TOUSA Case Takes Another Twist

In September 2006, following the Transeastern acquisition, the Florida housing market rapidly declined, causing the Transeastern JV to default under its credit facilities with the Transeastern Lenders. As a result, the Transeastern Lenders sued TOUSA and Tousa Homes in New York State court for the breach of their guarantees under the credit facilities. TOUSA and Tousa Homes settled the litigation with the Transeastern Lenders for approximately $421 million, among other reasons, to avoid having an adverse judgment filed against TOUSA in excess of $10 million, which would have triggered a cross-default under certain of its bond indentures and a revolving credit facility for which the Conveying Subsidiaries served as guarantors.

In July 2007, in order in part to fund the settlement with the Transeastern Lenders, TOUSA entered into new secured credit facilities with various lenders (the New Lenders), aggregating approximately $476 million. As a condition for obtaining the new loans, the Conveying Subsidiaries pledged their assets as collateral for the new loans even though they were not a party to the litigation and were not going to receive any of the new loan proceeds. The New Lenders transferred the proceeds of the new loans to Universal Land Title, Inc. (ULT), a TOUSA subsidiary, which in turn immediately transferred approximately $426 million of the new loan proceeds to the Transeastern Lenders as expressly directed in the new loan documentation.

On Jan. 29, 2008, TOUSA, Tousa Homes and the Conveying Subsidiaries, among other TOUSA affiliates, filed for relief (the TOUSA Bankruptcy Cases) under Chapter 11 of the United States Code (the Bankruptcy Code) in the U.S. Bankruptcy Court for the Southern District of Florida (the Bankruptcy Court).

Committee Commences Adversary Proceeding

On July 14, 2008, the Official Committee of Unsecured Creditors in the TOUSA Bankruptcy Cases (the Committee) filed an adversary proceeding in which it sought, in relevant part, to: 1) avoid, under ” 544 and 548 of the Bankruptcy Code, the lien transfers made by the Conveying Subsidiaries to the New Lenders; 2) avoid, under ” 544 and 548 of the Bankruptcy Code, the transfer of the new loan proceeds from ULT to the Transeastern Lenders; and 3) recover the value of the lien transfers and the proceeds transfer from the Transeastern Lenders under ' 550 of the Bankruptcy Code on the basis that the Transeastern Lenders were the direct transferees of the proceeds of the new loans and were entities for whose benefit the liens were transferred by the Conveying Subsidiaries.

Sections 544 and 548 of the Bankruptcy Code allow a trustee to avoid a transfer of “an interest of the debtor in property” or “obligation incurred by the debtor” that was: 1) made for “less than reasonably equivalent value”; and 2) made while the debtor was insolvent or had unreasonably small capital at the time of the transaction or as a result of the transaction. 11 U.S.C. ' 548. In its Complaint, the Committee argued that the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for either the transfer of their liens or the proceeds transfer. In addition, the Committee alleged that, as a result of the transfers, the Conveying Subsidiaries were either insolvent or rendered insolvent, left with unreasonably small capital or became unable to pay their debts as they were to come due.

Section 550(a)(1) of the Bankruptcy Code allows a trustee to recover an avoided transfer from: 1) the initial transferee; 2) the entity for whose benefit such transfer was made; or 3) a subsequent transferee. 11 U.S.C. ' 550(a)(1). In this case, the loan proceeds were received by ULT, but as required under the documentation, were immediately transferred to the Transeastern Lenders. In addition, although the lien transfers were made by the Conveying Subsidiaries to the New Lenders, the transfers actually benefited the Transeastern Lenders because they were able to receive the settlement proceeds only as a result of the lien transfers.

