fraudulent conveyance exposure for intercorporate...

Fraudulent Conveyance Exposure for

Intercorporate Guaranties, Integrated

Transactions and Designated-Use Loans Navigating the Contours of Section 548 Reasonably Equivalent

Value Defense in Complex Lending Transactions

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Presenting a live 90-minute webinar with interactive Q&A

Thomas J. Hall, Partner, Chadbourne & Parke, New York

Seven Rivera, Partner, Chadbourne & Parke, New York

Eric Daucher, Chadbourne & Parke, New York

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Strafford Webinar

Symposium

April 16, 2014

Panelists Thomas J. Hall

Partner

212-408-5487

[email protected]

Seven Rivera

Partner

212-408-5529

[email protected]

FRAUDULENT CONVEYANCE

EXPOSURE FOR

INTERCORPORATE

GUARANTIES, INTEGRATED

TRANSACTIONS AND

DESIGNATED-USE LOANS

Eric Daucher

Associate

212-408-5405

[email protected]

DISCLAIMER

The written materials distributed and the presentations made by this panel are intended for educational and discussion purposes only. Any views or opinions expressed during the course of this presentation are not intended to be attributable to clients of our panelists, and are not intended to bind any of our panelists or their clients to any positions they may or may not take in current or future litigation.

6

The Speakers

.

• Thomas J. Hall – Commercial litigation partner with Chadbourne & Parke LLP and co-head of Chadbourne's Commercial Litigation Practice. (212) 408-5487, [email protected].

• Seven Rivera – Bankruptcy and restructuring partner with Chadbourne & Parke LLP representing secured and unsecured lenders, creditors, debtors, and creditor committees in Chapter 11 cases. (212) 408-5529, [email protected].

• Eric Daucher – Bankruptcy and restructuring associate with Chadbourne & Parke representing a variety of parties in Chapter 9, 11 and 15 cases. (212) 408-5405, [email protected]

7

mailto:[email protected]



1. The Problem

2. Section 548

3. What Constitutes a Transfer or an Obligation

4. Loan Proceeds and Reasonably Equivalent Value

5. The Development of the Indirect Benefits Doctrine

6. How to Quantify Indirect Benefits

7. Who is Liable

8. Revolving Loans: When is the Transfer Made

9. Lender Strategies

10. Conclusions

11. Questions

Outline of Presentation

8

The Problem in the Loan Context

The possibility that a transaction might be characterized as a fraudulent transfer is probably the best known risk for secured lenders in bankruptcy (aside from simple undersecurity).

1. Upstream Guarantees

2. Downstream Guarantees

3. Corporate Affiliates as Co-Borrowers

4. Designated–Use Loans

9

Bankruptcy Code Section 548

• Constructive fraudulent transfer:

"The trustee may avoid any transfer . . . or any obligation . . . incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor . . . received less than a reasonably equivalent value in exchange for such transfer or obligation; and . . . was insolvent on the date that such transfer was made or such obligation was incurred."

10

What Constitutes a "Transfer" or "Obligation"

11

• Loan Repayment Obligations

• Pledges of Collateral

• Guarantees

• Cross-Collateralizations

Loan Proceeds as Reasonably Equivalent Value

• Where lender extends financing to a single obligor for general working capital, lender has strong argument that the loan proceeds are reasonably equivalent in value to the repayment obligation incurred.

• Even though the total value of the latter will include interest and perhaps the reimbursement of the lender's expenses, "the concept of 'reasonably equivalent value' does not demand a precise dollar-for-dollar exchange." Advanced Telecomm. v. Allen, 490 F.3d 1325, 1326 (11th Cir. 2007)

• The mere access to credit qualifies as value because the "the ability to borrow money has considerable value in the commercial world." Mellon Bank, N.A. v. Metro Communications, 945 F.2d 635 (3d Cir. 1991).

12

Upstream and Downstream Guarantees

• Upstream guaranties and downstream guaranties are common.

• In upstream guaranties, the lender extends credit to a parent whose principal assets are the equity in its subsidiaries (perhaps worthless in the event of a bankruptcy), and which consequently must rely on guaranties and/or collateral pledges by the subsidiaries to secure the repayment obligations.

• Downstream guaranties work in the other direction, parent guaranteeing the obligations of its subsidiaries.

13

Upstream and Downstream Guarantees (Con't.)

• Upstream guaranties can be the most vulnerable to fraudulent conveyance attack because the conveyance -- the subsidiary's incurrence of a guaranty obligation, often secured by the subsidiary's pledge of collateral -- is made by an entity that is not a direct recipient of the loan proceeds.

• Lenders may not be able to demonstrate a direct benefit to the subsidiaries insofar as the real "value" arises from a borrower's receipt of loan proceeds.

