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Pitfalls of Securing Debt With the Assets of a Borrower’s Subsidiaries

Bankruptcy and Financial Restructuring/Finance Alert | August 27, 2012
by: Joseph W. Weill

Lenders and other creditors should be aware of an opinion recently issued by the United States Court of Appeals for the Eleventh Circuit.  In Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors,[1] (Tousa) the court addressed a situation in which a parent company incurred millions of dollars in debt secured by the assets of its subsidiaries to finance the settlement of a claim owed by the parent.  The parent and subsidiaries subsequently filed bankruptcy, and the unsecured creditors' committee challenged the financing and the liens given by the subsidiaries as fraudulent transfers.  The Court of Appeals affirmed a bankruptcy court decision which unwound the financing and avoided the liens because, as found by the bankruptcy court, the subsidiaries were “insolvent” at the time of the loan and did not receive “reasonably equivalent value” in exchange for the liens placed on their assets.

Senior Transeastern

The parent company in Tousa was a company known as TOUSA, Inc. (TOUSA).  Tousa owed a substantial amount of debt to various lenders (the Transeastern Lenders).  Prior to the financing in question, TOUSA’s subsidiaries, however, were not indebted to the Transeastern Lenders, either primarily or as guarantors.  At the start of the economic downturn in 2007, Tousa defaulted on its loans and the Transeastern Lenders sued Tousa for more than $2 billion.  In July 2007, TOUSA and the Transeastern Lenders settled their litigation for approximately $421 million.  To finance the settlement, TOUSA and some of its subsidiaries agreed to take on additional debt from new lenders (the New Lenders).  TOUSA secured this debt with first-priority and second-priority liens on the assets of its subsidiaries.  Pursuant to this agreement, the New Lenders issued funds directly to TOUSA and TOUSA immediately forwarded the funds to the Transeastern Lenders to pay the settlement.[2]  Within six months, both TOUSA and its subsidiaries were forced to file bankruptcy.  TOUSA’s committee of unsecured creditors filed fraudulent transfer claims against the New Lenders and the Transeastern Lenders.

In affirming the decision of the bankruptcy court, the Court of Appeals reached two pivotal conclusions.  First, it affirmed the determination that the conveying subsidiaries did not receive “reasonably equivalent value” in exchange for the liens that the subsidiaries granted against their assets.  Second, it affirmed the determination that the Transeastern Lenders were found to be “entities for whose benefit a fraudulent transfer was made”.  As a result, the Court of Appeals affirmed the avoidance of the liens and forced the Transeastern Lenders to disgorge substantially all of the loan proceeds received from the settlement.[3] 

Lessons from Senior Transeastern

In Tousa, the Transeastern Lenders and the New Lenders argued, among other things, that the new loan prevented the subsidiaries’ imminent bankruptcy (which the lenders argued would have occurred had TOUSA not settled with the Transeastern Lenders).  The Court of Appeals, however, resoundingly rejected this argument, and the Tousa opinion supports the conclusion that undocumented, indirect benefits to subsidiaries may not be sufficient to defend fraudulent transfer claims.

Further, this decision has implications not only for lenders, but also for creditors receiving funds that are secured by a parent company’s subsidiaries.  When creditors are dealing with distressed companies, they should do extensive due diligence with respect to the “source” of the underlying funding.  As the Court of Appeals expressly states at the end of its opinion, “[i]t 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.”[4]  If the funds received are secured by assets of subsidiaries, then the creditor should ensure that the subsidiaries are receiving a well-documented benefit in return.

When dealing with distressed companies it is of the utmost importance to extensively document benefits received from the potential transaction.  Detailing these benefits up-front will help to avoid judicial scrutiny in subsequent litigation.  We recommend having bankruptcy counsel review, prior to closing, transactions that may raise fraudulent transfer exposure in order to structure financings to minimize this risk. 

[1] Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors, 680 F.3d 1298 (11th Cir. 2012).

[2] It should be noted that the funds were briefly held in escrow by a subsidiary of TOUSA per the terms of the loan agreement.  For all intent and  purposes, however, the subsidiary had no control over the funds, and it was forced to disburse the funds immediately upon closing.

[3] Section 548 of the Bankruptcy Code allows courts to avoid “fraudulent transfers” made within two years of filing, if the debtor received less than “reasonably equivalent value” in exchange for the transfer or obligation at issue. See 11 U.S.C. 548.  Furthermore, if a transfer is avoided under Section 548, Section 550 of the Bankruptcy Code allows the recovery of property transferred from an entity “for whose benefit such a transfer was made”.  See 11 U.S.C. 550.

[4] Tousa, 180 F.3d at 1315.

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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