On May 15, 2012, the United States Court of Appeals for the Eleventh Circuit held that security interests and liens granted by subsidiaries of a borrower to refinance obligations owed to the borrower's lenders constituted fraudulent transfers under section 548(a)(1) of the Bankruptcy Code in the borrower's and subsidiaries' bankruptcy cases. Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA, Inc.), 2012 WL 1673910 (11th Cir. 2012). This decision delivers a cautionary message to lenders because it increases the likelihood that more courts will invalidate upstream guaranties given by subsidiaries for the benefit of a parent borrower.

In this case, TOUSA, a large homebuilder, acquired assets owned by Transeastern Properties, Inc., funding the acquisition through a $675 million loan. When the business failed, TOUSA's lenders sued for repayment of the loan, and the parties ultimately reached a settlement whereby TOUSA agreed to pay the lenders $421 million. To finance the settlement, and despite TOUSA's distressed financial condition, TOUSA and various of its subsidiaries borrowed $500 million from a new group of lenders secured by liens on substantially all of their assets. Importantly, the subsidiaries were not parties to the litigation and not indebted to the original lenders. Nonetheless, the subsidiaries provided guaranties, incurred liabilities and granted liens to the new lenders to secure their parent's liabilities in connection with the settlement financing.

TOUSA and the subsidiaries filed bankruptcy cases only six months after the settlement financing. Thereafter, the creditors' committee commenced an action to avoid the security interests, liens and payments made under the guaranties as fraudulent transfers pursuant to sections 544(b) and 548 of the Bankruptcy Code because (i) the subsidiaries were insolvent at the time they executed the guaranties and security agreements, and (ii) they did not receive reasonably equivalent value in exchange for the guaranties and security interests. Following a 13-day trial, the bankruptcy court, finding that the subsidiaries had not received reasonably equivalent value for the upstream guaranties and grants of liens on substantially all of their assets since the subsidiaries received none of the loan proceeds, ruled in favor of the committee, voided the liens obtained by the holders of TOUSA's secured notes and ordered the original lenders to return the $421 million paid to them in connection with the settlement. 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).

On appeal, the district court reversed, and adopted a broader definition of "value," finding that the indirect, intangible benefits which the subsidiaries received from the transaction, including the opportunity for the entire TOUSA enterprise to avoid bankruptcy and continue as a going concern, constituted "reasonably equivalent value" in exchange for the security interests, liens and guaranties. 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).

On appeal, the Eleventh Circuit reversed the district court and affirmed the bankruptcy court's ruling. The Eleventh Circuit found that the issue of reasonably equivalent value was largely a question of fact that would not be disturbed unless clearly erroneous. In light of this deferential standard, the Eleventh Circuit chose not to decide whether to adopt the narrow definition of value adopted by the bankruptcy court or the broader definition employed by the district court. Rather, the court found that even if all of the benefits claimed by the lenders were legally cognizable, the bankruptcy court did not clearly err in finding a lack of reasonably equivalent value or in concluding that the subsidiaries would have been better off if TOUSA had filed for bankruptcy immediately rather than delaying an inevitable bankruptcy filing.

The Eleventh Circuit also considered whether the bankruptcy court erred in ruling the lenders were entities for whose benefit the liens were transferred under section 550(a) of the Bankruptcy Code. Section 550(a)(1) allows recovery of property transferred or its value from the initial transferee or from "an entity for whose benefit such transfer was made." 11 U.S.C. § 550(a)(1). The lenders argued that because the loan proceeds first passed through a subsidiary of TOUSA before being paid to them, they were subsequent transferees rather than entities which benefitted from the initial transfer. The Eleventh Circuit rejected the argument, stating that the subsidiary through which the loan proceeds had passed had no control over the funds because the loan documents required the subsidiary to immediately wire the funds to the lenders. Relying on prior case law, the Eleventh Circuit stated that when a debtor grants a lien to a lender, a creditor who receives the proceeds of such loan may be subject to liability under section 550(a) if the initial grant of the lien is later avoided. The Eleventh Circuit acknowledged that its holding would force creditors to exercise diligence when receiving payment from a struggling obligor.

The Eleventh Circuit's decision provides important lessons for both lenders and borrowers. Lenders should exercise caution when relying on upstream guaranties from subsidiaries who will receive none of the proceeds of a loan. To minimize the risk that such guaranties may be invalidated, lenders may consider structuring the loans so that guarantors will receive a substantial benefit from the loan, and confirm through due diligence that the guarantors are solvent at the time of the loan.

For borrowers with complicated corporate structures involving multiple subsidiaries and affiliates, this decision may increase the cost of financing because prudent lenders may discount the value of upstream guaranties in order to account for an increased fraudulent transfer risk. Borrowers may be able to address these concerns by consolidating their corporate structures to eliminate subsidiaries, obtaining independent valuations of their guarantors to prove the solvency of each guarantor, and documenting the benefit that guarantors will obtain from the loan.