14

The Development of the Indirect Benefits Doctrine

15

Indirect Benefits as Reasonably Equivalent Value Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981) :

• Second Circuit acknowledged that "[t]hree-sided transactions such as [the upstream guaranties] at issue here present special difficulties under the [Bankruptcy Act's] definition of fair consideration," the predecessor to "reasonably equivalent value" under the current Code.

• The court acknowledged the general rule that "transfers made to benefit third parties are clearly not made for a 'fair' consideration," but pointed out that a "transaction's benefit to the debtor need not be direct; it may come indirectly through benefit to a third person."

16

Indirect Benefits

• Established "identity of interests" for determining when a benefit to one party indirectly benefits another.

• Trustee brought fraudulent conveyance claim where debtor, a wholly owned subsidiary of Royal Crown, paid $35,000 to satisfy parent's obligation.

• The trustee maintained "that all the consideration from the defendant in this transaction passed to [Royal Crown], none passed to the debtor. . . ."

• Court disagreed, reasoning that "[t]his conclusion omits any consideration of the fact that to some extent these two corporations shared an 'identity of interests.'" Citing Rubin, court acknowledged the "general rule" that "an insolvent debtor receives 'less than a reasonably equivalent value' where it transfers its property in exchange for a consideration which passes to a third party," but stated:

17

Garrett v. Falkner (In re Royal Crown Bottlers of North Alabama, Inc.), 23 B.R. 28 (Bankr. N.D. Ala. 1982)

Indirect Benefits Identity of Interests (Royal Crown)

"A clear distinction from this rule exists, however, if the debtor and the third party are so related or situated that they share an "identity of interests," because what benefits one will, in such case, benefit the other to some degree. The ultimate question then becomes one of determining the value of this vicarious benefit and testing it by the measure of "reasonably equivalent" for the property transferred by the insolvent debtor."

• But Royal Crown introduced obstacle to "identity of interests" argument for

upstream guarantees:

"When the consideration for a transfer passes to the parent corporation of a debtor-subsidiary making the transfer, as in the case here, the benefit to the debtor may be presumed to be nominal, in the absence of proof of a specific benefit to it. On the other hand, the passing to a subsidiary of the consideration for a transfer by a debtor-parent may be presumed to be substantial, because the subsidiary corporation is an asset of the parent corporation, and what benefits the asset will ordinarily accrue to the benefit of its owner."

18

Telefest, Inc. v. VU-TV, Inc., 591 F. Supp. 1368 (D.N.J. 1984)

• Security agreement executed by VU-TV, wholly owned subsidiary of CATV Products, Inc. VU-TV agreed to guarantee and collateralize a loan to parent.

• A later-priority creditor argued that the security agreement was avoidable under New Jersey's fraudulent transfer statute (substantially the same as Section 548 of Bankruptcy Code).

• In finding that VU-TV received fair consideration in exchange for its secured obligations, the court cited Royal Crown's "identity of interests" principle and found that "a benefit would flow to VU-TV through the loans . . . ultimately guaranteed by VU-TV."

19 Indirect Benefits

Telefest, Inc. v. VU-TV, Inc., 591 F. Supp. 1368 (D.N.J. 1984) (Con't.)

• Court endorsed the principle that a guarantor can receive value from "the guaranty of a loan to a third party . . . whose continued health and existence is vitally important to the guarantor" and proceeded to acknowledge some specific benefits flowing to VU-TV.

• The court noted that "[m]onies loaned to VU-TV's parent to purchase a cable television system or for other moves directed toward expansion would most probably provide an additional and obviously secure market for VU-TV," a "specific enough benefit" on which to find that "fair consideration inhered in the conveyance."


• Cross-stream guarantee in which Xonics Photochemical and other subsidiaries of Xonics, Inc. guaranteed and pledged security to secure a loan to its sister company, Xonics Medical Systems.

• The value of the guarantees and collateral was considerably less than the $28 million owed on the loan, so Xonics Medical Systems' default sent the entire enterprise into bankruptcy.

• Xonics Photochemical brought adversary proceeding to recover payments it made to a chemical supplier, Mitsui & Co., as preferential. Mitsui's defense was that the guaranty obligations and collateral pledges that had rendered Xonics Photochemical insolvent were voidable as fraudulent transfers under Illinois law and Section 548.

• Citing Telefest, the court stated that "a guarantee of an affiliate's debt is enforceable provided that the guarantor derives some benefit, even if indirect, from the guarantee."

• In affirming the finding that Xonics Photochemical received such a benefit, the court reasoned:

"Although the primary benefit of the loan accrued to the borrower, Xonics Medical Systems, that company's fortunes were entwined with those of Xonics Photochemical because the smaller company used its larger affiliate's distribution system to distribute its own products."

In re Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988) (Posner, J.)


Indirect Benefits What Is Property?

22

• Section 548(d)(2)(A) provides that for the purposes of that section "value" is defined as: "property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor."

