6.29.2011

Advanced Distressed Debt Lesson: Fraudulent Conveyance and Tousa

In an earlier post, I explored fraudulent conveyance in concept and as it related to the current Tousa decision at that time. Our contributor, Josh Nahas, principal of Wolf Capital Advisors and moderator at the upcoming NYSSA Distressed Debt Panel, explores the issue in much more detail as well as adding updates to the Tousa decision with reversal coming from District court. This is a lengthy read where all distressed debt investors should learn a thing or two. Enjoy.


Fraudulent Conveyance and Lender Liability: Is the District Court’s Ruling in TOUSA a Pyrrhic Victory for Distressed Investors?

One of the more interesting consequences of the 2008-2009 distressed cycle was the rise in high profile fraudulent conveyance actions. The two most high profile cases thus far have been homebuilder Technical Olympic USA and newspaper publisher Tribune Inc., however, there have been numerous bankruptcies where junior and unsecured creditors have alleged fraudulent conveyance against banks, financial sponsors and senior lenders. Another prominent case In Re Yellowstone Mountain Club, LLC saw secured lenders come under stern rebuke from the Bankruptcy Court judge whose ordered imposed the rarely used remedy of equitable subordination. Fraudulent Conveyance claims seem to have risen partly due to the LBO boom in 2004-2007 resulting in some questionable transactions, at least in hindsight.

In TOUSA the Bankruptcy Court for the Southern District of Florida broke new ground with respect to fraudulent conveyance law and lender liability (see section labeled TOUSA I – Bankruptcy Court Decision). On appeal the U.S. District Court for Southern Florida found that Bankruptcy Court erred significantly on several important legal standards and the initial ruling was quashed (see section TOUSA II – District Court’s Reversal). The District Court’s decision reined in the Bankruptcy Court’s overreaching with respect to the duties of existing lenders to diligence the source of their repayment. Nevertheless, the reasoning employed by the District Court has implications that in the future could negatively impact distressed investors and creditors. The District Court has opened the door for debtors in financial distress to engage in all manner of transactions of questionable economic value in the avoidance of bankruptcy, even temporarily, as any action to stave off a bankruptcy filing allegedly confers sufficient economic benefit. Nor does the ruling does not bode well for distressed investors and unsecured creditors seeking to remedy transactions that took place when the debtor was insolvent or rendered the issuer insolvent upon consummation.

TOUSA Background

TOUSA was a Florida based homebuilder focused on the construction of single-family residences as well as townhomes and condominiums. TOUSA Inc and its subsidiary TOUSA Homes LP had also entered into a JV with Falcone/Ritchie LLC (Transeastern) that was funded by the group of creditors referred to by the court as the “Transeastern Lenders”. However, when the housing market began to turn down, the JV failed. As a result TOUSA wound up in litigation with lenders to the JV and ultimately agreed to a $420mm settlement. In order to pay for the settlement TOUSA raised a new first and second lien term loan facility. The loan was secured by essentially all of TOUSA’s unencumbered assets including its previously unencumbered subsidiaries (the subsidiaries were guarantors on the $700mm revolver). In January 2008, approximately six months after the closing of the new loan, TOUSA and is subsidiaries filed for Chapter 11 Bankruptcy protection. The Unsecured Creditors Committee (“UCC”) sought to have the new loan avoided as a fraudulent conveyance on behalf of the debtors’ estate and the proceeds paid out to the Transeastern Lenders returned for the benefit of the unsecured creditors. (1)

Overview of Fraudulent Conveyance Claims

While a full discussion of Fraudulent Conveyance actions is beyond the scope of this article, a quick look at the statutes is useful. Fraudulent Transfers can be pursued under both state law and under the Bankruptcy Code. The Bankruptcy Code also allows the trustee to rely on state fraudulent transfer law as long as there is at least one actual creditor in existence who would be able to attack the transfer under state law 11 U.S.C. § 544(b). Fraudulent transfers under the Federal Bankruptcy Code are addressed in Section 548(a)(1) of which provides that:

The Trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within one year (1) before the date of the filing of the petition, if the debtor voluntarily or involunatarily:

(A) made such transfer or incurred such obligation with actual intent to hinder, delay or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or

(B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and (ii)(I) 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; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or (III) 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. (2)

The following elements must be demonstrated in order to succeed in pursuing a fraudulent conveyance claim:
  1. There must be a transfer of an interest of the debtor in property or any obligation incurred by the debtor;
  2. The transfer must have been made or incurred within two years of the filing of the petition.
  3. The transfer was made with the actual intent to hinder delay or defraud a creditor
  4. The debtor was insolvent or made insolvent by the transfer, or the debtor would become insolvent because the transaction to be engaged in would incur debts beyond its ability to pay. (3)

Because it is difficult to prove that the debtor acted with intent to defraud its creditors, courts rely upon what is termed "badges" of fraud to prove intent. Some of these “badges” of fraud may include:
  1. Insolvency of the debtor;
  2. Theft of the proceeds of the transfer after their receipt;
  3. Absence of consideration when the transferor and transferee know that outstanding creditors will not be paid;
  4. A large disparity in value between the property transferred and the consideration received;
  5. The existence of a special relationship between the debtor and the transferee.(4)
Constructive Fraud

Constructive fraud differs from outright fraud in that the debtor's intent is not taken into account in determining whether a fraud has occurred. In cases of constructive fraud the transfer is deemed fraudulent if:
  1. The debtor received less than reasonably equivalent value in exchange for the transfer, and
  2. The debtor was (a) insolvent on the date of the transfer or became insolvent as a result of the transfer, (b) the debtor was engaged 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) the debtor intended to incur or believed that it would incur debts beyond the debtor's ability to pay as such debts matured. 11 U.S.C. § 548(a) § (1)(B).(5)
TOUSA I (Bankruptcy Court Decision)

Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida handed down a sweeping ruling in October of 2009 (In re TOUSA, Inc No. 08-1435) requiring the previous creditors (“Transeastern Lenders”) to disgorge $420mm of loan proceeds paid to them on the grounds of fraudulent transfer. Moreover, these proceeds were deemed to have been paid from insolvent subsidiaries known as (“Conveying Subsidiaries”). The Bankruptcy Court held that the Transeastern Lenders had acted in bad faith and were grossly negligent when they received the payment for the loans from the 2007 financing transaction. Judge Olson, ruled that the lender “knew or should have known on the basis of publicly available information that TOUSA and its Conveying Subsidiaries were insolvent or perilously close to insolvency”. (6) The court ruled that the lenders had a duty to determine whether the payment to them was a fraudulent conveyance.

In addition, Judge Olson avoided the liens incurred on the new loan used to repay the Transeastern Lenders which was secured by interests in the Conveying Subsidiaries, as well as liens secured by a $207mm tax refund. Finally Judge Olson held the new lenders liable for any diminution in the value of the Conveying Subsidiaries assets securing the new loan as well as all principal, interest and fees received by the new lenders, including fees paid to advisors and costs of litigating the adversary proceeding.(7) The ruling also included an invalidation of “savings clauses”, which cap the liability of a guarantor at an amount that will not trigger an insolvency.

In reaching his decision Judge Olson examined whether the company and its subsidiaries were insolvent when the debt was incurred. Extensive use was made of expert reports and testimony, as well as evidence of market conditions at the time. The evidence included downgrades from the ratings agencies, negative research reports and the decline in TOUSA’s stock price form $23 in 2006 to below $4 by April 2007.(8) The court held that these factors gave a strong indication that the subsidiaries were insolvent at the time of the 2007 transaction. These factors while compelling, do not necessarily prove that TOUSA’s subsidiaries were insolvent at the time of the loan. Irrespective of that, the Transeastern lenders should not have been held responsible for diligencing these factors with respect to their repayment. Nevertheless, the contemporaneous market and financial conditions certainly seem to weaken the case for the 2007 lenders which is on appeal before U.S. District Judge Adalberto Jordan of the Southern District of Florida. Judge Jordan has already affirmed the Bankruptcy Court's dismissal of fraudulent conveyance claims brought by a Creditors Committee against the Revolving Credit Facility lenders and Citibank as agent.

