August 20, 2010

TOUSA's Impact on Lenders: Are Savings Clauses Bankrupt?

Bankruptcy Court finds $500 million loan is a fraudulent transfer and that savings clauses in loan agreements are unenforceable.

In a 182-page decision that has significant implications regarding a lender's ability to secure loans made to a borrower approaching insolvency, the Bankruptcy Court for the Southern District of Florida (the Bankruptcy Court) held that a $500 million secured loan made a few months before the filing of a bankruptcy petition was a fraudulent conveyance. Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc., 2009 WL 3519403 (Bankr. S.D. Fla. 2009). In addition, the Bankruptcy Court invalidated so-called savings clauses in the credit agreements at issue. Savings clauses are a relatively standard fixture in credit agreements. The intended effect of savings clauses is to provide that a borrower is obligated to repay only such amount of a loan as will not exceed the value of its assets in order to keep it from being rendered insolvent by the loan. Because many lenders believe savings clauses are in fact unnecessary and only state what is in fact the law--that when liens are granted to lenders by various borrowers comprising a consolidated group of affiliated corporate borrowers, each such borrower is only liable for the indebtedness up to the value of such borrower's assets--the invalidation of these clauses in TOUSA has caused considerable confusion and consternation among lenders.

The TOUSA decision demonstrates that really bad facts can indeed make even worse law. TOUSA is a large residential developer with many subsidiaries. A single subsidiary of TOUSA owed some $420 million to certain lenders. When that loan went into default, TOUSA repaid that loan using proceeds from a new $500 million loan that was guaranteed by substantially allTOUSA-affiliated entities. Moreover, the lenders participating in the two loans, the old $420 million loan borrowed by a single TOUSA subsidiary and the new $500 million loan guaranteed by all TOUSA subsidiaries, were essentially the same. In other words, the lenders effectively repaid themselves with the new loan, which was now the obligation of substantially all TOUSA entities. Shortly thereafter, the TOUSA-affiliated entities (the Debtors) that were obligated under the $500 million facility filed voluntary chapter 11 bankruptcy petitions.

Adversary Proceeding

The official committee of unsecured creditors (the Committee) appointed in the Debtors' cases filed an adversary proceeding, seeking, inter alia, under the Bankruptcy Code and comparable state fraudulent transfer laws, to (1) invalidate the liens granted by all TOUSA entities securing the new $500 million loan and (2) recover the $420 million paid to the lenders in respect of the old loan made to the single TOUSA subsidiary.

Fraudulent Transfer

Under section 548 of the Bankruptcy Code, a debtor (or an official representative of the debtor such as the committee or a trustee) is permitted to avoid as a fraudulent transfer any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, within two years before the filing of the bankruptcy petition if the debtor received "less than a reasonably equivalent value" in exchange for the transfer and (a) was either insolvent at the time of such transfer or rendered insolvent by such transfer, (b) was left with an "unreasonably small" amount of capital, or (c) intended or believed at the time of such transfer that it would not be able to pay its debts as they came due (i.e., a "constructive" fraudulent transfer). Under section 544 of the Bankruptcy Code, a debtor is also permitted to avoid any transfers that would be avoidable under applicable state law. Most states have adopted in whole or in part either the Uniform Fraudulent Transfer Act or the Uniform Fraudulent Conveyance Act. Finding that, in connection with the new $500 million loan guaranteed by all TOUSA entities, the grant of the lien by each of the TOUSA subsidiaries on its property constituted a "transfer" of an interest in property and that each obligation incurred by the TOUSA subsidiaries constituted an "obligation" incurred by the debtor within the meaning of section 548, the Bankruptcy Court analyzed the transfers and found that (1) the TOUSA subsidiaries did not receive reasonably equivalent value, (2) the transfers rendered the TOUSA subsidiaries insolvent or were made while the TOUSA subsidiaries were insolvent, and (3) left the TOUSA subsidiaries with unreasonably small capital and unable to pay their debts as the debts came due. As a result, the Bankruptcy Court invalidated the guarantees and liens granted by the TOUSA subsidiaries.