• A difficulty may arise from an overly literal interpretation of the Bankruptcy Code's definition of "value."

• Section 548 defines value to mean "property, or satisfaction or securing of a present or antecedent debt of the debtor."

• Since the debt of a third party (even one's own corporate parent) is not a debt "of the debtor," an indirect benefit must fall under the other category -- "property" -- to qualify as "value."

• But "property" is not a defined term in the Bankruptcy Code.

• A court could import a broad definition of "property" that "extend[s] to every species of valuable right and interest" -- indeed, "anything of value" -- or a narrow definition that covers only things which are "the subject of ownership" and "guaranteed and protected by the government." Black's Law Dictionary 1216 (6th ed. 1990).

Indirect Benefits What Is Property?

• The important notion at the core of many cases is that the indirect benefits they recognize would likely not qualify as "property" under the stricter definitions of the term -- an asset that can appear on a company's balance-sheet.

• Eighth Circuit has clarified that indirect benefits are not limited to "legal or equitable rights or ownership interest" and that "value" therefore should not be defined "only in terms of tangible property or marketable financial value." United States v Crystal Evangelical Free Church, 82 F.3d 1407, 1415 (8th Cir. 1996).

• Examples of intangible indirect benefits that may constitute reasonable equivalent value

– "increased ability to borrow working capital;

– the general relationship between affiliates or 'synergy' within a corporate group as a whole; and

– a corporation's ability to retain an important source of supply or an important customer. . . ." Jumer's Castle Lodge, Inc. v. Jumer, 338 B.R. 344, 354 (C.D. I11. 2006).

23

Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 422 B.R. 783, 868 n.55 (Bankr. S.D. Fla. 2009):

"As a matter of natural usage, legal usage, and bankruptcy-law usage, the Conveying Subsidiaries could not receive "property" unless they obtained some kind of enforceable entitlement to some tangible or intangible article. See WEBSTER'S THIRD NEW INT'L DICTIONARY 1818 (1986) (defining "property" in its broadest sense as "something . . . in which or to which a person has a right protected by law") (emphasis added); 11 U.S.C. § 541(a)(1) (defining "[p]roperty of the estate" to include "all legal or equitable interests of the debtor in property as of the commencement of the case") (emphasis added); see also Bracewell v. Kelley (In re Bracewell), 454 F.3d 1234, 1239 (11th Cir. 2006) (debtor's "hope to an entitlement" not a property interest until it is legally cognizable.)"

24

How to Define Property

How to Define Property (Con't.)

3V Capital Master Fund Ltd. v. Official Comm. of Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613, 656 (S.D. Fla. 2011):

" In addition, the Bankruptcy Court's narrow dictionary definition of property is contrary to the meaning of the term in the Bankruptcy Code. The legislative history for the Bankruptcy Reform Act of 1978 provides that "[a]lthough 'property' is not construed in [Section 102 of the Code], it is used consistently throughout the Code in its broadest sense, including cash, all interests in property, such as liens, and every kind of consideration including promises to act or forbear to act as in section 548(d)." Statements by Legislative Leaders, 124 CONG. REC. 11,089 (1978), reprinted in 1978 U.S.C.C.A.N. 6439, 6508. "

25

How to Define Property (Con't.)


"Nonetheless, I conclude that the Bankruptcy Court committed legal error in holding that the "avoidance of default and bankruptcy by the Conveying Subsidiaries" is as a matter of law "not property and therefore is not cognizable as 'value' under" Section 548 of the Bankruptcy Code. "

Reversed by11th Circuit

26

How to Define Property Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA, Inc.), 680 F.3d 1298 (11th Cir. 2012)

27

"The bankruptcy court then assessed whether the Conveying Subsidiaries received reasonably equivalent value from the transaction. The bankruptcy court first noted that 'value' is defined in section 548 as being 'property' or 'satisfaction or securing of a present or antecedent debt of the debtor.' 11 U.S.C. § 548(a)(1)(B)(i), (d)(2)(A). The bankruptcy court determined that 'the Conveying Subsidiaries could not receive 'property' unless they obtained some kind of enforceable entitlement to some tangible or Intangible article.' In re TOUSA, 422 B.R. at 868 n. 55. Under this definition of 'Value,' the bankruptcy court found that, because the Conveying Subsidiaries did not receive any property, they did not receive reasonably equivalent value."

How to Define Property Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA, Inc.), 680 F.3d 1298 (11th Cir. 2012) (Con't.)

28

"The bankruptcy court also issued alternative findings in which it assessed the value the Conveying Subsidiaries received under the broadest definition of 'value' proposed by the Transeastern Lenders and New Lenders. The bankruptcy court found that even if all the benefits highlighted by the Transeastern Lenders and New Lenders were legally cognizable, their value 'considered… as a whole,… f[e]ll[ ] well short of 'reasonably equivalent value.' Id. at 869."