In the context of the Fraudulent Conveyance claim the court examined whether the Conveying Subsidiaries received reasonably equivalent value for the obligations they had incurred. Judge Olson concluded that the Conveying Subsidiaries received no direct benefit from the transaction because the loan proceeds went to the parent directly. Furthermore, the court concluded that the subsidiaries received no indirect benefit, because they received nothing of value as a debtor.(9) Not recognizing any of the indirect benefits to the subsidiaries by its parent of not filing for bankruptcy contravened established precedent and gave the appearance of impartiality. Certainly some value was received, however, the question is was that value reasonably equivalent. Obviously in hindsight it was not, however, that is not the legal standard and the judge erred by incorporating it into his decision, if even only anecdotally. An argument can be made that the value received was not reasonably equivalent, which one assumes the unsecured creditors will make on appeal.

In his ruling regarding “Savings Clauses” Judge Olson’s decision broke new ground essentially invalidating the enforceability of a savings clause. Savings clauses appear frequently in secured loan documents and typically seek to limit the liability of a guaranteeing party up to an amount that would not render the debtor insolvent. In TOUSA the Bankruptcy Court held that because the Conveying Subsidiaries were insolvent even before the refinancing transaction, and received no value from the transaction, the liabilities and liens were not enforceable at all.

Judge Olson further went on to hold that even if the Conveying Subsidiaries had not become insolvent until after the refinancing, the savings clauses would still not be enforceable for two reasons. First, according to the court, the clause violated Section 541(c)(1)(B) of the Bankruptcy Code, which the Court viewed as nullifying the operation of the provision that attempted to disrupt the fraudulent transfer claims from becoming property of TOUSA’s bankruptcy estate. Second, the court held that the savings clauses were unenforceable ipso facto because “efforts to contract around the core provisions of the Bankruptcy Code are invalid”. Finally, the court held that the savings clauses were unenforceable under contract law, because with multiple savings clauses for multiple obligors, “it is utterly impossible to determine the obligations that result from the operation of any particular savings clause.”(9)

Another aspect of the 2007 Financing that the court scrutinized was the fact that half of the CEO’s target incentive bonus was linked to successfully closing the 2007 transaction. As an investor one could argue quite forcefully that avoiding bankruptcy through legitimate means is worth rewarding. The question becomes did that encourage the CEO to act negligently and breach his fiduciary duties? Without a smoking gun, this is extremely difficult to prove and in this case does not appear compelling.

The contingency arrangement with the firm performing the insolvency analysis also was also called into question. This issue was also raised in the Tribune case and while it appears compelling on the surface, upon further scrutiny is not so clear. In both the Tribune and TOUSA cases the fee for the solvency opinion was much larger if the company was found to be solvent, a fact that would appear to impugn the credibility of the solvency opinion. However, the real problem is not that the valuation firm gets paid a larger fee for the solvency opinion, they should. Issuing a solvency opinion exposes the firm to much greater legal liability and that risk is compensated for by the increased fee.

The real problem has to do with the fact that solvency opinions are predicated on the projections provided to the valuation firm by the issuer. The valuation firm does not independently verify management’s projections, nor seek to create its own bottoms up projections. One could argue that the valuation firm should come up with its own independent projections, however, it is hard to argue that they can project revenue and earnings better than the issuer. Moreover, the presence of different, presumably more conservative projection for the solvency opinion would be problematic for the underwriter and may expose the underwriter or the company to claims that it overstated its projections to get a deal one.

