Eleventh Circuit Court of Appeals Reinstates TOUSA Bankruptcy Court Decision

In Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA, Inc.), the Eleventh Circuit Court of Appeals reinstated the decision of the United States Bankruptcy Court for the Southern District of Florida (the "Bankruptcy Court") in which the Bankruptcy Court avoided the liens given by TOUSA's subsidiaries to new lenders and permitted the recovery of the proceeds of the new loan from other TOUSA lenders that had taken the funds in repayment of their TOUSA-guaranteed loans.

This decision is important for several reasons - first, it casts doubt on the validity of "upstream guaranties" and supporting security interests, especially in circumstances where the subsidiaries do not receive a share of the loan proceeds and instead receive only less concrete intangible benefits from the loan. Second, lenders may wish to consider carefully the source of the funds they receive when they receive repayment of their loans other than by a sale or refinancing of their primary collateral. Third, the cost of capital for some borrowers will likely increase because lenders will discount the value of upstream guarantees unless guarantors can produce convincing proof that they are solvent and will receive a tangible benefit in exchange for guaranteeing any loan transaction.

Brief Factual Background

TOUSA, Inc., the thirteenth largest homebuilder in America, was created through a series of acquisitions. TOUSA, Inc. was the holding company - its subsidiaries (the "Subsidiaries") owned the individual developers that it acquired.
In 2005, TOUSA, Inc. entered into a joint venture with Falcone/Ritchie LLC (the "Transeastern Joint Venture") to acquire the Florida assets of Transeastern Properties, Inc. The joint venture borrowed around $500 million from the Transeastern Lenders to facilitate the purchase (the "Transeastern Loan"). The Transeastern Loan was guaranteed by TOUSA, Inc., but not by the Subsidiaries.

In 2006, the Transeastern Joint Venture failed, and the Transeastern Loan went into default. To resolve its liability for the Transeastern Loan, TOUSA, Inc. arranged for two new secured loans (collectively, the "New Loan") totaling $500 million from new lenders (the "New Lenders"). The New Loan was made to TOUSA, Inc. in July, 2007, and was guaranteed and secured by the assets of the Subsidiaries. $421 million of the proceeds of the New Loan were paid to the Transeastern Lenders to satisfy TOUSA, Inc.'s Transeastern Loan obligation. Six months later, TOUSA, Inc. and its Subsidiaries filed for bankruptcy under Chapter 11 of title 11, United States Code (the "Bankruptcy Code").

Lower Court Decisions

In the bankruptcy case, the Official Committee of Unsecured Creditors (the "Committee") filed an adversary proceeding against the Transeastern Lenders and the New Lenders. The Committee sought to avoid the security interests given by the Subsidiaries to the New Lenders securing the New Loan and sought to recover from the Transeastern Lenders the monies that they had received in repayment of the Transeastern Loan. In pursuing its claims, the Committee asserted that the Subsidiaries had not received "reasonably equivalent value" for the New Loan and that the Subsidiaries were either insolvent when the New Loan was made or were rendered insolvent thereby.

The Bankruptcy Court agreed with the Committee, avoiding the security interests of the New Lenders and ordering the Transeastern Lenders to repay the monies they received from the New Loan. The District Court reversed the Bankruptcy Court on liability, finding that the possibility of avoiding bankruptcy, tax benefits, administrative services such as cash management, purchase and payment administration provided by TOUSA, Inc. to its Subsidiaries, and other intangible benefits provided sufficient value to the Subsidiaries to support their granting of security interests in connection with the New Loan.

Eleventh Circuit Decision

The Eleventh Circuit framed the appellate issues as (1) whether the Subsidiaries received "reasonably equivalent value" for the pledge of their assets to secure the New Loan, and (2) whether the Transeastern Lenders were parties "for whose benefit" the liens were transferred, making them liable as "initial transferees" under Section 550 of the Bankruptcy Code.