• Third Circuit found that "potential, intangible benefits" should be deemed to have "conferred value on [the debtor] despite their failure to materialize."

• Court cited a Fifth Circuit precedent rejecting the argument that "the only value that can be considered is property actually received" and finding that "[t]he narrow 'realized property' approach to value . . . finds no approbation in the law."

• The most famous line of cases in which courts have found no "value" is where the transferee claims such amorphous, non-economic benefits as "spiritual fulfillment," "love and affection," or "the preservation of [a] family relationship." Those benefits have been held insufficient precisely because they are non-economic in nature, since non-economic benefits to the debtor "are not likely to be of much benefit to creditors." Allard v. Flamingo Hilton, 69 F.3d 769, 776 (6th Cir. 1995).

29

Mellon Bank, N.A. v. Official Comm. of Unsecured Creditors of R.M.L., 92 F.3d 139, 151-52 (3d Cir 1996).

Indirect Benefits

• Subsidiaries of a homebuilding enterprise pledged collateral to secure $500 million in term loans used to settle litigation against their parent company arising from an alleged default under an earlier credit facility on which the subsidiaries were not directly liable.

• Relying on Telefest and like cases, the lenders argued that the intertwined relationship among all the entities in the corporate enterprise resulted in the subsidiaries' receiving indirect benefits from their loan guarantees, such as continued access to centralized services and cash flow and the elimination of a risk of a default under their, $1 billion collective bond financing.

• The bankruptcy court held that none of those benefits were cognizable for purposes of assessing "value," taking direct aim at the entire body of law concerning indirect benefits:

"Section 548 does not refer to 'benefits,' whether direct or indirect. It requires reasonably equivalent 'value' and includes a precise definition of 'value' that encompasses only 'property' and 'satisfaction or securing of a present or antecedent debt of the debtor.'"

30

Official Committee of Unsecured Creditors of Tousa, Inc., et. al v. Citicorp., no. 08-1435, 2009 Bankr. Lexis 3311 (Bankr. S.D. F19. Oct. 13, 2009)

Indirect Benefits

Indirect Benefits 3V Capital Master Fund Ltd. v. Official Comm. of Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613, 666 (S.D. Fla. 2011)

• In holding the subsidiaries received value by eliminating that risk of a bond default, the District Court held that the opportunity "to avoid default and bankruptcy," even if "this 'breathing room' may have ultimately proved to be short-lived," can amount to reasonably equivalent value." The court added:

"[T]his is exactly the kind of case, as supported by applicable case law, that shows that a debtor's opportunity to avoid default, to facilitate its rehabilitation, and to improve its prospects of avoiding bankruptcy are precisely the kind of benefits that, by definition, are not susceptible to exact quantification but are nonetheless legally cognizable under Section 548. Inherently, these benefits have immense economic value that ensure the debtor's net worth has been preserved, and, based on the entirety of this record, were not disproportionate between what was given up and what was received."

31

Indirect Benefits: Can Intangible Benefits Constitute Value?

• Other courts have rejected the notion that a debtor must receive a direct, tangible economic benefit in order to receive "value" for purposes of Section 548(a)(2).

32

Can Intangible Benefits Constitute Value? (Con't.)

• "It has long been established that '[w]hether fair consideration has been given for a transfer is "largely a question of fact, as to which considerable latitude must be allowed to the trier of the facts." ' " Nordberg v. Arab Banking Corp. (In re Chase & Sanborn Corp.), 904 F.2d 588, 593 (11th Cir. 1990) (quoting Mayo v. Pioneer Bank & Trust Co., 270 F.2d 823, 829–30 (5th Cir. 1959) (Wisdom, J.)).

33

Avoidance of Bankruptcy as Reasonably Equivalent Value

• The Court was "unpersuaded" that the record compels the finding that the July 31 transaction allowed the Conveying Subsidiaries to escape the "existential threat" of the likely bankruptcy that would ensue and that the chance to avoid that bankruptcy was a benefit reasonably equivalent in value to the obligations the Conveying Subsidiaries incurred.

• "A corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it." Bloor v. Dansker (In re Investors Funding Corp. of New York Sec. Litig.), 523 F. Supp. 533, 541 (S.D.N.Y. 1980). "In other words, not every transfer that decreases the odds of bankruptcy for a corporation can be justified."

• "The opportunity to avoid bankruptcy does not free a company to pay any price or bear any burden. After all, 'there is no reason to treat bankruptcy as a bogeyman, as a fate worse than death.'" Olympia Equip. Leasing Co. v. W. Union Tel. Co., 786 F.2d 794, 802 (7th Cir. 1986) (Easterbrook, J., concurring).

