TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

Before we get to the post: Ira Sohn thoughts/commentary will be posted over the weekend. In the meantime, Jay at MarketFolly has a comprehensive set of notes up. I wrote this on my Twitter feed: John Paulson's idea of the CVI contingent value securities was the most compelling - I'm still doing my research on it. Behind that was Bill Ackman's thesis on JCP: First time I've heard it and I get the premise of the pitch. I am long JCP stock as of yesterday.

To more relevant, distressed business. Contributor Josh Nahas, Principal of Wolf Capital Advisors, and I were speaking today. Earlier this week, the TOUSA decision was overturned by the appellate court. Aurelius, one of the best distressed funds around, benefited greatly on this ruling. This could be one of the more salient stories in distressed debt land this year and no one out there is as good in covering these situations like Josh. Enjoy!

TOUSA Two-Step Ruled Fraudulent Conveyance by 11th Circuit Court of Appeals

On May 15, 2012 The United States Court of Appeals for the Eleventh Circuit reversed the decision of Judge Alan S. Gold of the U.S. District Court for the Southern District of Florida in the Bankruptcy of homebuilder TOUSA Inc. The Circuit court upheld the previous ruling by the Bankruptcy Court that in fact the financing of the payment to Transeastern Lenders constituted a fraudulent conveyance. The issues in the case have has been closely followed by bankruptcy attorneys, secured lenders and distressed investors as the implications are far reaching, particularly as it relates to rescue financing for companies near insolvency. Link to ruling: http://react.bracewellgiuliani.com/reaction/documents/BasisPointsTousa11thCircuitOpinion.pdf

Not only did the Circuit court uphold the Bankruptcy Court’s finding that a fraudulent conveyance had occurred, but it also found that the Transeatern Lenders were repaid by the proceeds of that fraudulent conveyance and were subject to potential claw back litigation as “initial transferees”. In addition, the court found  that the Transeatern Lenders bore some responsibility for diligencing the source of funds that was being used to repay them, and therefore should have known that their repayment was likely the result of a fraudulent transfer.

The distressed community has been split on the issues in TOUSA with most willing to acknowledge that the 2007 financing was highly suspect, while uncomfortable with idea that lenders should be held responsible for diligencing the sources of their repayment.  Funds specializing in rescue financing and secured lending, as well as distressed funds who were in the Transeatern Loan, were the most disturbed by the ruling; while distressed investors, and certainly TOUSA’s unsecured bondholders, felt that a line was finally being drawn over perceived corporate maneuvering and asset shuffling prior to a Chapter 11 filing.

As a quick refresh for our readers (see earlier post for more details) 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 “Conveying subsidiaries” (the subsidiaries were guarantors on the $700mm revolver).  In January 2008, approximately six months after the closing of the new loan, TOUSA and its subsidiaries filed for Chapter 11 Bankruptcy protection. (1)

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.  The UCC argued that the Conveying Subsidiaries had not received reasonably equivalent value in exchange for securing the new credit facilities.  The unsecured creditors filed litigation to recover the value of said liens from the Transeastern Lenders under section 550(a)(1) of the Bankruptcy Code on the ground that the Transeastern Lenders were the entities to whose benefit the liens had been granted. (2)

Judge John K. Olson of the Bankruptcy Court for the Southern District of Florida agreed with the claims asserted by the unsecured creditors and found that a fraudulent conveyance had indeed occurred.  As part of his decision Judge Olson relied heavily on the evidence from the public domain regarding the condition of the housing market, TOUSA’s sagging stock price as well as the public comments of TOUSA executives regarding a potential restructuring that demonstrated the company’s precarious financial situation and called into question the solvency of the debtor prior to the 2007 refinancing.

On appeal Judge Gold heavily criticized the Bankruptcy Court’s reasoning and its reliance on anecdotal evidence and took the unusual step of quashing the bankruptcy courts ruling.  Judge Gold found that the Transeatern Lenders had no duty to conduct what he deemed “extraordinary due diligence” and that the Conveying Subsidiaries received reasonably equivalent value.  This value was almost entirely attributed to TOUSA avoiding bankruptcy as a result of the Transeatern Lenders being repaid and thus averting a a Chapter 11 filing..

The 11th Circuit disagreed with Judge Gold’s finding and held  that a fraudulent transfer had taken place and that lenders should have a duty to conduct some level of due diligence as to the source of their repayment, particularly when the entity is in financial difficulty.  While the Circuit court did not address specifically whether reasonably equivalent value was received by the Conveying Subsidiaries and affirmed that avoiding bankruptcy is a source of value, the court found in favor of the Bankruptcy Court’s ruling that the risk assumed by the Conveying Subsidiaries far outweighed the perceived benefits of avoiding bankruptcy.

