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Every lender sincerely hopes that, even when its borrower is flat on the floor and seems down for the proverbial count, the borrower will still find the wherewithal to repay it. A lender often starts counting the days after it is repaid until the 90-day preference period (11 U.S.C. §547) has passed. The lender generally breathes a sigh of relief on the 91st day, confident that if its borrower files for bankruptcy, the money paid to the lender is safe from being clawed back by the Bankruptcy Court. In a recent appeals court decision, however, the 11th Circuit Court of Appeals gave lenders more to worry about than the preference period. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA, Inc.), Case No. 11-11071 (11th Cir. May 15, 2012). In TOUSA, the court confirmed the decision of the Bankruptcy Court that a fraudulent transfer could be recovered from “the entity for whose benefit such transfer was made” (11 U.S.C. §550(a) (1)) by expanding the scope to certain payments made to unsecured lenders from a subsequent secured loan. Since the statue of limitations for fraudulent transfers under the Bankruptcy Code is two years (11 U.S.C. §548(a)(1)), a lender may have to wait longer to be assured that its repayment is safe from disgorgement under circumstances similar to those found in TOUSA.

By way of background, TOUSA, Inc. was the thirteenth largest homebuilding enterprise in the country before it filed for bankruptcy. TOUSA, but not its operating subsidiaries, owed a group of unsecured lenders well in excess of $500 million and perhaps as much as $1 billion. Approximately six months prior to filing bankruptcy (well outside of the 90-day preference period), TOUSA paid a $421 million settlement to its existing unsecured lenders (the court refers to them as the “Transeastern Lenders”). TOUSA received these funds from a group of new lenders (aptly named the “New Lenders”). To persuade the New Lenders to lend, TOUSA had a number of its subsidiaries grant liens in their assets to the New Lenders. These subsidiaries had not previously been borrowers from the Transeastern Lenders. Six months later, TOUSA and all of these subsidiaries filed for bankruptcy.

The Bankruptcy Code’s fraudulent transfer statute is 11 U.S.C. §548. The general purpose of fraudulent transfer statutes is to prevent a debtor from transferring its assets for little or no money in order to keep the property out of the hands of the debtor’s creditors. 11 U.S.C. §548 describes two main types of fraudulent transfers under the Bankruptcy Code:

(a) transfers made with actual intent to hinder, delay, or defraud creditors (11 U.S.C. §548(a) (1) (A)); and

(b) “constructively fraudulent” transfers (11 U.S.C. §548(a)(1)(B)), in which the court has to determine whether the debtor received less than “reasonably equivalent value” in exchange for a transfer made while insolvent, while nearing insolvency, or out of the ordinary course of business.

The Bankruptcy Court may reverse or unwind any transfer found to violate the fraudulent transfer provisions of the Bankruptcy Code. The Bankruptcy Court may order the transferee to pay back the value of the property improperly transferred and may order recovery from parties “for whose benefit” the transfer was made (11 U.S.C. 550(a) (1)).

The Bankruptcy Court found that the subsidiaries, by granting liens in their property to secure $403 million of the new loan from the New Lenders, had engaged in a constructively fraudulent transfer under 11 U.S.C. §548(a)(1)(B). All parties agreed that the subsidiaries were or had become insolvent as a result of this loan. The Bankruptcy Court then found that the subsidiaries did not receive “reasonably equivalent value” for the transfer. Official Comm. of Unsecured Creditors of TOUSA, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 422 B.R. 783 (Bankr. S.D. Fla. 2009). The Transeastern Lenders and the New Lenders argued that the loan gave TOUSA and its subsidiaries the opportunity to avoid bankruptcy and litigation involving the Transeastern Lenders by paying off the Transeastern Lenders as part of an overall settlement. The Bankruptcy Court, after an extensive review of the facts, concluded that a bankruptcy for both TOUSA and its subsidiaries was inevitable and that even assuming, that avoiding bankruptcy was “value” for purposes of 11 U.S.C. §548, loan from the New Lenders was far more harmful for the subsidiaries than helpful. More importantly, the Bankruptcy Court found that the Transeastern Lenders were entities “for whose benefit” the transfer was made and that under 11 U.S.C. 550(a) (1) the Transeastern Lenders could be required to repay all of the amounts previously paid to them.

The Bankruptcy Court had ordered that: (i) the New Lenders be stripped of the liens granted to them by the subsidiaries of TOUSA, (ii) the Transeastern Lenders return the funds they received from the New Lenders’ loan, (iii) certain of those funds be paid to the Creditors Committee for the costs of the litigation, (iv) the bankruptcy estate receive funds for the benefit of creditors equal to the diminution in the value of the property in which the New Lenders were granted a lien, and (v) the balance recovered be paid to the New Lenders (leaving them with an unsecured claim). Finally, the Bankruptcy Court ordered that the unsecured claim of the Transeastern Lenders would be reinstated as an unsecured claim in the TOUSA bankruptcy. The 11th Circuit did not rule on the Bankruptcy Court’s remedy but left this for further rulings by the District Court and/or the Bankruptcy Court on remand.

The 11th Circuit did uphold the ruling of the Bankruptcy Court, using the “not clearly erroneous” standard that the grant by the Tousa subsidiaries of liens to the New Lenders was not made for “reasonably equivalent value.” The 11th Circuit was convinced that there had been sufficient fact finding by the Bankruptcy Court to decide that a TOUSA bankruptcy was all but inevitable at the time of the transaction, calling it a “slow-moving category 5 hurricane.” TOUSA, Case No. 11-11071 (slip op. at 32). The 11th Circuit did not decide as a matter of law whether the avoidance of bankruptcy court ever be “value” for purposes of 11 U.S.C. 548(a)(1)(B), but upheld the Bankruptcy Court’s findings that in TOUSA it was not “reasonably equivalent value.”

The 11th Circuit also affirmed the Bankruptcy Court’s finding that the Transeastern Lenders were the entities “for whose benefit” the transfer was made. This supported the recovery of the funds paid to the Transeastern Lenders from the New Lenders’ secured loan, pursuant to 11 U.S.C. §550(a)(1). The 11th Circuit looked through the formality that the funds were first paid to a TOUSA entity that was not a borrower and then to the Transeastern Lenders as form over substance and did not give much regard to the lenders’ objection that such a reading of 11 U.S.C. §550(a) (1) would impose “extraordinary” duties of due diligence on creditors accepting repayment. The court noted that due diligence should always be undertaken, especially “when being repaid hundreds of millions of dollars by someone other than [a] debtor.” TOUSA, Case No. 11-11071 (slip op. at 39).

As a side note, state fraudulent transfer statues are not overridden by the Bankruptcy Code and can be enforced in the Bankruptcy Court. These statutes have longer statutes of limitation (four years in Massachusetts) and contain similar language about transfer for the benefit of third parties to 11 U.S.C. 550(a)(1).

After TOUSA, an unsecured lender who is paid with funds from a subsequent secured loan will be at risk until the statute of limitations on fraudulent transfers passes, if the borrower is either insolvent or rendered insolvent by the transaction. The 11th Circuit’s opinion does not give much guidance as to the legal determination of “value” under 11 U.S.C. 548 and leaves that to future decisions. The decision in TOUSA should make any unsecured lender very wary of any payment received from a troubled debtor.

This advisory was prepared by the Commercial Finance practice group at Nutter McClennen & Fish LLP. For more information, please contact your Nutter attorney at 617.439.2000.

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.