34



"Contrary to the Bankruptcy Court's legal conclusion, the weight of authority supports the view that indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise's rehabilitation, and to avoid bankruptcy, even if it provided to be short lived, may be considered in determining reasonable equivalent value. An expectation, such as in this case, that a settlement which would avoid default and produce a strong synergy for the enterprise, would suffice to confer 'value' so long as that expectation was legitimate and reasonable."

35



"By virtue of the Transeastern Settlement, the Conveying Subsidiaries' 'net worth' was preserved and imminent default was avoided, thereby preserving, at that point of time, the interests of the Committee's unsecured creditors by allowing the enterprise to continue to meet its bond interest obligations and Revolver loan payments. As such, additional Revolver payments were paid out in excess of $65 million following the Transeastern Settlement, that allowed the enterprise's business to continue until the real estate industry totally collapsed later that year in a manner that was not foreseen at the time of the settlement."

36

Designated Use Loans

• Where credit facilities designated for general working capital of corporate group, it can be easy to establish a borrower's control over the loan proceeds.

• Where loan proceeds are contractually designated for a specific purpose, borrower has little or no discretion how the funds are used. Issues when corporate affiliates are co-borrowers, but use of funds is contractually limited.

• "Dominion" or "control" tests determine whether the borrower had a property interest in the funds.

• These tests focus on whether the borrower had "the right to put the money to one's own purposes" or "the ability to use [the money] as he sees fit." Bonded Fin. Servs. v. European Am. Bank, 838 F.2d 890, 893 (7th Cir. 1988).

37

The Control Test Leveraged Buyouts

• Acquisition target borrows, secures, or makes payments in satisfaction of a loan whose proceeds are designated for payouts to the selling shareholders.

• The loan proceeds might pass through the borrower without ever giving the borrower sufficient control over the proceeds for a court to deem them "property" of the borrower under the dominion or control tests.

• If loan proceeds are never deemed "property" of the borrower, the party defending the transfer must point to something else to establish reasonably equivalent value from the transaction.

38

• The doctrine that permits courts to ignore a borrower's temporary interest in the loan proceeds in such transactions is based on the notion that the multiple steps amount to a "single integrated transaction" rather than a series of individual transactions. Once a court finds that it is appropriate to treat "a series of transactions" as a single integrated transaction, it may "collapse" each step and consider the result as one transaction.

• Thus, the doctrine is often invoked "for purposes of demonstrating that the insolvent . . . company did not, in the aggregate, receive fair consideration or reasonably equivalent value for the transfer in question," even though it might literally have received loan proceeds equivalent in value to the challenged transfer or obligation.

39

Official Comm. Of Unsecured Creditors v. Clark, 344 B.R. 340, 348 (W.D. Pa. 2006)

The Control Test

Dillworth v. Ginn, No. 10-2976, 2010 WL 8756756 (Bankr. S.D. Fla. Dec. 10, 2010)

• Debtor may have a property interest even if it does not have complete control over the loan proceeds.

• Trustee sought to avoid transfer of debtors' interest in $148 million loan proceeds.

• Debtors guaranteed and secured $148 million loan, but did not receive proceeds.

• Trustee sought to avoid as fraudulent the $148 million of loan proceeds.

6374566.1

The Control Test 40

• As Debtors did not receive proceeds, defendants argue the transfer did not involve property of Debtors.

• Creditors moved to dismiss, arguing that trustee cannot avoid direct transfers of non-debtor property to non-debtor borrowers. They argued the loan proceeds were not debtor property because the debtors were not borrowers or signatories of the credit agreement, but merely "subsidiary guarantors" who never had any control over the loan proceeds.

Dillworth v. Ginn, No. 10-2976, 2010 WL 8756756 (Bankr. S.D. Fla. Dec. 10, 2010) (Con't.)

The Control Test 41

• The court rejected the argument that debtors must control property to have a property interest, relying on the Tousa decision's holding that a debtor may have an interest in property "even if the debtor has no power to prevent some other party from transferring the property."

• The court still granted the motion to dismiss, finding that the trustee's complaint failed to adequately allege enough facts to support that the debtors were substantively borrowers rather than guarantors.

Dillworth v. Ginn, No. 10-2976, 2010 WL 8756756 (Bankr. S.D. Fla. Dec. 10, 2010) (Con't.)

The Control Test 42

Bay Plastics v. BT Commercial Corp. (In re Bay Plastics), 187 B.R. 315 (Bankr. C.D. Cal. 1995)

• Straightforward example of the doctrine in operation.

• Case arose from a failed LBO pursuant to which BT "lent . . . $3.95 million to [Bay Plastics], [Bay Plastics] promised to repay the loan, and [Bay Plastics] gave a first priority security interest in essentially all of its assets to secure the repayment." The court commented that if that were the extent of the transaction, "it would not be vulnerable to fraudulent transfer attack."

• Court proceeded to note that "the foregoing structure obscures the reality of the transaction."