Bankruptcy Court Finds in Favor of Committee

The Bankruptcy Court ruled in favor of the Committee, holding that the Conveying Subsidiaries: 1) did not receive reasonably equivalent value in exchange for the lien transfers and proceeds transfer; 2) were insolvent both before and after the date of the July 2007 transaction; and 3) were left with unreasonably small capital with which to operate their businesses as a result of the July 2007 transaction. Official Comm. 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 avoided the lien transfer on the basis that the Conveying Subsidiaries did not receive “reasonably equivalent value” for the transfers by narrowly interpreting the meaning of “value,” finding that value includes “only 'property' and 'satisfaction or securing of a present or antecedent debt of the debtor.'” 422 B.R. at 868. In this case, the Conveying Subsidiaries did not receive any property in exchange for the lien transfer because they did not receive any of the new loan proceeds. Rather, the new loan documentation specifically provided that the new loan funds be transferred to the Transeastern Lenders for the settlement of the TOUSA litigation. In addition, the Conveying Subsidiaries did not receive the satisfaction of a present or antecedent debt because the Conveying Subsidiaries did not have any obligations under the Transeastern loans or settlement. As a result, the Conveying Subsidiaries did not receive reasonably equivalent value from the Transeastern Lenders in exchange for the transfers.

The Bankruptcy Court explicitly rejected the Transeastern Lenders' arguments that they had provided value to the Conveying Subsidiaries in that their settlement with TOUSA and Tousa Homes prevented the occurrence of an event of default on debt that the Conveying Subsidiaries had guaranteed, which would have likely resulted in an immediate bankruptcy filing by the Conveying Subsidiaries. As a result, the settlement delayed the Conveying Subsidiaries' bankruptcy filings and gave them the opportunity to continue their operations. Unconvinced, the Bankruptcy Court held that the Conveying Subsidiaries had not received any direct value as a result of the transaction and that, if they had received “any value at all, it was minimal and did not come anywhere near the millions of dollars of obligations they incurred.” 422 B.R. at 844.

In addition, the Bankruptcy Court held that the Transeastern Lenders were entities “for whose benefit” the transfers were made under ' 550(a)(1) of the Bankruptcy Code, allowing the Committee to recover the proceeds transferred to the Transeastern Lenders.

In issuing its decision the Bankruptcy Court ordered $403 million, plus interest and fees, of the $421 million paid to the Transeastern Lenders set aside as a fraudulent transfer and disgorged. Not surprisingly, the Transeastern Lenders appealed the Bankruptcy Court's decision to the District Court.

District Court Quashes and Reverses Bankruptcy Court's Ruling

In the TOUSA case's first twist, the District Court on appeal vehemently disagreed with the Bankruptcy Court's findings and ruling, ultimately quashing the Bankruptcy Court's decision. 3V Capital Master Fund Ltd. v. Official Comm. Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613 (S.D. Fla. 2011). One of the main issues on appeal was whether, for purposes of ' 548(a)(1)(B) of the Bankruptcy Code, the Conveying Subsidiaries had received reasonably equivalent value in exchange for their liens and obligations under the new loans, as well as for the transfer of the new loan proceeds by ULT to the Transeastern Lenders. Holding that the Bankruptcy Court's ruling was clearly erroneous, the District Court found that the Conveying Subsidiaries' ability to avoid bankruptcy as a result of the transaction provided “indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise's rehabilitation, and to avoid bankruptcy, even if it proved to be short lived” and that such benefits constituted sufficient value “so long as the expectation was legitimate and reasonable.” 444 B.R. at 660.

The District Court held further that the Bankruptcy Court's definition of “value” was overly narrow and that “a debtor's opportunity to improve its prospects of avoiding bankruptcy are precisely the kind of benefits that, by decision, are not susceptible to exact quantification but are nonetheless legally cognizable under section 548.” 444 B.R. at 660.

