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United States Court of Appeals for the Eleventh Circuit issued an opinion in In Re: TOUSA, INC., et al.

On May 15, 2012, the United States Court of Appeals for the Eleventh Circuit issued an opinion in In Re: TOUSA, INC., et al. (Case No. 11-11071; to see the full opinion, click here). The opinion reversed the judgment of the U.S District Court for the Southern District of Florida (click here to see our February 16, 2011 newsletter regarding the district court opinion) and affirmed the findings of the bankruptcy court which avoided, as fraudulent transfers, liens granted by various subsidiaries of TOUSA, Inc. to secure new loans made to TOUSA, Inc. The basis for the bankruptcy court's decision was that the subsidiaries, which were co-borrowers on the new loans, were insolvent at the time they granted the liens and did not receive "reasonably equivalent value" in exchange for granting the liens. Further, the bankruptcy court required the creditors of TOUSA, Inc. that received proceeds of the new loans to disgorge the proceeds on the ground that the creditors were entities for whose benefit the avoided liens were granted.

A. The Eleventh Circuit's holding with respect to "reasonably equivalent value"

Under §548(a)(1)(B)(i) of the Bankruptcy Code, a transfer (such as the granting of liens) is not a fraudulent transfer so long as the debtor received "reasonably equivalent value" in exchange for the transfer. The bankruptcy court in TOUSA had found that the subsidiaries had not received reasonably equivalent value in exchange for the liens they granted. The district court disagreed with the bankruptcy court, finding that the subsidiaries received ample value in the form intangible benefits, including the possibility of avoiding bankruptcy, an opportunity to escape further litigation and various tax benefits. Although the Eleventh Circuit did not expressly opine on what might, or might not, constitute reasonably equivalent value, it held that the findings of the bankruptcy court with respect to value were not "clearly erroneous," and therefore should be affirmed.

As a matter of bankruptcy law, the court's application of the "clearly erroneous" standard to its review of the bankruptcy court's findings may have been error. Since the Supreme Court's decision in Stern v. Marshall that Article III of the U.S. Constitution prohibits authorizing bankruptcy courts to enter final judgments in certain types of proceedings, there has been considerable legal commentary to the effect that the same rule would apply to fraudulent transfer proceedings. In fact, in the recent Refco-related fraudulent transfer litigation, the U.S. District Court for the Southern District of New York held that bankruptcy judges could do no more than issue reports and recommendations, and not final judgments. Of significance to TOUSA, this means that the findings in a report and recommendation must be reviewed by an Article III judge de novo (that is, afresh), and that it is error to review such findings under a deferential standard (such as the "clearly erroneous" standard) because doing so deprives the parties of their rights to adjudications by Article III judges (such as a U.S. district court judge). Thus, the TOUSA decision may be subject to challenge on that ground, by way of a motion to reconsider or petition for certiorari to the U.S. Supreme Court. Although the plaintiffs might argue that the defendants waived the objection to the bankruptcy court's power to rule in this case, the question of whether such an objection may be waived is itself the subject of debate in the bankruptcy community.

Even if the Eleventh Circuit's opinion is overruled for jurisdictional or other reasons, however, lenders should be attentive to the risks it illustrates. For decades, lenders and their counsel have been cognizant of the fraudulent transfer risks associated with making loans to a parent entity secured by upstream guaranties from, or joint liability with, its subsidiaries, where the proceeds of the loans do not directly flow to the subsidiaries and the resulting transaction leaves the subsidiaries insolvent, unable to pay their debts as they come due or with insufficient capital to conduct their business. The Eleventh Circuit's decision in TOUSA serves as a reminder that fraudulent transfer risks in loan transactions must be carefully evaluated.

B.  The Eleventh Circuit's holding with respect to disgorgement of proceeds

Perhaps the most alarming aspect of the Eleventh Circuit's opinion is its affirmation of the ruling of the bankruptcy court that the lenders receiving the proceeds of the new loans had to disgorge them. The Eleventh Circuit states in its opinion that:

"[e]very creditor must exercise some diligence when receiving payments from a struggling debtor. It is far from a drastic obligation to expect some diligence from a creditor when it is being repaid hundreds of millions of dollars by someone other than its debtor."

This holding suggests that lenders whose loans are being refinanced by new loans from another lender may be subject to the risk that they must return the proceeds if it is later determined that the new loans involved fraudulent transfers. As a practical matter, even if those creditors conduct such diligence and conclude that the proceeds to be paid to them are the product of a fraudulent transfer, it is not clear what course of action is available to such creditors. It is by no means certain that the lenders can refuse to be repaid. Moreover, lenders being refinanced typically do not have access to the kind of information that would enable them to determine whether the new loans constitute fraudulent transfers.

Section 548(c)  of the Bankruptcy Code builds in a defense for good faith transferees of a fraudulent transfer to the extent of value given to the debtor.  Section 550(b)(1) of the Code similarly protects a secondary transferee who "takes for value"  and "in good faith, and without knowledge of the voidability of the transfer avoided." The Eleventh  Circuit could (and should) have required a determination as to whether the lenders receiving the proceeds of the new loans did so in good faith and without knowledge of the voidability of the transfer. Instead, the court essentially ignored §550(b)(1) and collapsed the initial transfer and the subsequent transfer into one.

As a result of this opinion, lenders that are refinanced with the proceeds of a fraudulent transfer  in the Eleventh Circuit will undoubtedly have more difficulty asserting the "good faith transferee" defense available to secondary transferees in refinancing scenarios. Not surprisingly, the opinion is receiving substantial negative commentary from the lending community, and it is highly likely that substantial litigation in the matter will continue for years to come. For the time being, lenders doing business outside of the Eleventh Circuit should take comfort that the normal "good faith" transferee provisions provided by the Bankruptcy Code should apply to all transactions, except those where the lenders are on both sides of the transaction and know that the initial transferee is a mere conduit.

C.  The enforceability of fraudulent transfer savings clauses

On a related matter, the bankruptcy court's decision in TOUSA also declared unenforceable the fraudulent conveyance "savings clauses" that are often included in upstream guaranties. This was the first reported decision on the issue. Such a clause provides that, if the guaranty is ever challenged as a fraudulent transfer, the obligations of the guarantor are reduced to the extent necessary to prevent the guaranty, and any liens securing the guaranty, from being avoided as a fraudulent obligation or transfer. Goldberg Kohn, in its role as Co-General Counsel to the Commercial Finance Association, joined in filing a brief with the district court in TOUSA supporting these clauses. However, that issue was not addressed by the district court, and was not before the Eleventh Circuit. It remains to be seen if this issue will be further addressed in the TOUSA litigation.



May 29, 2012

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