were liable under Section 550(a)(1) as initial transferees. The Eleventh Circuit focused on the fact that, because Tousa never had “control” over the funds (the terms of the July Financing required that Tousa transfer the funds to the Existing Transeastern Lenders), Tousa was a mere conduit of the funds and not the “initial transferee.”
The Eleventh Circuit dismissed the Existing Transeastern Lenders’ concerns regarding the expansive reading of Section 550(a)(1), stating that “[E]very 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”.
It is unclear if this recent decision will have a significant impact or whether its holding is limited to the specific facts presented. Nevertheless, the Eleventh Circuit’s ruling provides uncertainty for lenders involved with distressed companies. Lenders should be mindful of the fraudulent transfer issues raised in the Tousa decision when structuring loan transactions with counterparties that are at risk of becoming insolvent.
The major takeaway from the Eleventh Circuit’s opinion is the Court’s placement of an extensive duty of due diligence on a lender when accepting repayment of pre-petition debt. To help safeguard against that risk, lenders may need to undertake greater diligence before investing money and/or receiving funds.
Please feel to contact any of the attorneys listed at left if you would like to discuss this matter.