Monday, February 14, 2011

TOUSA Fraudulent Conveyance Judgment Reversed by District Court

In a 113 page opinion, U.S. District Judge Alan S. Gold has reversed a controversial fraudulent conveyance judgment in the TOUSA bankruptcy case. In re TOUSA, Inc., Case No. 10-60017 (S.D. Fl. 2/11/11). You can find the opinion here.

A Series of Highly Unfortunate Events

TOUSA involved a network of related companies in the homebuilding business. They obtained liquidity for their operations through a revolving line of credit granted by Citicorp North America as administrative agent ("the Revolver"). Ultimately, the Revolver was guaranteed by the TOUSA subsidiaries and their assets were pledged as collateral.

Meanwhile, TOUSA entered into a Joint Venture with Falcone/Ritchie, LLC to acquire some of the homebuilding assets of Transeastern Properties, Inc. ("the TransEastern JV"). To fund the TransEastern JV, they took out new debt independently of the Revolver (the "TransEastern Debt"). The lenders on this debt were known as the TransEastern Lenders. TOUSA and some, but not all, of its subsidiaries, guaranteed the TransEastern Debt.

The joint venture did not go well and the TransEastern Lenders declared a default.

At this point, Citicorp became uncomfortable and demanded that the TOUSA subs pledge collateral for the Revolver. Because they wanted to continue benefitting from the funds available under the Revolver, they agreed.

Meanwhile, the TransEastern Lenders brought suit against TOUSA and the other parties liable on the TransEastern Debt. TOUSA saw that it had three choices: 1) litigate; 2) file bankruptcy or 3) settle. They didn't believe that they could survive an extensive lawsuit. They also were afraid that if the parent filed bankruptcy, funding for the operating subsidiaries would dry up.

With settlement being the only viable option, they settled. The TOUSA group took out new loans from, appropriately enough, the New Lenders. The debt to the New Lenders was guaranteed by the subsidiaries and the subsidiaries pledged their assets. Citicorp agreed to allow the New Lenders to have an equal lien on the assets that were already pledged to them.

The effect of this transaction was that a larger group of TOUSA companies (the "Conveying Subsidiaries") pledged their assets and guaranteed the new debt where previously, only the parent company and a few subsidiaries had been liable for the TransEastern Debt.

The settlement occurred on July 31, 2007. The TransEastern Lenders received payment of over $426 million on debt exceeding $600 million.

Unfortunately, the settlement with the TransEastern Lenders did not spell the end of the TOUSA troubles. August 2007 was described as a “once in a century credit tsunami,” a “Black Swan” event, and an “economic Pearl Harbor.” TOUSA and many of its subsidiaries filed chapter 11 on January 29, 2008. The Creditors' Committee filed suit against the TransEastern Lenders and the New Lenders asserting that the TransEastern settlement constituted a fraudulent conveyance.

The Bankruptcy Court found that the Conveying Subsidiaries did not receive reasonably equivalent value. The Court found that they did not receive any direct benefit from having their assets encumbered and that, on top of that, they failed to prevent the bankruptcy of the parent company. The Bankruptcy Court dismissed the prospect that the Conveying Subsidiaries would have been harmed by a default under the Revolver caused by the TransEastern litigation.

The Court also found that "the New Lenders and the Transeastern Lenders did not act in good faith and were grossly negligent when they engaged in the July 31 Transaction on the basis that there was 'overwhelming evidence that TOUSA was financially distressed.'” District Court Opinion, p. 38.

The Bankruptcy Court avoided the liens of the New Lenders and ordered the TransEastern Lenders to disgorge the payments it had received and to pay prejudgment interest.

The District Court Opinion

The District Court teed up the issues as:

(1) whether the Transeastern Lenders can be compelled to disgorge to the Conveying Subsidiaries funds paid by TOUSA to satisfy a legitimate, uncontested debt, where the Conveying Subsidiaries did not control the transferred funds, and

(2) whether the Transeastern Lenders are liable for disgorgement as the entities “for whose benefit” the Conveying Subsidiaries transferred the Liens to the New Lenders, where the Transeastern Lenders received no direct and immediate benefit from the Lien Transfer.

District Court Opinion, p. 42.

Parroted Findings Not Entitled to Clearly Erroneous Review

Normally "reasonably equivalent value" would be a fact question reviewed under the clearly erroneous standard. However, the District Court had harsh words for the Bankruptcy Court 's findings. The Bankruptcy Court adopted 446 out of 448 proposed findings from the Committee in whole or in part while adopting none of the 1,600 findings proposed by the Defendants. In its Brief, the Defendants contended that out of 500 pages of post-trial submissions, not "a single case, exhibit or other piece of evidence cited by them appears in the Opinion unless and to the extent it was also cited by the Committee."