The Bankruptcy Court's holding was based primarily on the finding that there was little or no value to the TOUSA subsidiaries to issue the guarantees and grant liens with respect to the new $500 million loan, as the proceeds of that loan were principally to be used to repay the old $420 million that was the obligation of just one TOUSA subsidiary.

Starting with the housing market downturn in 2006, the TOUSA companies increasingly needed financing. During the meeting of TOUSA's board of directors at which the new $500 million loan was approved, the board was informed by management that the U.S. housing market was at its lowest point in 16 years. In addition, there were many published reports that TOUSA was near insolvency or would be insolvent if TOUSA's board approved the new $500 million (i.e., its debt would exceed its assets). Moreover, the Debtors' lack of capital was exacerbated by TOUSA's owners' unwillingness to permit the dilution of their equity interests by the infusion of additional equity from other investors. The Bankruptcy Court found that this unwillingness by the owners to permit the infusion of additional equity "forced TOUSA to take on excessive debt."

Indeed, indicia of insolvency were apparent in the lenders' own analyses of the proposed new $500 million loan. Documents produced in discovery demonstrated that the lenders were "well aware of the negative effect [the] financing would have on TOUSA's bondholders." The Bankruptcy Court found that, despite the red flags, the lenders "pressed on with the transaction," as it "saw the proposed new financing as a highly attractive opportunity for fees."

The Bankruptcy Court further found that compensation to third-party advisors "was contingent on providing opinions that facilitated the closing" and that TOUSA's CEO had "a strong personal incentive" as a result of a bonus to be awarded to him if the new $500 million loan were consummated.

Furthermore, the Bankruptcy Court was particularly troubled by the opinions of the lenders' experts, finding them less than credible--the Bankruptcy Court complained that one expert "would opine as desired on anything." The Bankruptcy Court applied the "balance sheet" test for insolvency, which demonstrated that the TOUSA subsidiaries, individually and on a consolidated basis, were insolvent prior to the closing of the new $500 million loan.

The Bankruptcy Court also found that a solvency opinion procured at the lenders' request was unpersuasive. In the Bankruptcy Court's view, the solvency opinion was issued under particularly dubious circumstances, did not employ proper methodology, and relied on questionable data. In addition, the advisor's compensation included a contingency fee component, the payment of which was predicated on its delivery of a favorable opinion. Moreover the opinion was issued "in remarkable speed"; was based solely on management's projections, which relied on flawed--if not fraudulent--assumptions; and employed methodologies that experts on "both sides'" (emphasis in original) agreed at trial were unreliable.

Perhaps the most important point brought out by the Bankruptcy Court's solvency analysis is that, absent some equitable grounds (alter ego or veil piercing, or substantive consolidation under the Bankruptcy Code) for treating the Debtors as a consolidated entity, each of the Debtors would be separately evaluated to determine whether fraudulent transfers had occurred, thus requiring each of the conveying subsidiaries to demonstrate solvency such that its increase in liabilities (i.e., additional liens) saw a corresponding increase in assets (i.e., receipt of loan proceeds). In rejecting as a matter of law the lenders' argument that a "common enterprise" theory should be applied, the Bankruptcy Court noted that each of the Debtors was run as a separate corporate entity and that the defendants did not advance any legal basis as to why the entities' separateness should be disregarded. While not explicitly stated, the Bankruptcy Court's finding that the TOUSA subsidiaries received no benefit from the new $500 million loan likely figured into this facet of the decision; if there had been some sort of consolidated benefit (i.e., the "whole" is greater than the "sum of the parts") to the Debtors' overall operations by entering into the new $500 million loan, then that incremental value could have provided a reason for determining the Debtors' solvency on a consolidated basis.

The Savings Clauses

The Bankruptcy Court ruled as a matter of law that the "savings clauses" in the credit agreements were invalid. Applying questionable logic, the Bankruptcy Court found numerous reasons for discounting the savings clauses.

First, the Bankruptcy Court found that, prior to the new $500 million loan transaction, the conveying subsidiaries were insolvent, which makes it unclear why the Bankruptcy Court found it necessary to gratuitously rule on the savings clauses' validity.

