In a decision with significant implications for borrowers and lenders, on May 15, 2012, the 11th Circuit Court of Appeals affirmed a bankruptcy court's findings that upstream guarantees and associated liens delivered by a bankrupt debtor's subsidiaries were avoidable as fraudulent transfers. The decision, which came in the bankruptcy case of housebuilder TOUSA and its affiliates, undermines the enforceability of upstream guarantees given by subsidiaries for the benefit of a parent borrower. To protect against its effects, lenders will need to ensure that subsidiary guarantors are solvent or will tangibly benefit from loans to the parent corporations.
In June 2007, TOUSA (a large housebuilder) borrowed $421 million in new debt from one group of lenders, which it used to pay down some of its existing debt. Only the parent company had been liable on that prior debt, but various TOUSA subsidiaries guaranteed the new debt and pledged certain assets as security.
TOUSA and the subsidiaries filed for bankruptcy just six months later. The TOUSA creditors' committee then launched a fraudulent transfer action against the new lenders. The suit alleged that the guarantees and liens the TOUSA subsidiaries had delivered to the new lenders should be avoided as constructively fraudulent as to other creditors because (1) the TOUSA subsidiaries were insolvent at the time they executed the guarantees, and (2) the TOUSA subsidiaries (as distinguished from TOUSA itself) received no reasonably equivalent value in exchange for their guarantees.
After a 13-day trial, the bankruptcy court held that the guarantees and liens were in fact avoidable as fraudulent transfers. See 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 bankruptcy court found that the benefits to the subsidiaries (who received none of the loan proceeds) were insubstantial. The bankruptcy court rejected arguments that the subsidiaries materially benefited from the continued operation of the parent company. The bankruptcy court's decision was widely publicized at the time and was received with dismay by financial institutions and their attorneys.
In a decision last year, a Florida district court reversed the bankruptcy court. See 3V Capital Master Fund Ltd. v. Official Comm. of Unsecured Creditors of Tousa, Inc. (In re Tousa, Inc.), 444 B.R. 613 (S.D. Fla. 2011). The district court focused on the intangible, indirect benefits that the TOUSA subsidiaries received from the transaction, including the opportunity to avoid bankruptcy, continue as a going concern, and make further payments to creditors.
In its recent decision, the 11th Circuit Court of Appeals reversed the district court and affirmed the bankruptcy court's original findings. The only issue on appeal was whether the TOUSA subsidiaries received reasonably equivalent value.
The appeals court applied a generous standard of review and held that the bankruptcy court's factual findings on the reasonably-equivalent-value issue were not clearly erroneous. The bankruptcy court was not clearly wrong when it held that TOUSA's subsidiaries and their creditors would have been better off if TOUSA had filed for bankruptcy immediately, rather than staving off the inevitable for six months while burdening the subsidiaries with substantial new debts.
The appeals court did not directly address some of the issues that had caused the most consternation among the lending community. For example, each of the subsidiary guarantees included a savings clause to the effect that the liability of each guarantor was limited to the largest amount that would still leave the guarantor solvent. If given effect, a savings clause essentially precludes a successful constructive fraudulent transfer action, since insolvency is an essential element of that claim. It is not clear whether that part of the bankruptcy court’s decision has been revived by the appeals court because the appeals court focused its analysis on value issues, not solvency.
This decision has significant implications for lenders and borrowers. Lenders should be wary of relying on upstream guarantees from subsidiaries who will receive none of the proceeds of a loan. To guard against the risk that those guarantees may be invalidated later, lenders should either ensure that the guarantors will benefit from the loan, or ensure that the guarantors are solvent at the time of the loan.
For borrowers with complicated corporate structures, this decision may raise the cost of capital because lenders will likely discount the value of upstream guarantees. Borrowers can address this issue by consolidating their corporate organizations and compiling solid evidence of the solvency of each guarantor and the benefit to each guarantor derived from the loan.