The District Court stated:

The “clearly erroneous” standard of review for factual findings is relaxed in circumstances where a lower court adopted one party’s proposed order verbatim. (citation omitted). This practice has been heavily criticized and discouraged by the U.S. Supreme Court and by the Eleventh Circuit. (citation omitted). (“Many courts simply decide the case in favor of the plaintiff or the defendant, have him prepare the findings of fact and conclusions of law and sign them. This has been denounced by every court of appeals save one. This is an abandonment of the duty and the trust that has been placed in the judge by these rules. It is a noncompliance with Rule 52 specifically and it betrays the primary purpose of Rule 52—the primary purpose being that the preparation of these findings by the judge shall assist in the adjudication of the lawsuit. I suggest to you strongly that you avoid as far as you possibly can simply signing what some lawyer puts under your nose. These lawyers, and properly so, in their zeal and advocacy and their enthusiasm are going to state the case for their side in these findings as strongly as they possibly can. When these findings get to the courts of appeals they won't be worth the paper they are written on as far as assisting the court of appeals in determining why the judge decided the case.”) (citing J. SKELLY WRIGHT, SEMINARS FOR NEWLY APPOINTED UNITED STATES DISTRICT JUDGES 166 (1963).
District Court Opinion, pp. 44-45.

I have no way to know whether the Bankruptcy Court's wholesale adoption of the Committee's findings was the result of judicial laziness or simply because the Committee's lawyers were extremely persuasive. However, when the Court simply parrots back the findings proposed by one party, the court has ceased being a neutral arbiter and has become a mouthpiece for the winning party. As the District Court correctly noted, "When these findings get to the courts of appeals they won't be worth the paper they are written on as far as assisting the court of appeals in determining why the judge decided the case.”

Before You Can Figure Out If It Was a Fraudulent Conveyance, You Have to Figure Out What Happened

The District Court began its analysis by examining the substance of the transactions.

Those transactions involved three distinct asset transfers:

1. TOUSA caused certain of the Conveying Subsidiaries to convey the liens on their real property assets and become obligated to a collection of financial entities referred here as the New Lenders.

2. In exchange for the liens and the obligations, the New Lenders loaned funds and provided credit facilities, the New Loans, to TOUSA; and

3. TOUSA used the funds from the New Lenders in part to satisfy its $421 million debt to the Transeastern Lenders.
District Court Opinion, p. 47. The District Court then contrasted this analysis with the Bankruptcy Court's findings.

The Bankruptcy Court found the Transeastern Lenders liable under Section 548 on two different bases of liability, for two distinct fraudulent transfers:

(1) as direct transferees of the New Loan proceeds paid in satisfaction of a valid antecedent debt; and (2) as entities “for whose benefit” the Conveying Subsidiaries transferred the liens to the New Lenders. In essence, the Bankruptcy Court found that the Conveying Subsidiaries had a property interest in the New Loan proceeds that TOUSA transferred to the Transeastern Lenders, received only minimal value in exchange for relinquishing that property, and were insolvent. Accordingly, the Bankruptcy Court voided the entire transfer and ordered the Transeastern Lenders to disgorge the funds received in satisfaction of the undisputed debt they were owed. [Op., p. 180–81]. The Bankruptcy Court’s Opinion adopted both of the Committee’s theories of liability in the same language used in the Committee’s post-trial papers with only the barest of word changes, and without attempting to harmonize these two mutually exclusive theories.

District Court Opinion, pp. 47-48.

This passage highlights an important aspect of applying fraudulent transfer law to complex financial transactions. Because these transactions involve multiple transactions and multiple parties, the way that you slice and dice the transactions may determine the outcome. The Bankruptcy Court collapsed the transactions into a single transfer where the assets of the Conveying Subsidiaries were used to pay the debt of the parent TOUSA. On the other hand, the District Court examined each transaction independently.

The District Court Rejects the Direct Transferee Theory

The District Court had no trouble rejecting the theory that the TransEastern Lenders were the recipient of a direct transfer of property of the Conveying Subsidiaries. The loan proceeds from the New Lenders were deposited into an account of a subsidiary which was not one of the Conveying Subsidiaries. The Conveying Subsidiaries never had any control over these funds. As a result, the Conveying Subsidiaries did not have a property interest in the funds paid to the TransEastern Lenders. The control test is important under the Eleventh Circuit decision in In re Chase & Sanborn Corp., 848 F.2d 1196 (11th Cir. 1988).

The District Court was dismissive of both the Bankruptcy Court's reasoning and the arguments advanced by the Committee on appeal.

Without any factual dispute in the record, both the First and Second Lien Term Loan Agreements directed that the proceeds of the New Loans be used to satisfy the Transeastern Settlement. Specifically, Section 4.12 of the agreements required the proceeds of the loans to be used to fund the “Acquisition,” defined as “the contribution by the ‘Administrative Borrower’ [TOUSA] to the Transeastern JV Entities of an amount necessary to discharge all amounts of outstanding indebtedness of the Transeasatern JV Entities.” [Trial. Exh. 360 §§ 1.1, 4.12]. Under the totality of the circumstances, the Bankruptcy Court’s findings and legal conclusions were neither “logical” nor “consistent with the equitable concepts underlying bankruptcy law.”