Some of the other more controversial aspects of Judge Olson’s ruling were his reliance and “Observable Market Value” of the company’s debt and equity securities for determining enterprise value, as well as his reliance on internal TOUSA documents not made available to the lenders. Overreliance on current market values is problematic for a distressed investor as there are often times when the current market price does not accurately reflect the inherent value of the business. The ability of creditors to litigate disagreements over valuation would be rendered obsolete if there is an over reliance on the current market price. If such a standard were to be uniformly adopted by the courts senior lenders would gain even greater leverage when seeking to cram down junior creditors. Additionally, Judge Olson’s reasoning that in hindsight the transaction did not avoid bankruptcy was rightly pointed out by the District Court as having no legal relevance.(10)

Implications

It is the author’s opinion that in the TOUSA case the Bankruptcy Court went a bridge too far in imposing a duty upon the Transeatern lenders to diligence the source of funds (new loan) that its loan was being repaid with and know that is constituted a fraudulent conveyance. If the precedent were to be followed in other jurisdictions lending and capital formation would be dramatically inhibited and the door would be opened to endless litigation. Additionally, the legal reasoning employed by the Court to reach its conclusion was tenuous at best and many elements were flat out wrong, particularly the ex post facto viewpoint that the transaction did not prevent a bankruptcy filing.

While the court went to great lengths to examine the value of TOUSA around the time of the transaction to determine reasonably equivalent value, it erred in assigning no consideration to the value of avoiding bankruptcy. Nevertheless, while there is value to avoiding bankruptcy, often times the optimal solution is for a company to file for bankruptcy to preserve the value for its existing creditors, rather than gamble with more leverage. Had the Bankruptcy Court carefully weighed the value of avoiding a bankruptcy versus a undergoing a court-supervised restructuring, that aspect of decision would have been at less risk for reversal by the district court. Depending on the results of the appeal to the circuit court, distressed investors may find themselves at greater risk to priming transactions. Likewise, distressed investor will have reduced bargaining leverage with debtors and underwriters when negotiating settlement as a result of having a stronger defense against fraudulent conveyance actions.

TOUSA II (District Court’s Reversal)

Upon appeal to the District Court, Judge Olson’s ruling against the Transeastern lenders was reversed and came under a scathing critique by Judge Alan Gold. The 2007 Lenders case remains on appeal in front of a different judge. The District Court’s decision to quash the Bankruptcy Court’s ruling as it related to the Transeastern Lenders was unusual and demonstrated how far overreaching the District Court believed the Bankruptcy Court had gone. Ordinarily, the District Court would have remanded the decision to the Bankruptcy Court for further proceedings consistent with the District Court’s opinion. Judge Gold’s decision held that:
  1. The Transeastern Lenders, as recipients of debt payment had no legal duty to conduct extraordinary due diligence with respect to the provenance of the funds with which they were repaid. (11)
  2. Payment to the Transeastern Lenders was not a fraudulent transfer because the conveying subsidiaries never exercised “actual control” over the 2007 Financing proceeds and accordingly had no property interest in the proceeds therefore there was no transfer. (11)
  3. Creditors of the Conveying Subsidiaries could not recover the parent’s payment to its lenders when the subsidiaries, as members of the parent’s corporate family, received “reasonably equivalent value”. And that avoiding default as well as imminent bankruptcy constituted reasonable value. (11)
  4. That the Transeastern Lenders had no liability in the absence of a voidable transfer. The transfer by TOUSA to the Transeastern Lenders of the settlement proceeds would not trigger liability under Section 550 because it was not a direct consequence of the liens granted by the Conveying Subsidiaries, but rather a separate settlement of a previously contracted and outstanding debt. (11)
  5. The District Court also ruled that the transfers made by the Conveying Subsidiaries in connection with the 2007 Financing were in exchange for “reasonably equivalent value.” As a result, the liens were not avoidable under section 548 of the Bankruptcy Code.
The ruling addressed most of the controversial aspects of the Bankruptcy Court’s decision, however, the court avoided ruling on the savings clause which will hopefully be clarified on appeal.

Implications

While the District Court corrected many of the egregious aspects of the Bankruptcy Court’s ruling, particularly the responsibility of pervious lenders to diligence the source of the funds repaid to them, the ruling has several disturbing implications for distressed investors and unsecured creditors. The District Court appears to have granted broad latitude to debtors to use their subsidiaries assets in any way they deem fit, for the unquantifiable benefit of avoiding bankruptcy. Judge Gold cited a “totality of the circumstances” test as the basis for ruling that the new loan transaction conferred reasonably equivalent value to creditors by avoiding bankruptcy (at least temporarily). Since such a benefit is impossible to quantify all the debtor needs to do to establish a defense against fraudulent conveyance is have his advisors and counsel provide a theoretical valuation scenario that justifies a transaction. Distressed investors frequently are frustrated by the number of debtors who engage in transactions of dubious economic benefit that have the potential to diminish collateral value and enterprise value while avoiding a much needed restructuring. The District Court’s ruling will likely encourage more such transactions.