In addition, the District Court reversed the Bankruptcy Court's finding that the Transeastern Lenders were entities “for whose benefit” the transfers were made pursuant to ' 550(a)(1) of the Bankruptcy Code. In holding so, the District Court stated that the “for whose benefit” language “does not apply where the 'benefit' is not the immediate and necessary consequence of the initial transfer, but flows from the manner in which the initial transfer is used by its recipient.” 444 B.R. at 674. In other words, the Transeastern Lenders had only received the new loan proceeds, not the liens of the Conveying Subsidiaries. The transfer of the new loan proceeds was not a direct consequence of the transfer of liens to the New Lenders. Rather, the New Lenders received the immediate benefit of the lien transfers, and the Transeastern Lenders received the new loan proceeds backed by the liens, which was not the immediate and necessary consequence of the lien transfer. As a result, the District Court found that the Transeastern Lenders were too far removed from the lien transfer to be held liable as initial transferees for the fraudulent transfers.

The Committee then appealed the District Court's decision to the Court of Appeals.

Bankruptcy Court Didn't 'Clearly Err'

In a second twist, the Court of Appeals reversed the District Court's ruling and reinstated the ruling of the Bankruptcy Court, finding that the Bankruptcy Court did not “clearly err” when it ruled against the Transeastern Lenders. In doing so, the Court of Appeals agreed with the Bankruptcy Court that the Conveying Subsidiaries did not receive reasonably equivalent value for their lien transfers to the New Lenders. 2012 WL 1673910, at *12-14. Declining to decide whether the definition of “value” had been interpreted too narrowly by the Bankruptcy Court or too broadly by the District Court, the Court of Appeals held that even if the delay or avoidance of the Conveying Subsidiaries could be considered “value,” such value was entirely outweighed by the cost of the transaction. Id. at *12.

The Court of Appeals also reaffirmed the Bankruptcy Court's findings that the Transeastern Lenders were entities from whom the Committee could recover under Bankruptcy Code ' 550(a)(1). Id. at *16. In doing so, the Court of Appeals reviewed the plain language of the statute and relied on the language of the new loan documents, which expressly provided that the proceeds of the new loan be used to satisfy TOUSA's settlement with the Transeastern Lenders. As a result, the Court of Appeals held that it didn't matter that the funds passed through ULT before they were wired to the Transeastern Lenders because the Conveying Subsidiaries never had control over the funds. As a result, the Transeastern Lenders were the initial transferees of the Conveying Subsidiaries' liens.

Implications

For better or worse, the Court of Appeals has provided some finality on the TOUSA question of whether the Conveying Subsidiaries received reasonably equivalent value for their lien transfers. Because the Court of Appeals did not adopt the Bankruptcy Court's or the District Court's definition of “value,” however, it remains to be seen how future fraudulent transfer cases will be decided in light of TOUSA.

If nothing else, the TOUSA case provides a good reminder to lenders that, especially with respect to “upstream” loan transactions, they must act with an utmost duty of diligence and due care when analyzing the solvency of a prospective borrower. Lenders should also ensure that any subsidiary company that will be providing an upstream guaranty in a loan transaction is either solvent at the time of the transaction or that it will receive a tangible benefit as a result of the transaction. Some questions that lenders, and official committees in Chapter 11 cases investigating potential fraudulent transfer claims, should ask themselves when reviewing loan transactions include the following.

1. Which company holds the assets? Lenders should lend to the company that holds the assets. This will ensure the likelihood that the lender will be reimbursed by the company and, as a result, the transaction may not need to involve subsidiary companies.

2. If a subsidiary is going to act as a guarantor for a parent company's loan, is such subsidiary going to receive any value for its role in the transaction? If not, then the transaction may have a TOUSA issue. The documentation surrounding the transaction should include factual representations or recitals, signed by the subsidiary company, specifically detailing the value that such subsidiary is going to be receiving for its role in the transaction.

3. Are the companies that are to be involved in the loan transaction solvent? Lenders should measure the financial strength of each company to be involved in the transaction, whether such company will be acting as a borrower, guarantor or in some other role. Part of such review should include ensuring that the lender has received accurate and updated audited financial information from all companies that are to be involved in the transaction to ensure that such companies are solvent and able to pay their debts as they come due. While solvency opinions should be included as part of the loan documentation, lenders should conduct their own independent review of each company's financial information as well to test for solvency.

