Fraudulent Conveyance

Before getting to our lesson on fraudulent conveyance, I would like thank those that have applied to the Distressed Debt Investors Club. The rate of applications coming in is better than I expected. I am humbled by the response of our readers. Remember, we will take applications through next weekend before the site is opened up to admitted members. Apply soon!

This post continues our series of Advanced Distressed Debt Topics. You can find the first two posts at:

This week we are going to be discussing fraudulent conveyance. Section 548 of the bankruptcy code deals with transactions that are fraudulently made. While malicious transfers are also dealt with in the bankruptcy code (i.e. doing something purposefully to malign creditors), we are going to be focusing on the more "practical" kind of fraudulent conveyance.

Now, I know this is technical. And believe me, it will get more technical. But the concept of fraudulent conveyance is literally never more important than it is today. Why? The simple reason: The Tousa Ruling. Here is the relevant docket and the actual fraudulent conveyance ruling by the judge.

The ruling is 182 pages. I am not going to do it the mis-justice of simply summarizing it in a few lines. For those that really want to understand how judges make decisions in these sorts of cases, it is imperative you read the ruling.

To prove a transfer is fraudulent, one must not only prove the absence of reasonably equivalent value granted, but also that the entity doing the transfer was insolvent at the time. Section 548 of the bankruptcy code looks back 2 years - so in addition to the two concepts above, this transfer must have also happened in the last two years.

If you look at the docket mentioned above, you will see a litany of appeals and "clarifications of judgement and order" as well as "findings of fact" which are all actions that try to reverse this judge's decisions. They are all fascinating reads. I am going to pull out 7 or 8 blocks of text from various filings and comment on them as I think that will enlighten the readers the most. But first, just a little background on the case.

In July of 2007, Tousa, a homebuilder, borrowed $500M and granted lenders security in all their assets. This capital was used to settle litigation against Tousa and one of its subsidiaries (Transeastern) because of a default at the Transeastern JV. The problem was, Tousa had other subsidiaries, that were not party to the litigation / lawsuit. Tousa, and subsidiaries subsequently filed for bankruptcy in January 2008. The creditor committee, i.e. those holding unsecured claims against Tousa, was seeking to avoid the $500M debt/lien obligation and avoid liens on a tax refund issued in 2007.

As a quick summary, and this is a broad based statement, but I am going with it: If a lien is shown to be "fraudulent", that lien is effectively worthless. That means a secured creditor would now be an unsecured creditor. This is important because now instead of getting a piece of the pie after the secured lenders get paid off, everyone gets their fair share.

A simple example will suffice:

Say a company has $100M in assets. This company also has $100M in debt secured against those assets and $100M of unsecured debt. With a simple bankruptcy waterfall we see that the secured lenders will get 100% of their claim ($100M of assets / $100M of secured debt) and unsecured creditors will get 0% of their claim ($0M of remaining assets / $100M of unsecured claims).

Now lets say those liens are worthless. The $100M of assets would now be split between $200M of unsecured claims ($100M voided secured debt + $100M of unsecured debt) with a recovery of 50 cents on the dollar for each. With liens, unsecured lenders are getting donuts. Without the liens, they are getting 50 cents on the dollar back.

In this 182 page ruling, the judge lays out the case/reasoning behind the claims he is postulating. For example, he lays out the housing downturn and the effect it had on Tousa's business, including management communication with advisers and investors at the times. My favorite:

In a May 25, 2007 email to himself, Wagman stated that TOUSA “will fail” to satisfy covenants in its bond indentures “into late 2008 or 2009. Not even close.” Ex. 2113 at 1-2 (emphasis added). He noted the view of the rating agencies that the homebuilding industry was “grim and getting grimmer,” with downward pressure on prices and margins. He wrote, "As CFO, and in light of all of this market uncertainty, I have absolutely no desire to fly this plane too close to the ground, achieve some from [sic] of consensual settlement today and crash within the upcoming year. That would be a clusterf*ck."
I really hope I'm not the only one that thinks this line is incredible.

The judge continues discussing "contemporaneous evidence" suggesting that the Tousa subs were insolvent at the July transaction, they were left MORE insolvent as a result of said transaction, left them too small a capital base, and left them unable to pay their debts as they matured.

For example: "Prior to the July 31 transaction, Citi harbored significant doubts about TOUSA’s solvency, but – motivated by the prospect of substantial fee income – pressed forward nonetheless" ... Quoting from the ruling
"Citi saw the proposed new financing as a highly attractive opportunity for fees. In a March 23, 2007 email, Citi employees discussed their strategy of structuring the deal so that, even in a worst-case scenario, Citi would lose less than its fees. Citi ultimately collected approximately $15 million in fees for the transaction, including funds paid to its advisers by TOUSA. Citi was keenly aware of its ultimate goal. In early March 2007, when TOUSA requested an amendment of the Revolver to relax the interest coverage ratio and avoid a going concern opinion from its auditors, Citi assented to modifying the covenants because “[a] going concern [opinion] would not be
particularly helpful in putting in place the $1.2B financing we’re working on, as you know, and for which we are slated to earn roughly $8mm in fees."
The judge goes on like this for quite some time, getting into things as deep as not being able to trust a certain expert's witness testimony or the use of certain discount rates when doing a valuation. Deep deep stuff.

Moving to the "Conclusions of Law" section where the judge lays out his ruling in relation to the bankruptcy code, we can start to figure out what all this fraudulent transfer talk really means. For example
"Section 548(a)(1)(B) permits the avoidance of any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred within 2 years before the date of filing of the petition, if the debtor voluntarily or involuntarily received less than a reasonably equivalent value in exchange for such transfer or obligation and (A) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation, (B) was engaged in a business or transaction, or was about to engage in a business or transaction, for which any property remaining with the debtor was an unreasonably small capital; or (C) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured. 11 U.S.C. § 548(a)(1)(B)."
And using the law, the judge discusses the evidence and arguments laid out (like in the examples above) to show that point A, B, and C of USC 548(a)(1)(B) was indeed the case at Tousa. This continues going deeper and deeper, digging into what "unreasonably small capital" means for example, or how the inability to pay debts can be shown. This is great learning for all those interested.

In the end, the judge ruled that all claims of the First and Second Lien Lenders (from the July 2007 transaction) and all liens granted by the subsidiaries are to be avoided and disallowed (i.e. everyone is unsecured). ALSO, the judge ruled that the Transeastern lenders (that had gotten paid back with the $500M July 2007 deal) need to disgorge to the subsidiaries $403M plus interest. Yes, you thought you got paid out, but now I want the money back. And to knock them in the teeth, the tax refund liens were also disgorged.

Now, as I mentioned, everyone is appealing this thing. Everyone. And tomorrow, we will look at their reasoning and the arguments they are making. This fraudulent conveyance case has wide reaching implications for distressed debt investors in the future (and current cases as well). We will also discuss that tomorrow.


Mezz,  11/11/2009  

Agreed, this an absolutely great read... the run down of the entire situation from a high level to the valuation issues reads more like a story than a court document... thanks for the post Hunter

Anonymous,  11/18/2009  

Just to clarify - the reason why the transfer was arguably for "less than reasonably equivalent value" is because the subs were not themselves a party to the litigation, and thus were (from a legal standpoint) granting a lien on their property in exchange for a benefit to a third party (the JV)?


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.