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Four recent cases have raised important issues for commercial lenders. First, in In re TOUSA, Inc., No. 08-10928-JKO, 2009 WL 3261963 (Bankr. S.D. Fla. Oct. 13, 2009), the court called into question the enforceability of fraudulent conveyance "savings clauses" that are common in commercial loan agreements. Second, the court in In re Chrysler LLC, 576 F.3d 108 (2d Cir. 2009), addressed the protections provided by unanimous lender consent provisions in situations where the agent exercises remedies against the collateral consistent with the rights originally granted to the agent by the lenders. Finally, in In re Pacific Lumber Co., No. 08-40746, 2009 WL 3082066 (5th Cir. Sept. 29, 2009) and In re Philadelphia Newspapers, LLC, No. 09-mc-178 (E.D. Pa. Nov. 10, 2009), the courts addressed whether the secured lender had a right to credit bid where its collateral was being sold under a plan of reorganization.

In re TOUSA, Inc.
No. 08-10928-JKO, 2009 WL 3261963 (Bankr. S.D. Fla. Oct. 13, 2009)

TOUSA, Inc. and its subsidiaries design, build, and market homes. In June 2005, TOUSA entered into a joint venture that was partially funded by loans from certain lenders (the "Transeastern Lenders") guaranteed by TOUSA. None of TOUSA's Conveying Subsidiaries was an obligor or guarantor on the debt to the Transeastern Lenders. With the turn in the housing market, the joint venture ran into hard times, and litigation ensued between TOUSA and the Transeastern Lenders.

On July 31, 2007, TOUSA entered into a settlement agreement with the Transeastern Lenders by which TOUSA agreed to pay approximately $420 million to the Transeastern Lenders (the "Transeastern Settlement"). In connection with the Transeastern Settlement, TOUSA and the Conveying Subsidiaries, as borrowers, entered into a $200 million first lien facility (the "First Lien Facility") and a $300 million second lien facility (the "Second Lien Facility" and collectively, the "July Transaction"). Using the proceeds of the new financing, TOUSA and the Conveying Subsidiaries paid approximately $420 million to the Transeastern Lenders. The Conveying Subsidiaries pledged substantially all of their previously unencumbered assets to secure repayment of the loans advanced pursuant to the July Transaction. The Conveying Subsidiaries did not retain any of the proceeds advanced under the July Transaction.

On January 28, 2008, TOUSA and the Conveying Subsidiaries filed for bankruptcy protection, and the creditors' committee commenced an adversary proceeding seeking to unwind the Conveying Subsidiaries' obligations under the July Transaction and to recover the $420 million paid to the Transeastern Lenders.  

The United States Bankruptcy Court for the Southern District of Florida found that the liens granted by the Conveying Subsidiaries in connection with the loans to TOUSA would be avoided as fraudulent transfers because: (1) the Conveying Subsidiaries were insolvent both before and after the July Transaction; (2) the Conveying Subsidiaries did not receive reasonably equivalent value in exchange for the obligations incurred and liens granted under the July Transaction; and, (3) the Conveying Subsidiaries were left with unreasonably small capital with which to operate their businesses as a result of the July Transaction. The court's opinion on fraudulent transfer avoidance applies well-established fraudulent transfer law to the facts. The opinion is over 80 pages long but makes for fascinating reading for lenders and bankruptcy lawyers. In addition to the cautionary tale about upstream security interests, there are two noteworthy parts of the opinion for lenders.

Lack of Good Faith

First, the court avoided the payoff to the Transeastern Lenders, finding that the Transeastern Lenders could not assert the good faith defense because, applying an objective test, the Transeastern Lenders should have known that the July Transaction was a fraudulent conveyance. Thus, the court imposed an obligation on the existing lenders to investigate the source of refinancing and the risk if the refinancing is avoidable as a fraudulent transfer.

Savings Clause Unenforceable

Second, like most commercial loan agreements involving multiple borrowers or guarantors, the First Lien Facility and Second Lien Facility contained a fraudulent conveyance savings clause that provided:

Each Borrower agrees if such Borrower's joint and several liability hereunder, or if any Liens securing such joint and several liability, would, but for the application of this sentence, be unenforceable under applicable law, such joint and several liability and each such Lien shall be valid and enforceable to the maximum extent that would not cause such joint and several liability or such Lien to be unenforceable under applicable law, and such joint and several liability and such Lien shall be deemed to have been automatically amended accordingly at all relevant times.