* * *

The Bankruptcy Court erred by failing to apply the Eleventh Circuit’s control test to the totality of the circumstances as established by the actual documents governing the transactions. Rather, it dismissed the test, expressly rejecting as “clearly wrong” the proposition that ‘control’ is an essential element of any property interest under Section 548. [Op., p. 157]. The Bankruptcy Court expressed the view that a control test “would negate the paradigmatic example of a fraudulent transfer, in which the owner of an insolvent corporation transfers corporate funds to a personal account for his personal use” because the owner’s de facto control over the funds cannot vitiate the corporation’s control over, and property interest in, the funds. [Id. at 158].
District Court Opinion, p. 49, 50-51. Similarly, the Court noted that, "In its Appeal Brief, the Committee offered no substantive response to the Transeastern Lenders’ position that the Conveying Subsidiaries never had any property interest in the New Loan proceeds, and thus transferred nothing to the Transeastern Lenders." District Court Opinion, p. 54.

District Court Finds Clear Error in Finding Lack of Reasonably Equivalent Value

In a mind-numbing discussion, the District Court found that the Bankruptcy Court committed clear error in finding lack of reasonably equivalent value. On the one hand, the Bankruptcy Court found that the Conveying Subsidiaries had only a minimal interest in the loan proceeds because they had been "forced" to agree to the use of these funds to pay the TransEastern Lenders. The District Court held that if the Conveying Subsidiaries had only a minimal interest in the loan proceeds, that they needed only to receive a minimal value to receive reasonably equivalent value.

The approaches taken by the Bankruptcy Court and the District Court illustrate the difference between a forest or the trees approach. The Bankruptcy Court looked at the forest. It concluded that the Conveying Subsidiaries' assets were encumbered to pay a debt of the parent. The District Court looked at the trees. The Conveying Subsidiaries encumbered their assets in return for loan proceeds. If those loan proceeds were used improvidently, that did not change the fact that they received reasonably equivalent value from the loan itself. They all had boards and the boards voted to approve the transaction.

At this point, the District Court opinion has an almost Alice in Wonderland quality. If you encumber your assets in return for loan proceeds in which you have a minimal interest, you need only receive minimal value in return. Of course, if the assets were encumbered by full value liens and the Conveying Subsidiaries received only a minimal interest in the net proceeds, it stands to reason that there is a disconnect here.

Indirect Value Is Still Value

The District Court returned to surer footing when it analyzed the question of indirect value. The Bankruptcy Court held that if the Conveying Subsidiaries did not receive direct value, that the TransEastern Lenders had the burden to prove receipt of indirect value. However, the District Court noted that the Plaintiff had the burden to prove lack of reasonably equivalent value, whether it was direct or indirect. Thus, the Bankruptcy Court placed the burden of proof on the wrong party.

The District Court concluded that "the record establishes beyond dispute that the Conveying
Subsidiaries themselves, as compared to only the TOUSA Parent, received indirect economic benefits, constituting reasonably equivalent “value,” in exchange for their lien transfers." District Court Opinion, pp. 63-64.

The District Court found that the Bankruptcy Court committed an error of law when it held that avoiding default under the Revolver could not constitute value to the Conveying Subsidiaries.
Nonetheless, I conclude that the Bankruptcy Court committed legal error in holding that the “avoidance of default and bankruptcy by the Conveying Subsidiaries” is as a matter of law “not property and therefore is not cognizable as ‘value’” under Section 548 of the Bankruptcy Code.
District Court Opinion, p. 64.

I think this is an important conclusion. Using the forest and the trees analogy again, at the forest level, it was reasonable for the Conveying Subsidiaries to conclude that avoiding the financial decapitation of their parent was in their collective interest. As Ben Franklin once said, "We must all hang together or we shall all hang separately." However, in this case, the Bankruptcy Court was looking at the trees when it concluded that the Conveying Subsidiaries encumbered their assets for the gratuitous benefit of their parent. If the economy had not descended into an economic black hole, the decision of the Conveying Subsidiaries to attempt to save themselves by saving their parent would have been quite sound. Reasonably equivalent value must be determined based on July 31, 2007 rather than August 2007.

The District Court opinion goes on for another fifty pages. However, the most important part is on page 64.

The District Court opinion is Act II of a drama which will continue to at least Act III and possibly Act IV. What it does is set forth two very different approaches to the same problem. The Eleventh Circuit panel which receives this appeal will have some deep thinking in store for them.


Anonymous said...

*The Eleventh Circuit panel which receives this appeal will have some deep thinking in store for them.*

Either that or they'll adopt the findings of the district court (or maybe the findings of the bankruptcy court) verbatim and affirm (or reverse) the district court. :)

Danial123 said...

Hopefully with attorneys like you and Jennifer out there, contractors will be able to keep from needing them as much in 2011.
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