Reasonably Equivalent Value

On the first issue, the New Lenders argued, among other things, that "reasonably equivalent value" was provided to the Subsidiaries by reason of the economic benefit of avoiding default and bankruptcy. The Eleventh Circuit was unpersuaded by the New Lenders' argument that the transaction allowed the Subsidiaries to escape the "existential threat" of the likely bankruptcy that would ensue and that this chance to avoid bankruptcy was a benefit reasonably equivalent in value to the obligations the Subsidiaries incurred, noting that "[a] corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it. In other words, not every transfer that decreases the odds of bankruptcy for a corporation can be justified. The bankruptcy court considered the potential benefits of the transaction and found that they were nowhere close to its expected costs. In the light of all the evidence, we are not 'left with the definite and firm conviction that' the bankruptcy court clearly erred."

The Eleventh Circuit further noted that "the opportunity to avoid bankruptcy does not free a company to pay any price or bear any burden. After all, 'there is no reason to treat bankruptcy as a bogeyman, as a fate worse than death.' The bankruptcy court correctly asked, 'based on the circumstances that existed at the time the investment was contemplated, whether there was any chance that the investment would generate a positive return.' And the record supports the negative answer found by the bankruptcy court."

Although reversing the district court, the Eleventh Circuit avoided defining "value" in the context of determining "reasonably equivalent value." The district court had adopted a broad definition of "value" that included the avoidance of bankruptcy and other factors advanced by the New Lenders, while the Bankruptcy Court took a much narrower view of what constitutes "value." The Eleventh Circuit, without formulating its own view, relied upon the Bankruptcy Court's findings---concluding that "[t]he record supports the finding by the bankruptcy court that, for the [Subsidiaries], the almost certain costs of the [new credit facilities] far outweighed any perceived benefits." Thus, the issue of exactly what "value" constitutes "reasonably equivalent value" still remains to be decided on a case by case basis in the Eleventh Circuit.

For Whose Benefit The Transfer Is Made

Having decided that the transfer of the liens by the Subsidiaries could be avoided under Section 548 of the Bankruptcy Code, the Court moved on to Section 550 of the Bankruptcy Code, and to the identity of the party or parties from whom the transfer, or its value, could be recovered. If a transfer is avoided under Section 548 of the Bankruptcy Code, Section 550(a)(1) allows the recovery of the property transferred or its value from the initial transferee or from an "entity for whose benefit such transfer was made."

In this case, although the liens of the Subsidiaries were transferred to secure loans used to pay the Transeastern Lenders, the Transeastern Lenders argued that they were not parties "for whose benefit" those transfers had been made under Section 550 because they were subsequent transferees, not entities for whose benefit the initial transfer had been made. The difference between the liability of a person for whose benefit a transfer is made and a subsequent transferee under Section 550 (a)(1) of the Bankruptcy Code is that a subsequent transferee may defend against a fraudulent transfer to the extent it "takes for value…in good faith, and without knowledge of the voidability of the transfer" under Section 550(a)(2). Such a defense is not available for an "initial transferee" or for an entity "for whose benefit such transfer was made."

The Eleventh Circuit found that the Transeastern Lender's argument was contradicted by the loan agreements for the New Loan, which required that the proceeds of the New Loan be transferred to the Transeastern Lenders. Although the funds technically passed through the TOUSA, Inc. subsidiary, the Eleventh Circuit noted that this formality did not make the Transeastern Lenders subsequent transferees of the funds because TOUSA, Inc. never had control over the funds.

The Eleventh Circuit thus concluded that under the plain language of Section 550(a)(1) and its existing precedent (American Bank of Marin County v. Leasing Service Corp. (In re Air Conditioning, Inc. of Stuart), 845 F.2d 293 (11th Cir. 1988), the Transeastern Lenders were entities for whose benefit the Subsidiaries transferred their liens.

Remand; Issue Left Undecided

The Eleventh Circuit refused to address the requests of both parties with regard to where to send the case after appeal, other than it would be remanded to the District Court. The primary initial issue on remand will be the appeal of the remedies ordered by the Bankruptcy Court, which the District Court did not previously address because it found no liability.