The defendants argued that the fraudulent conveyance savings clauses in the First Lien Facility and the Second Lien Facility prohibited the avoidance of the July Transaction because TOUSA and the Conveying Subsidiaries, as sophisticated parties, had agreed to limit the ability of TOUSA and the Conveying Subsidiaries to later avoid the July Transaction as a fraudulent transfer under the Bankruptcy Code.

The court disagreed and found that the fraudulent conveyance savings clauses were unenforceable for several reasons. First, the Conveying Subsidiaries received no benefit under the Transeastern Settlement and the corresponding July Transaction since the proceeds were used to repay the Transeastern Lenders for a debt they had no obligation to repay. Second, the savings clauses contained inherently indefinite contract terms since the enforceability of each facility was circularly dependent upon the enforceability of the other facility. Third, the fraudulent conveyance savings clauses would effectuate amendments to the credit facilities, and the defendants had failed to take the necessary steps under the loan agreements to affect the required amendments. Fourth, the right to avoid a fraudulent transfer is property of the debtor and contract provisions conditioned on the insolvency or financial condition of the debtor that affect a forfeiture of a debtor's interest in property violate the Bankruptcy Code. Fifth, enforcement of the fraudulent conveyance savings clauses would violate public policy as an attempt to contract around core provisions of the Bankruptcy Code.

The court's reasoning under the first two reasons is fact-specific and will vary in each case. The third reason appears to be a drafting issue with the savings clause in TOUSA. The other two reasons are more problematic because they are applicable to most fraudulent conveyance savings clauses. The court seems to say that savings clauses are per se unenforceable and that reliance by lenders on fraudulent conveyance savings clauses may be misplaced. In reaching its conclusion, the court focused on the impact on creditors of TOUSA rather than those of the Conveying Subsidiaries. At the Conveying Subsidiary level, the savings clauses, if effective, would have reduced the Conveying Subsidiaries' liabilities so that creditors of the Conveying Subsidiaries would receive 100 percent of their claims, thus suffering no harm. In the end, even if effective, the savings clauses would not have benefited the Lenders in this case. Because the court found that the Conveying Subsidiaries were insolvent prior to the transfers, the savings clause would have reduced the Lenders' claims against the Conveying Subsidiaries to zero.

If TOUSA is the law, lenders may be able to protect against fraudulent transfer avoidance by taking security interests in the equity interests of the borrower's subsidiaries. The Transeastern Lenders and the July Transaction Lenders could have secured their claims with a pledge by TOUSA of its equity of the Conveying Subsidiaries without risk of fraudulent conveyance avoidance. The Transeastern Lenders' security interests would not have been avoidable because a security interest granted to secure a pre-existing claim (the TOUSA guaranty of the Transeastern obligations) is for reasonably equivalent value under the Bankruptcy Code by definition. Similarly, the pledge of equity interests in the Conveying Subsidiaries to the July Transaction Lenders would not be avoidable because TOUSA owns the equity interests and received the loan proceeds to pay off its obligation to the Transeastern Lenders. Of course, in TOUSA, the pledge of the equity interests while enforceable would not have protected the Lenders if the Conveying Subsidiaries were insolvent.

In re Chrysler LLC
576 F.3d 108 (2d Cir. 2009)

After filing a bankruptcy petition under Chapter 11 on April 30, 2009, Chrysler sought court approval to sell substantially all of its assets over the objections of some pre-petition secured lenders (the "First-Lien Holders"). The First-Lien Holders had arranged their investment in Chrysler by means of three related agreements. Under the terms of the agreements, the collateral was held by a designated trustee for the benefit of the various First-Lien Holders. In the event of a bankruptcy, the trustee was empowered to take any action deemed necessary to protect, preserve, or realize upon the collateral. The trustee could only exercise this power at the direction of the First-Lien Holders' agent. The First-Lien Holders were required to authorize the agent to act on their behalf and any action the agent took at the request of the First-Lien Holders holding a majority of Chrysler's debt was binding on all First-Lien Holders regardless of whether they agreed.  

When Chrysler went into bankruptcy, the First-Lien Holders holding a majority of Chrysler's debt authorized the agent to direct the trustee to consent to the sale of the collateral free and clear of all interests under § 363. The minority First-Lien Holders argued that by virtue of a subclause in one of the loan agreements, all of the First-Lien Holders' written consent was required before selling the collateral assets. The clause in question provided that the loan documents themselves could not be amended without the written consent of all lenders if the amendment would result in the release of all, or substantially all, of the collateral property.