43 The Control Test: Collapsing The Transactions

• There was a second transaction in which Bay Plastics "directed that $3.5 million be transferred to its incoming parent, BPI, and BPI in turn directed that the funds be paid out for [a] stock purchase. Thus in substance $3.5 million of the funds that Bay Plastics borrowed from BT went to pay for the stock of the selling shareholders, rather than to Bay Plastics."

• Court collapsed the two stages into a single integrated transaction, the effect of which was to find that Bay Plastics received only $450,000 in value from the $3.95 million loan proceeds (i.e., "the $3.95 million loan less the $3.5 million paid to the selling shareholders"), which was "not reasonably equivalent to the $3.95 million obligation that it undertook."

44

Bay Plastics v. BT Commercial Corp. (In re Bay Plastics), 187 B.R. 315 (Bankr. C.D. Cal. 1995)

The Control Test: Collapsing The Transactions


• Collapsing transactions enables court to deviate from the rule that value must be measured as of the time of the transfer and to determine that a debtor received less than reasonably equivalent value from a loan -- notwithstanding its receipt of the loan proceeds -- because of the use to which those loan proceeds subsequently were put.

• The consequences of this can be dramatic, since it can be said of any company in bankruptcy that its capital could have been more valuably put to other uses.

45

Beemer v. Heller & Co. (In re Holly Hill Medical Center, Inc.), 44 B.R. 253, 256 (Bankr. M.D. Fla. 1984)

• "As a practical matter, in a bankruptcy context, we could rarely find that optimum use of borrowed funds had been made."

• The lending transactions at issue in Holly Hill had at least four stages, but fundamentally they entailed simply substituting one lender for another.

• Court characterized trustee's argument: "[T]he plaintiff does not suggest that, had the debtor been the borrower and the defendant the sole lender in a simple two-sided transaction, he as trustee would be able to recover any payments as fraudulent transfers -- clearly the debtor would be deemed to have received reasonably equivalent value in the form of use of the money loaned it."

46 The Control Test: Collapsing The Transactions

• Court rejected this theory, holding that "the reasonably equivalent value for the continuing interest payments was access to the money for whatever use the borrower chose to make on behalf of the debtor."

• Court reasoned:

"The criterion for whether a debtor received reasonably equivalent value cannot in any instance be whether the debtor used sound judgment in exploiting what it received to the best advantage. As a practical matter, in a bankruptcy context, we could rarely find that optimum use of borrowed funds had been made. Far more importantly, that approach is supported by neither logic nor fairness. The debtor received in the first instance $750,000 worth of potential benefit. Whether borrowed money is used brilliantly or wasted by the recipient does not inflate or reduce its value from the lender's standpoint . . . ."

47

Beemer v. Heller & Co. (In re Holly Hill Medical Center, Inc.), 44 B.R. 253, 256 (Bankr. M.D. Fla. 1984) (Con't)


Quantifying Indirect Benefits

48

How to Quantify Value

Official Comm. of Unsecured Creditors of Toy King Distrib., Inc. v. Liberty Sav. Bank, FSB (In re Toy King Distrib., Inc.), 256 B.R. 1, 133-34 (Bankr. M.D. Fla. 2000):

• The first approach is an objective one that relies upon a mathematical formula to determine equivalence. Using this approach, a court will find a per se lack of equivalent value when the transfer is for less than 70 percent of the market value of the debtor's property.

49

How to Quantify Value (Con't.)

• The second approach is a subjective test which focuses on the fairness aspect. Under this approach, the consideration is presumed fair so long as it is not so far short of the real value of the property as to startle a correct mind or shock the moral sense. One could characterize this approach as a "smell test."

50


• The third approach is the "totality of the circumstances test." This test combines both objective and subjective elements. Using this approach, courts have looked to the totality of the circumstances surrounding the transaction to determine whether "fair consideration" or "reasonably equivalent value" is given in exchange for a transfer of property." In applying this test, the court considers the transfer in the context of the surrounding circumstances and from the perspective of the creditor.

51

How to Quantify Value? (Con't.)

Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp North America, Inc. (In re Tousa, Inc.), 408 B.R. 434, 438 (Bankr. S.D. Fla. 2009):

"Although the Plaintiff has both the burden of going forward in attempting to establish that the Conveying Subsidiaries did not receive 'value' directly, and has the ultimate burden of proof, it is equally the case that upon a prima facie showing by the Plaintiff of no direct value, the Defendants have the burden of going forward to establish that the Conveying Subsidiaries received indirect 'value,' In re Aqua Clear Technologies, Inc., 361 B.R. 567, 582 (Bankr. S.D. Fla. 2007), and that such indirect value was tangible, concrete, and quantified with reasonable precision. In re Richards & Conover Steel Co., 267 B.R. 602, 614 (8th Cir. BAP 2001)."

