Every now and then, a few cases that are clearly critical to commercial lending and loan recoveries float to the surface of the flood of bankruptcy court opinions. This is the first in a series of short synopses of cases that you should factor into your strategies.
Upstream Subsidiary Guaranty As A Fraudulent Conveyance
The case of In re TOUSA has been widely followed on appeal and is among the most significant in the country. Simply stated, the U.S. Bankruptcy Court for the Southern District of Florida found (1) that the granting of a guaranty by subsidiary corporations to secure more than $420,000,000 of new loans extended to the parent corporation, secured by liens on the corporate assets of the subsidiaries, was an avoidable fraudulent conveyance. The new lender provided funding for a compromise and settlement of prior secured debts, which rendered the parent company, in the opinion of the Court, the "most highly - leveraged company in the industry". TOUSA, Inc. was a large residential builder. Six months later, the parent company and all of its subsidiaries filed a Chapter 11 case. The fraudulent conveyance claim was advanced against the original lenders who received the compromise and settlement payment and they were ordered to return the $420,000,000 payment.
The Bankruptcy Code provides, in Section 548, that a trustee may avoid as fraudulent any transfer of an interest of the debtor (such as a lien) if the debtor received less than reasonably equivalent value in exchange for the transfer and the debtor was insolvent at the time or rendered insolvent as a result of the transfer. Obviously, to the extent that a transfer is avoided under Section 548 of the Bankruptcy Code, the trustee may recover the property transferred, either from the initial transferee or from an entity which benefited from the transfer.
The Bankruptcy Court found that the subsidiaries were, in fact, insolvent at the time that the guaranty and new collateral were granted and that the subsidiaries did not receive reasonably equivalent value for the guaranty and liens. The Court found that the subsidiaries received indirect and minimal benefits from the transaction and rejected the contention that avoidance of contingent claims, avoidance of litigation or avoidance of imminent bankruptcy were sufficient consideration.
On appeal, the U.S. District Court reversed the decision of the Bankruptcy Court.(2) On further appeal to the U.S. Court of Appeals for the Eleventh Circuit, the District Court was reversed and the Eleventh Circuit essentially overruled the District Court and supported the original trial court decision. (3)
The Bankruptcy Court also discounted the viability of insolvency "savings clauses" in the subsidiary guaranty, which are not unusual in these transactions and purport to have the effect of reducing the amount of the guaranty by a sum sufficient to assure that the subsidiary remains solvent, thereby preventing a fraudulent conveyance claim. Neither the District Court nor the Eleventh Circuit ruled on the validity or effect of the savings clause.
The TOUSA decision may ultimately be little more than an obvious response to a refinancing occurring six months before a bankruptcy filing and the court’s judgment about the lenders’ due diligence. Nevertheless, the case raises several points that should be considered by both lenders and workout officers. For example:
(a) Due diligence on the financial condition and solvency of the subsidiary providing a guaranty must be thoroughly conducted and the creation of contemporary evidence of solvency at the time of the transaction is essential to the enforcement of the upstream guaranty.
(b) Incidental and intangible benefits to the subsidiary providing the guaranty, particularly in a setting where the companies are already stressed or in trouble, is unlikely to win the day in defending against a fraudulent conveyance claim. More concrete benefits must be identified - and documented. Some lenders resort to a "co-borrower" structure to work around the benefits/consideration problem. We urge caution in a co-borrower structure where there is ample evidence that the parties have no expectation that the subsidiary will borrow under the credit facility.
(c) The degree of foreseeability of subsequent financial difficulty must be assessed and a lack of credible evidence supporting the lender’s or recipient’s contention that they could not anticipate subsequent insolvency will be problematic.
(d) Credit underwriting decisions which rely upon the value of subsidiary assets and upstream guaranties have been common in the past, with the lender often arguing that the subsidiary received "indirect value", even though it did not receive loan proceeds. The TOUSA decision indicates that the possible prevention of an immediate bankruptcy filing is not "reasonably equivalent value", in and of itself. Upstream guarantys should be discounted as a credit support in the credit underwriting process, unless the lender can identify either (1) that the subsidiary will receive a direct and demonstrable benefit from the transaction or (2) the subsidiary was clearly, as shown by evidence, solvent at the time of the transaction.
(e) Receiving payoff proceeds from a transaction involving other funding sources, which include an upstream guaranty, may subject the recipient of the payoff to a fraudulent conveyance claim and to a refund of the payoff. Again, due diligence is necessary in any material payoff or settlement situation.
(f) Continue using "savings clauses" in upstream guaranties. Their protective value has not yet been finally determined.
(1) Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp N. Am. Inc. (In re TOUSA Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009).
(2) 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. 2011).
(3) Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA Inc.), 680 F.3d 1298 (11th Cir. 2012).