The Circuit court also addressed the question of whether the Transeatern Lenders constituted initial transferees under section 550(a)(1)  of the Bankruptcy Code subject to a clawback of funds as a “subsequent transferee” under section 550(b)(1) which provides for good faith defense against litigation seeking the recovery of funds.  Ultimately the court ruled that the Transeastern Lenders met the definition of initial transferees which will likely make them subject to recovery actions by the UCC. The Court has now remanded the case back to the District court to determine what the appropriate remedies should be given that a fraudulent transfer has been ruled to have occurred.(3)

It appears that the Court is not looking to impose unrealistic expectations on all future lenders, nor is it questioning the value attributable to avoiding restructuring.  Rather, they seem to be focused on the facts in TOUSA which appear to be particularly egregious and therefore should not be considered standard. Indeed, the Court’s analogy to TOUSA’s demise being more akin to a “slow-moving category 5 hurricane than an unforeseen tsunami.” seems to indicate that debtors will still be able to exercise their best judgment and pre-petition rescue lenders will not routinely be found liable for fraudulent conveyance, despite what opponents to the Bankruptcy Court’s ruling feared it would imply.  However, debtors, lenders and their advisors will likely now be more cautious in situations where they are operating near the zone of insolvency.

Given that many distressed investors participate in rescue financing as well as in distressed loans that they believe may be refinanced, there are reasons to be concerned about a ruling that requires investors to diligence the source of funds being used to repay them.  Nevertheless, distressed investors routinely find themselves in situations where they feel the debtor is given far too much leeway to maneuver its assets and engage in rescue financing when an orderly restructuring is in the best interests of creditors and is likely inevitable.

The courts both in and out of bankruptcy already provide the debtor with broad latitude in their financial decisions as per the business judgment rule and efforts by distressed investors to negotiate a consensual restructuring are frequently stymied as a result.  Dynegy is a good analog for the TOUSA situation and most distressed investors (and the court appointed examiner) would agree that the kind of maneuvering that occurred in that case was disturbing and should be prevented from occurring in the future.

Finally, while potential fraudulent conveyance litigation is not usually the primary driver behind an investment thesis, it is a valuable chip in the negotiations with the debtor and the pre-petition lenders.  Had the district court’s ruling stood, distressed investors would have faced an almost insurmountable hurdle in proving a fraudulent conveyance had occurred, and would have lost a valuable leverage point in negotiating with the debtor.  Moreover, it would have likely emboldened debtors and their advisors to engage in even more pre-petition maneuvering rather than pursue a meaningful restructuring.  Too often creditor value is eroded while management of financially distressed companies pursue unrealistic plans to avoid the inevitable restructuring.

Net/Net while the ruling has some potential negative effects for distressed investors focused on rescue lending or when betting on a distressed piece of paper being refinanced, the ruling itself will likely be a positive for distressed investors. Hopefully it will encourage debtors to engage its creditors in meaningful dialog prior to filing a Chapter 11 and avoid some of the more questionable transactions such as TOUSA, Dynegy and Tribune.

(1) Judicial Backlash Adds to Challenges Faced by Lenders.  Edward Estrada, Reed Smith.  The Journal Of Corporate Renewal, July/August 2010
(2) Eleventh Circuit Upholds Bankruptcy Court’s Fraudulent Transfer Ruling in TOUSA  Debra Dandeneau. Weil Bankruptcy Blog, MAY 16, 2012 http://business-finance-restructuring.weil.com/fraudulent-transfers/eleventh-circuit-upholds-bankruptcy-courts-fraudulent-transfer-ruling-in-tousa/#axzz1vANZnoP5


Anonymous,  5/18/2012  

Hunter, did you catch Einhorn's GO-UPs? It's a shame he didn't have more time on that.

As a former VC and now value investor I thought it was a fascinating proposal to solve some of the (admittedly... high quality!...) problems of cash generating technology companies and their shareholders.


Anonymous,  5/18/2012  

Dont waste your time on the CVIs - it is too late now, you had to have the securities settled in the account by today.

Anonymous,  5/19/2012  

I am a fairly green high yield analyst and am curious about an aspect of this, can someone please give an example of what would have been "reasonably equivalent value" for the Conveying Subs? I get that they had their claim on assets stripped, just curious what reasonable equivalent value would be.

Anonymous,  5/21/2012  

Author's Note:

In this case there would have been very little value for the Conveying subs to receive given since none of the cash being raised was being injected into the business, but was simply being used to payoff the lenders to the JV. Had the proceeds of the loan been used to finance investments or assets then it would be a much harder case to make.

Given the state of the housing market at the time, particularly in Florida, and TOUSA's deteriorating condition, legveraging up the remaining unencumbered assets to pay off the jv lenders was akin to burning the furniture to keep the lights on.

That is why the Debtor had to argue that the value received was intangible, in that TOUSA avoided BK as a result of paying of Transeatern lenders with the proceeds of the new Citi facility.


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.