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How to Quantify Value (Con't.) 3V Capital Master Fund Ltd. v. Official Comm. of Unsecured Creditors of TOUSA, Inc. (In re TOUSA, Inc.), 444 B.R. 613, 661 (S.D. Fla. 2011):

"Having concluded that the Bankruptcy Court erred in its legal definition of value, and in its determination that the Conveying Subsidiaries did not receive value in the transaction, the Bankruptcy Court further legally erred by not considering the 'totality of the circumstances' in measuring reasonable equivalency. This test, as adopted by the Third Circuit in In re R.M.L., Inc., has been applied in this Circuit by U.S. District Courts and U.S. Bankruptcy Courts in Florida."

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"Under such circumstances, no further proof of ‘quantification’ was required to establish reasonably equivalent value, and the Bankruptcy Court further erred as a matter of law in requiring the same. Even the Committee concedes in its brief that ‘courts sometimes can, without precise mathematical quantification, decide that particular facts and circumstances show that a debtor received reasonably equivalent value.’ [Committee's Br., p. 109 (emphasis in original)]. Thus, a per se rule, as applied by the Bankruptcy Court, that indirect benefits must be mathematically quantified is error."

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• Expert analysis is important

• Identify the benefits and have expert quantify

• If transaction avoided bankruptcy:

– Value of goodwill

– Value of shareholder equity

• Need to be creative

Proving the Value of Indirect Benefits

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Who is Liable

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• § 550(a): "Except as otherwise provided in this section, to the extent that a transfer is avoided under Section 544, 545, 547, 548, 549, 553(b), or 724(a) of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property from

(1) the initial transferee of such transfer of the entity for whose benefit such transfer was made."

Who is Liable? (Con't.)

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1. Initial transferee

2. Entity for Whose Benefit

– Examples

Revolving Loans: When is the Transfer Made

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Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981) • Debtors were affiliated companies in business of selling money orders and cashing checks

• Credit agreement with Manufacturers Hanover

- collateralized

- Loan closed 1972

- Draw at issue December 1976

• Enterprise collapses

• Trustee sues Manufacturer Hanover for fraudulent conveyance

• District court dismisses due to failure to establish insolvency on date loan closed

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Rubin (Con't.)

• Second Circuit vacates: Test solvency at the time of the draw

• The Second Circuit held:

"The district court stated that UMO's trustee had failed to prove that UMO was insolvent 'at the time the guarantees were made.' . . . [H]owever, UMO's incurring of obligations as guarantor must also be tested as of December 1976, when the loans for which it was charged were made. Accordingly, the question for decision was whether UMO was, or was rendered, insolvent or insufficiently capitalized as of December 1976, not just as of September 1976, when it executed its third guarantee . . . Or as of any earlier time."

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Rubin (Con't.)

• In support of this holding, the Second Circuit reasoned:

"Whenever National, TWO, and Propper borrowed under the loan lines, they of course incurred an obligation of repayment under the terms of their financing agreements with MHT. At the same time . . . . USN and UMO, as secondary guarantor, became contingently liable . . . . Undoubtedly, therefore, USN and UMO 'incurred' an 'obligation' of repayment, although admittedly a contingent one, whenever National, TWO, and Propper borrowed under the loan line, as they did in September and December 1976."

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Uniform Fraudulent Transfer Act

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• Forty-four states have adopted the Uniform Fraudulent Transfer Act ("UFTA") as their statutory regime. In 1984, three years after Rubin, the National Conference of Commissioners on Uniform State Laws promulgated an amendment to the UFTA that was explicitly designed "to resolve uncertainty arising from Rubin." The amendment provides that "an obligation is incurred…when the writing executed by the obligor is delivered to or for the benefit of the obligee."

• By making "the relevant time for testing the transfer…the outset of the transaction when the writings are delivered," the UFTA "assure[s] that with respect to guarantors, a separate fraudulent conveyance analysis will not be made each time an advance is made to the principal debtor — which could be over a period of months or years — but only at the time the guaranty is signed."

In re TOUSA, Inc., No. 08-10928 (Bankr. S. D. Fla. Sept. 19, 2008)

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"I believe it to be the law that transfers under Section 548 occur when a lien granted becomes so perfected that a bona fide purchaser for value could not acquire a superior interest. I am troubled by the notion that the transfer occurs at a time after the granting of the lien…. It certainly is the case that the vast majority of states [that] have adopted the Uniform Fraudulent Transfer Act, which Florida adopted in Chapter 726, intended to overrule Rubin…. The parties appear to be arguing only under Section 548 for purposes of this hearing, but Section 548 appears to me to be substantially similar to Florida's version of the Uniform Fraudulent Transfer Act."

Commentary on Rubin

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Official Comm. of Unsecured Creditors of TOUSA, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), No. 09-60589, 2011 WL 1627129 at *5 n.4 (S.D. Fla. Mar. 4, 2011):

• Few cases have relied on Rubin for the proposition that an obligation is incurred every time a borrower draws money on a revolving credit line.