4. How are the companies managed? Lenders should be familiar with the operating agreements and boards or managers of each company to be involved in the transaction. Subsidiary companies that will be involved in the transaction should provide lenders with clear authority from their directors in the form of a resolution or otherwise to enter into the transaction and such resolution should again recite the value that the subsidiary will receive for its role in the transaction.

5. How will the closing of the transaction affect the companies financially? Lenders should not loan funds to companies and then turn a blind eye to the effects of the loan. Rather, lenders should review the balance sheet of each company that will be involved in the loan and should then work with the company to project what the balance sheets will look like after the closing of the loan. In this way, lenders will be able to get comfort that the companies will be able to service the debt on a go-forward basis.

Conclusion

Any loan transactions involving upstream guaranties should be carefully reviewed for TOUSA issues, and the latest ruling by the Court of Appeals makes clear that all parties involved in such a transaction should be alert for potential fraudulent transfer issues.

Ted A. Berkowitz is a partner in the Bankruptcy & Creditors' Rights practice group of Farrell Fritz, P.C. Veronique A. Urban is an associate in the same group. The authors may be contacted at [email protected] and at [email protected], respectively.

The closely watched TOUSA, Inc. case took another twist on May 15, when the Eleventh Circuit Court of Appeals (the Court of Appeals) reversed the decision of the U.S. District Court for the Southern District of Florida (the District Court) and reinstated the bankruptcy court opinion in its entirety. Senior Transeastern Lenders v. Official Comm. Of Unsecured Creditors of TOUSA, Inc., No. 11-1107, 2012 WL 1673910 (11th Cir. May 15, 2012). In doing so, the Court of Appeals affirmed the bankruptcy court's ruling that transfers made by certain subsidiaries of TOUSA, Inc. (the Conveying Subsidiaries) were fraudulent and paved the way for the possible disgorgement of $403 million by the lenders that were on the receiving end of those fraudulent transfers. The decision reinforces the level of diligence and care that lenders must undertake in cases involving borrower subsidiaries, especially with respect to upstream loan transactions.

Factual Background

The facts of this case date back to June 2005, when Tousa Homes LP (Tousa Homes), a wholly owned subsidiary of TOUSA, Inc. (TOUSA), announced plans to acquire one of its competitors, Transeastern Properties, Inc. The acquisition was structured as a joint venture between Tousa Homes and Falcone/Ritchie LLC (Transeastern JV). In order to fund the acquisition, the Transeastern JV entered into three credit facilities with various lenders (the Transeastern Lenders), aggregating approximately $675 million. While TOUSA and Tousa Homes guaranteed the obligations under the credit facilities, none of the Conveying Subsidiaries had any obligations under the Transeastern credit facilities.

In September 2006, following the Transeastern acquisition, the Florida housing market rapidly declined, causing the Transeastern JV to default under its credit facilities with the Transeastern Lenders. As a result, the Transeastern Lenders sued TOUSA and Tousa Homes in New York State court for the breach of their guarantees under the credit facilities. TOUSA and Tousa Homes settled the litigation with the Transeastern Lenders for approximately $421 million, among other reasons, to avoid having an adverse judgment filed against TOUSA in excess of $10 million, which would have triggered a cross-default under certain of its bond indentures and a revolving credit facility for which the Conveying Subsidiaries served as guarantors.

In July 2007, in order in part to fund the settlement with the Transeastern Lenders, TOUSA entered into new secured credit facilities with various lenders (the New Lenders), aggregating approximately $476 million. As a condition for obtaining the new loans, the Conveying Subsidiaries pledged their assets as collateral for the new loans even though they were not a party to the litigation and were not going to receive any of the new loan proceeds. The New Lenders transferred the proceeds of the new loans to Universal Land Title, Inc. (ULT), a TOUSA subsidiary, which in turn immediately transferred approximately $426 million of the new loan proceeds to the Transeastern Lenders as expressly directed in the new loan documentation.