While it is true that option value is an economic benefit, particularly for shareholders and management, the disproportionate harm caused to creditors when firms in financial distress pursue these types of actions often times far outweigh the benefits received. Unfortunately, due to erosion of creditor protections, particularly with respect to the “zone of insolvency” and fiduciary duties owed towards creditors for distressed firms, these types of rulings are inevitable. Unless some balance is brought to the process, debtors will be more emboldened to pursue transactions of questionable long term economic value because the inherent benefit of avoiding bankruptcy confers enough value to provide a defense against fraudulent conveyance actions

Moreover, the ruling creates an almost insurmountable defense for debtors with regards to fraudulent conveyance claims as there are always enough plausible scenarios generated by bankers and attorneys to justify engaging in the transaction. The standard applied by the District Court will likely encourage debtors to push the envelope with their corporate assets and encourage those in financial distress to pursue financial and legal gamesmanship rather than a sensible restructuring. In the end, such practices will increase the cost of capital for borrowers and hurt recoveries for distressed investors as enterprise value is burned away while management or the owners hold out for option value rather than restructure. Moreover, distressed investors will have fewer remedies against debtors and lose a valuable bargaining chip in the bankruptcy negotiating process.

Conclusion

The District Court’s decision was certainly a victory, particularly with respect to lender liability for diligencing the repayment of borrowed funds. Nevertheless, elements of the decision were expansive with regard to the ability of debtors to encumber its subsidiaries and engage in transactions of questionable economic benefit in order to stave off a bankruptcy. The appeal to the Circuit Court as well as the District Court’s decision on the 2007 financing will be closely watched. Distressed investors may find themselves in the future with less ammunition to take action to preserve the value of their collateral and enterprise value with companies in need of a restructuring. Equity owners and company management have a long track record of “burning the furniture to keep the lights on” as was seen in Calpine and other high profile conflicts with creditors. Giving issuers greater protections will likely inhibit timely and sensible restructurings and lead to lower recoveries as enterprise value is eroded in order to preserve option value.

Notes:
  1. Judicial Backlash Adds to Challenges Faced by Lenders. Edward Estrada, Reed Smith. The Journal Of Corporate Renewal, July/August 2010.
  2. http://www.finkellaw.com/CM/PublishedWorks/Actions-Defenses.asp
  3. Fraudulent transfers under the bankruptcy code. Jill Murch, Foley & Lardner The Challenge, an Illinois State Bar Association publication for Distribution to the Members of the Standing Committee on Minority and Women Participation, August 2002 Vol. 13, No.
  4. Ibid.
  5. Ibid.
  6. Bankruptcy Court Voids Subsidiary Guaranties and Liens as Fraudulent Transfers. Wachtell, Lipton, Rosen and Katz. Restructuring Developments November 2, 2009.
  7. Edward Estrada. The Journal Of Corporate Renewal, July/August 2010.
  8. Wachtell, Lipton, Rosen and Katz. Restructuring Developments November 2, 2009.
  9. Selected Current Issues in Fraudulent Transfer and Preference Litigation. American Bankruptcy Institute. Irving E. Walker and G. David Dean Cole, Schotz, Meisel, Forman & Leonard, P.A.
  10. Edward Estrada. The Journal Of Corporate Renewal, July/August 2010.
  11. In re TOUSA, Inc.: Commercial Lending and Debt Trading Markets Breathe a Sigh of Relief. Morrison Foster Client Alert February 17, 2011. Larren M. Nashelsky, Rafael L. Petrone, Geoffrey R. Peck, and Chrys A. Carey.


1 comments:

Anonymous,  7/05/2011  

well shit!

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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.