Second, the Bankruptcy Court found that the clauses were, in substance, "ipso facto" clauses, and thus should be given no effect under the Bankruptcy Code. Ipso facto clauses are contractual provisions that purport to affect a debtor's contract or property rights upon the commencement of a bankruptcy case, and are generally deemed to be unenforceable against a debtor under the Bankruptcy Code. The Bankruptcy Court determined that the savings clauses were "provision[s] in an agreement" that were "conditioned on the insolvency of the debtor" and that "effect[ed] a forfeiture, modification, or termination of the debtor's interest in property." The Bankruptcy Court reasoned that the savings clauses, if given the effect claimed by the lenders, would "defeat the debtors' cause of action for a fraudulent transfer, and a cause of action is unquestionably property of the debtor."

Third, the Bankruptcy Court found that the multiple savings clauses contained in the new $500 million loan agreement and a second-lien prepetition loan agreement were invalid as a matter of contract law, as such clauses conflicted with one another and the Bankruptcy Court could not determine which clauses should be applied first.

Finally, the Bankruptcy Court found that enforcing the savings clauses would effect a modification of the conveying subsidiaries' obligations and liens, but that such modification was invalid as the lending documents required that any amendments be made in a separate signed writing (of which there was none).

Particularly troubling is that the Bankruptcy Court's analysis of the savings clauses appears to lead nowhere. If the Bankruptcy Court had determined that the savings clauses were valid, then the lenders' liens would be reduced to the value of each Debtor's assets, whereas if the Bankruptcy Court found that the clauses were not valid, then the Debtors would be able to commence a fraudulent transfer action, but only to reduce the lenders' liens to the value of each Debtor's assets. Invaliding clauses that actually represent an agreement by the lenders as to what would result from the application of fraudulent transfer laws has resulted in considerable negative comments by many analysts.


The lenders that made both the new $500 million loan and the old $420 million loan have appealed the Bankruptcy Court's decision in TOUSA to the U.S. District Court for the Southern District of Florida (the district court). In their appeals, the lenders have raised various issues, including (1) violation of the "single satisfaction rule" by granting the Committee both an avoidance of the liens of the lenders with respect to the new $500 million loan and the disgorgement of the funds transferred to repay the lenders with respect to the old $420 million loan to a single TOUSA subsidiary, (2) errors in finding lack of good faith, (3) errors in the remedies ordered, and (4) errors in the evidence (including expert evidence) presented. The Committee has moved for consolidation of the various appeals filed by the lenders. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors, Case No. 10-cv-60017 (Jordan); Wells Fargo Bank, NA v. Official Committee of Unsecured Creditors, Case No. 10-cv-60018 (Jordan); Citicorp North America Inc., v. Official Committee of Unsecured Creditors of TOUSA, Inc., Case No. 10-cv-60019 (Jordan). The Committee also quickly moved to dismiss the appeals as premature, claiming that the Bankruptcy Court's judgment was not final, and thus that the district court should not exercise jurisdiction, or, in the alternative, to dismiss the appeal. That motion has been denied in at least one of the appeals (Case No. 10-cv-60017 (Jordan), Order Denying the Motion of the Official Committee of Unsecured Creditors to Stay Briefing, or, in the Alternative, to Dismiss [Docket No. 66]), but granted in another (Case No. 10-cv-60018 (Jordan), Order Staying Briefing [Docket No. 56]), and no decision has been rendered yet in the appeal by the lenders with respect to the new $500 million loan (this motion has been heard, though not yet formally decided—see Case No. 10-cv-60019 (Jordan), Minute Entry [Docket No. 58]).


Given the fact-intensive nature of the Bankruptcy Court's analysis of the fraudulent conveyance and preference claims, it is unlikely that the district court will disturb the Bankruptcy Court's findings of fact. On the evidence presented, the Bankruptcy Court had numerous grounds on which to base its determinations of insolvency, good faith, reasonably equivalent value, etc., and thus these findings will likely survive the appeals. However, should the appellants pursue reversal of the Bankruptcy Court's ruling as a matter of law that savings clauses are unenforceable, they may meet with some success.

The ultimate lesson from TOUSA for lenders is to avoid situations where borrowers already in distress receive little or no benefit from a financing and to fully protect themselves with respect to professional opinions, due diligence, market data, and borrowers' financial information.