On Jan. 29, 2008, TOUSA, Tousa Homes and the Conveying Subsidiaries, among other TOUSA affiliates, filed for relief (the TOUSA Bankruptcy Cases) under Chapter 11 of the United States Code (the Bankruptcy Code) in the U.S. Bankruptcy Court for the Southern District of Florida (the Bankruptcy Court).

Committee Commences Adversary Proceeding

On July 14, 2008, the Official Committee of Unsecured Creditors in the TOUSA Bankruptcy Cases (the Committee) filed an adversary proceeding in which it sought, in relevant part, to: 1) avoid, under ” 544 and 548 of the Bankruptcy Code, the lien transfers made by the Conveying Subsidiaries to the New Lenders; 2) avoid, under ” 544 and 548 of the Bankruptcy Code, the transfer of the new loan proceeds from ULT to the Transeastern Lenders; and 3) recover the value of the lien transfers and the proceeds transfer from the Transeastern Lenders under ' 550 of the Bankruptcy Code on the basis that the Transeastern Lenders were the direct transferees of the proceeds of the new loans and were entities for whose benefit the liens were transferred by the Conveying Subsidiaries.

Sections 544 and 548 of the Bankruptcy Code allow a trustee to avoid a transfer of “an interest of the debtor in property” or “obligation incurred by the debtor” that was: 1) made for “less than reasonably equivalent value”; and 2) made while the debtor was insolvent or had unreasonably small capital at the time of the transaction or as a result of the transaction. 11 U.S.C. ' 548. In its Complaint, the Committee argued that the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for either the transfer of their liens or the proceeds transfer. In addition, the Committee alleged that, as a result of the transfers, the Conveying Subsidiaries were either insolvent or rendered insolvent, left with unreasonably small capital or became unable to pay their debts as they were to come due.

Section 550(a)(1) of the Bankruptcy Code allows a trustee to recover an avoided transfer from: 1) the initial transferee; 2) the entity for whose benefit such transfer was made; or 3) a subsequent transferee. 11 U.S.C. ' 550(a)(1). In this case, the loan proceeds were received by ULT, but as required under the documentation, were immediately transferred to the Transeastern Lenders. In addition, although the lien transfers were made by the Conveying Subsidiaries to the New Lenders, the transfers actually benefited the Transeastern Lenders because they were able to receive the settlement proceeds only as a result of the lien transfers.

Bankruptcy Court Finds in Favor of Committee

The Bankruptcy Court ruled in favor of the Committee, holding that the Conveying Subsidiaries: 1) did not receive reasonably equivalent value in exchange for the lien transfers and proceeds transfer; 2) were insolvent both before and after the date of the July 2007 transaction; and 3) were left with unreasonably small capital with which to operate their businesses as a result of the July 2007 transaction. Official Comm. 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 avoided the lien transfer on the basis that the Conveying Subsidiaries did not receive “reasonably equivalent value” for the transfers by narrowly interpreting the meaning of “value,” finding that value includes “only 'property' and 'satisfaction or securing of a present or antecedent debt of the debtor.'” 422 B.R. at 868. In this case, the Conveying Subsidiaries did not receive any property in exchange for the lien transfer because they did not receive any of the new loan proceeds. Rather, the new loan documentation specifically provided that the new loan funds be transferred to the Transeastern Lenders for the settlement of the TOUSA litigation. In addition, the Conveying Subsidiaries did not receive the satisfaction of a present or antecedent debt because the Conveying Subsidiaries did not have any obligations under the Transeastern loans or settlement. As a result, the Conveying Subsidiaries did not receive reasonably equivalent value from the Transeastern Lenders in exchange for the transfers.