• Those that have cited Rubin for this proposition, moreover, have done so in dicta and without much analysis. See, e.g., In re Heartland Chems., 103 B.R. 1012, 1016 (Bankr. C.D. III. 1989).

• No cases that I am aware of have explicitly rejected Rubin. Nevertheless, commentators have vociferously criticized Rubin, and 44 states rejected its holding through passage of the UFTA.

• Uniform Fraudulent Transfer Act 6 cmt. 3 (1984): "Paragraph (5) is new. It is intended to resolve uncertainty arising from Rubin …, infofar as the case holds that an obligation of guaranty may be deemed to be incurred when advances covered by the guaranty are made rather than when the guaranty first became effective between the parties.")

Official Comm. of Unsecured Creditors of Tousa, Inc. v. Citicorp. N. Am., Inc. (In re Tousa, Inc.), No. 09-60589, 2011 WL 1627129 (S.D. Fla. Mar. 4, 2011)

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• Dismissal of claims against Revolver affirmed. Amended loan agreement continued pre-existing obligations and were transfers occurring on initial loan date, not dates of amendments or subsequent draws.

• Liens re-perfected during period of insolvency are deemed

transferred on the date of the original perfection. • Post-insolvency draws on Revolver – District Court does not

reach substance of issue as it affirmed on waiver grounds.

Official Comm. of Unsecured Creditors of TOUSA, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 2011 WL 1627129 at *5 n.4 (S.D. Fla. Mar. 4, 2011)

Bash v. Textron Fin. Corp., 483 B.R. 630 (N.D. Ohio 2012)

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• A debtor's bankruptcy trustee asserted claims against lenders for the recovery of fraudulent transfers based on the debtor refinancing a loan.

• The court relied on the reasoning in Tousa and found that no transfer had occurred when the loan was refinanced, because the refinancing did not impair collateral that wasn't already secured by a financing agreement, the amount of credit available to the debtor after refinance was reduced from the amount available under the original loan, and the refinance did not result in novation.

LaRosa v. LaRosa, 482 Fed. Appx. 750 (4th Cir. 2012)

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• The court interpreted the West Virginia Uniform Fraudulent

Transfer Act to deem that a transfer is made when a credit agreement is entered, rather than with every drawdown on the credit facility. The court noted that the Act was amended in order to resolve the uncertainty created by Rubin.

Lender Strategies

1. Amendments to loan agreements while borrower is financially distressed should clearly specify that pre-existing obligations are continuing.

2. Lenders may avoid fraudulent conveyance claims for loans to a corporate family on a consolidated basis if benefits from loan to individual entities are clear.

3. Providers of rescue financing perhaps can point to the avoidance of bankruptcy and default, even if temporary, as concrete value provided to debtors.

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Lender Strategies (Con't.)

4. Contractual language setting forth benefits.

5. Savings clauses.

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Savings Clauses

"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."

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Invalidation of the Savings Clause

• In re TOUSA, Inc., 422 B.R. 783 (Bankr. S.D. Fla. 2009), held savings clauses invalid

because:

"The savings clause is unenforceable under Section 541(c)(1)(b), which provides that an interest of the debtor in property becomes property of the estate, notwithstanding any 'provision in an agreement' that is 'conditioned on the insolvency or financial condition of the debtor' that 'effects or gives an option to effect a forfeiture, modification, or termination of the debtor's interest in property.'"

• Efforts to contract around provisions of the Bankruptcy Code are invalid:

"If given effect, the only purpose served by the savings clauses is to ensure that the transferee can preserve its claim to every last penny of the debtor's remaining assets without providing reasonably equivalent value. The savings clauses are a frontal assault on the protections that section 548 provides to other creditors. They are, in short, entirely too cute to be enforced."

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Invalidation of the Savings Clause (Con't.)

"There is something inherently distasteful about really clever lawyers overreaching. Some problems cannot be drafted around. The fact that this sort of drafting was felt necessary by Citi ought to have given it pause that maybe this deal was not possible. In any event, Citi and the rest of the Defendants assumed the risk that the Transaction would be regarded by a reviewing court as a fraudulent transfer."

"The existence of multiple savings clauses creates an indefinite contract. 'The value of A can be determined only after knowing the value of B; but the value of B can be determined only after knowing the value of A.'"

"The express provisions of the loan agreements require a written amendment to effectuate a modification of the loan (the reduction of the liability of a subsidiary which is deemed to occur as a result of a savings clause), and no such further writing existed."

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Conclusions

Use caution:

• Loans to consolidated corporate enterprise at time of financial distress.

• Paydowns of antecedent debts at time of financial distress.

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fraudulent conveyance exposure for intercorporate...

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