Consent Issue

The United States Court of Appeals for the Second Circuit upheld the sale of substantially all of Chrysler's assets because the sale did not entail amendment of any loan document. To the contrary, the court found that the sale was effected by implementing the clear terms of the loan agreements: (1) the lenders assigned an agent to act on their behalf; (2) the agent was empowered, upon request from the majority lenders, to direct the trustee to act; and, (3) the trustee was empowered, at the direction of the agent, to sell the collateral in the event of a bankruptcy. Because the sale required no amendment to the loan documents, the court held that Chrysler was not required to seek the minority First-Lien Holders' written consent. As a result, the unanimous lender consent provisions provided no protection for minority lenders in situations where the agent exercises remedies against the collateral consistent with the rights originally granted to the agent by the lenders.

In re Pacific Lumber Co.
No. 08-40746, 2009 WL 3082066 (5th Cir. Sept. 29, 2009)

On January 18, 2007, six affiliated entities (the "Debtors") involved in the growing, harvesting, and processing of redwood timber filed for bankruptcy under Chapter 11. On the petition date, certain noteholders (the "Noteholders") were owed approximately $740 million. The Chapter 11 reorganization plan (the "Plan") proposed to pay the Noteholders $513.6 million in cash. The Noteholders voted against confirmation, but the bankruptcy court ultimately confirmed the Plan. The Noteholders appealed asserting that the Debtors could not cram down the Plan over their objections under section 1129(b). They argued that the Plan violated their rights under the absolute priority rule and the fair and equitable standard because the Plan did not offer the Noteholders an opportunity to credit bid for their collateral.

Cram Down Issue

The United States Court of Appeals for the Fifth Circuit held that the Plan, insofar as it paid the Noteholders the allowed amount of their secured claim, did not violate the absolute priority rule and was fair and equitable. The court found that the Plan could be confirmed as fair and equitable under section 1129(b) even if it did not offer the Noteholders an opportunity to credit bid for their collateral if it offered them the realization of the "indubitable equivalent" of their allowed secured claims. Judge Learned Hand coined the term "indubitable equivalent" in explaining why the reorganization plan in In re Murel Holding Co., 75 F.2d 941 (2d Cir. 1935) could not be confirmed over the secured creditors' objection:

[A] creditor who fears the safety of his principal will scarcely be content with [interest payments alone]; he wishes to get his money or at least the property. We see no reason to suppose that the statute was intended to deprive him of that … unless by a substitute of the most indubitable equivalence.

Since the Noteholders received the value of their collateral as determined by the bankruptcy court (i.e. $513 million in cash), the Plan paid them the indubitable equivalent of their claims. The Noteholders argued, however, that by depriving them of the right to credit bid and presumably foreclose on the collateral, the Plan failed to afford them the indubitable equivalent of their secured claims because they forfeited the possibility of later increases in the collateral's value. The court rejected this argument and concluded that the Bankruptcy Code does not protect a secured creditor's upside potential, but instead protects the "allowed secured claim." The court noted that in Bank of Am. Nat'l Trust and Sav. Ass'n v. 203 N. LaSalle St. P'ship, 526 U.S. 434 (1999), the Supreme Court questioned the accuracy of court determined value. The court held that this case was different from LaSalle because the property was actively marketed, exclusivity had ended, the Noteholders had not appealed the court's determination that they would receive more than in a liquidation, and the Noteholders had not preserved a timely objection to the court's procedures.

In re Philadelphia Newspapers, LLC
No. 09-mc-178 (E.D. Pa. Nov. 10, 2009)

In Philadelphia Newspapers, the issue arose in connection with an auction sale held under a plan but prior to confirmation. The plan provided that the secured creditor could not credit bid. The bankruptcy court held that the plan could not be confirmed because section 1129(b)(2)(A)(ii) required that secured creditors be permitted to credit bid if their collateral is sold under a plan. The United States District Court for the Eastern District of Pennsylvania reversed the bankruptcy court and agreed with the Fifth Circuit that a secured creditor does not have the right under section 1129(b) to credit bid at a public auction held as part of a reorganization if the secured creditor receives the indubitable equivalent of its secured claim. The court did not decide, however, whether denying the right to credit bid under the circumstances satisfied the fair and equitable or indubitable equivalent standards under section 1129. The court expressly reserved the issue of whether an auction sale at which the secured creditor could not credit bid was the indubitable equivalent of the lender's interest in the collateral. The United States Court of Appeals for the Third Circuit has expedited the appeal and will hear oral argument on December 15, 2009.