The Bankruptcy Court explicitly rejected the Transeastern Lenders' arguments that they had provided value to the Conveying Subsidiaries in that their settlement with TOUSA and Tousa Homes prevented the occurrence of an event of default on debt that the Conveying Subsidiaries had guaranteed, which would have likely resulted in an immediate bankruptcy filing by the Conveying Subsidiaries. As a result, the settlement delayed the Conveying Subsidiaries' bankruptcy filings and gave them the opportunity to continue their operations. Unconvinced, the Bankruptcy Court held that the Conveying Subsidiaries had not received any direct value as a result of the transaction and that, if they had received “any value at all, it was minimal and did not come anywhere near the millions of dollars of obligations they incurred.” 422 B.R. at 844.

In addition, the Bankruptcy Court held that the Transeastern Lenders were entities “for whose benefit” the transfers were made under ' 550(a)(1) of the Bankruptcy Code, allowing the Committee to recover the proceeds transferred to the Transeastern Lenders.

In issuing its decision the Bankruptcy Court ordered $403 million, plus interest and fees, of the $421 million paid to the Transeastern Lenders set aside as a fraudulent transfer and disgorged. Not surprisingly, the Transeastern Lenders appealed the Bankruptcy Court's decision to the District Court.

District Court Quashes and Reverses Bankruptcy Court's Ruling

In the TOUSA case's first twist, the District Court on appeal vehemently disagreed with the Bankruptcy Court's findings and ruling, ultimately quashing the Bankruptcy Court's decision. 3V Capital Master Fund Ltd. v. Official Comm. Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613 (S.D. Fla. 2011). One of the main issues on appeal was whether, for purposes of ' 548(a)(1)(B) of the Bankruptcy Code, the Conveying Subsidiaries had received reasonably equivalent value in exchange for their liens and obligations under the new loans, as well as for the transfer of the new loan proceeds by ULT to the Transeastern Lenders. Holding that the Bankruptcy Court's ruling was clearly erroneous, the District Court found that the Conveying Subsidiaries' ability to avoid bankruptcy as a result of the transaction provided “indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise's rehabilitation, and to avoid bankruptcy, even if it proved to be short lived” and that such benefits constituted sufficient value “so long as the expectation was legitimate and reasonable.” 444 B.R. at 660.

The District Court held further that the Bankruptcy Court's definition of “value” was overly narrow and that “a debtor's opportunity to improve its prospects of avoiding bankruptcy are precisely the kind of benefits that, by decision, are not susceptible to exact quantification but are nonetheless legally cognizable under section 548.” 444 B.R. at 660.

In addition, the District Court reversed the Bankruptcy Court's finding that the Transeastern Lenders were entities “for whose benefit” the transfers were made pursuant to ' 550(a)(1) of the Bankruptcy Code. In holding so, the District Court stated that the “for whose benefit” language “does not apply where the 'benefit' is not the immediate and necessary consequence of the initial transfer, but flows from the manner in which the initial transfer is used by its recipient.” 444 B.R. at 674. In other words, the Transeastern Lenders had only received the new loan proceeds, not the liens of the Conveying Subsidiaries. The transfer of the new loan proceeds was not a direct consequence of the transfer of liens to the New Lenders. Rather, the New Lenders received the immediate benefit of the lien transfers, and the Transeastern Lenders received the new loan proceeds backed by the liens, which was not the immediate and necessary consequence of the lien transfer. As a result, the District Court found that the Transeastern Lenders were too far removed from the lien transfer to be held liable as initial transferees for the fraudulent transfers.

The Committee then appealed the District Court's decision to the Court of Appeals.

Bankruptcy Court Didn't 'Clearly Err'

In a second twist, the Court of Appeals reversed the District Court's ruling and reinstated the ruling of the Bankruptcy Court, finding that the Bankruptcy Court did not “clearly err” when it ruled against the Transeastern Lenders. In doing so, the Court of Appeals agreed with the Bankruptcy Court that the Conveying Subsidiaries did not receive reasonably equivalent value for their lien transfers to the New Lenders. 2012 WL 1673910, at *12-14. Declining to decide whether the definition of “value” had been interpreted too narrowly by the Bankruptcy Court or too broadly by the District Court, the Court of Appeals held that even if the delay or avoidance of the Conveying Subsidiaries could be considered “value,” such value was entirely outweighed by the cost of the transaction. Id. at *12.

The Court of Appeals also reaffirmed the Bankruptcy Court's findings that the Transeastern Lenders were entities from whom the Committee could recover under Bankruptcy Code ' 550(a)(1). Id. at *16. In doing so, the Court of Appeals reviewed the plain language of the statute and relied on the language of the new loan documents, which expressly provided that the proceeds of the new loan be used to satisfy TOUSA's settlement with the Transeastern Lenders. As a result, the Court of Appeals held that it didn't matter that the funds passed through ULT before they were wired to the Transeastern Lenders because the Conveying Subsidiaries never had control over the funds. As a result, the Transeastern Lenders were the initial transferees of the Conveying Subsidiaries' liens.

Implications

For better or worse, the Court of Appeals has provided some finality on the TOUSA question of whether the Conveying Subsidiaries received reasonably equivalent value for their lien transfers. Because the Court of Appeals did not adopt the Bankruptcy Court's or the District Court's definition of “value,” however, it remains to be seen how future fraudulent transfer cases will be decided in light of TOUSA.

If nothing else, the TOUSA case provides a good reminder to lenders that, especially with respect to “upstream” loan transactions, they must act with an utmost duty of diligence and due care when analyzing the solvency of a prospective borrower. Lenders should also ensure that any subsidiary company that will be providing an upstream guaranty in a loan transaction is either solvent at the time of the transaction or that it will receive a tangible benefit as a result of the transaction. Some questions that lenders, and official committees in Chapter 11 cases investigating potential fraudulent transfer claims, should ask themselves when reviewing loan transactions include the following.

1. Which company holds the assets? Lenders should lend to the company that holds the assets. This will ensure the likelihood that the lender will be reimbursed by the company and, as a result, the transaction may not need to involve subsidiary companies.

2. If a subsidiary is going to act as a guarantor for a parent company's loan, is such subsidiary going to receive any value for its role in the transaction? If not, then the transaction may have a TOUSA issue. The documentation surrounding the transaction should include factual representations or recitals, signed by the subsidiary company, specifically detailing the value that such subsidiary is going to be receiving for its role in the transaction.

3. Are the companies that are to be involved in the loan transaction solvent? Lenders should measure the financial strength of each company to be involved in the transaction, whether such company will be acting as a borrower, guarantor or in some other role. Part of such review should include ensuring that the lender has received accurate and updated audited financial information from all companies that are to be involved in the transaction to ensure that such companies are solvent and able to pay their debts as they come due. While solvency opinions should be included as part of the loan documentation, lenders should conduct their own independent review of each company's financial information as well to test for solvency.

4. How are the companies managed? Lenders should be familiar with the operating agreements and boards or managers of each company to be involved in the transaction. Subsidiary companies that will be involved in the transaction should provide lenders with clear authority from their directors in the form of a resolution or otherwise to enter into the transaction and such resolution should again recite the value that the subsidiary will receive for its role in the transaction.

5. How will the closing of the transaction affect the companies financially? Lenders should not loan funds to companies and then turn a blind eye to the effects of the loan. Rather, lenders should review the balance sheet of each company that will be involved in the loan and should then work with the company to project what the balance sheets will look like after the closing of the loan. In this way, lenders will be able to get comfort that the companies will be able to service the debt on a go-forward basis.

Conclusion

Any loan transactions involving upstream guaranties should be carefully reviewed for TOUSA issues, and the latest ruling by the Court of Appeals makes clear that all parties involved in such a transaction should be alert for potential fraudulent transfer issues.

Ted A. Berkowitz is a partner in the Bankruptcy & Creditors' Rights practice group of Farrell Fritz, P.C. Veronique A. Urban is an associate in the same group. The authors may be contacted at [email protected] and at [email protected], respectively.