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On Tuesday, setting an important precedent, a three-judge panel of the 11th Circuit Court of Appeals declared that the interests of banks and lenders cannot be put first by companies heading towards Chapter 11 bankruptcy. In a case involving $421 million which has been swinging this way and that in the courts, this is the latest in a series of controversial decisions.
The fight is between the bankrupt home-building company Tousa and the distressed debt hedge funds which bought up Tousa funds. The hedge funds have claimed that the $421 million pre-Chapter 11 deal that Tousa made with secured lenders was a fraudulent conveyance and the money, thus, belongs to them.
The courts, first a federal bankruptcy judge, then a district court, and now the 11th Circuit Court of Appeals have considered the issue.
Tousa was the 13th largest home builder in the United States. It grew through leveraged acquisitions and by July 2007, it had $1.2 billion in debt. Tousa defaulted on its loans after the housing market dropped and in 2007 the lenders sued claiming $2 billion in damages.
To fight impending bankruptcy, Tousa reached a settlement for $421 million outside the court with its secured lenders including Citigroup and others. In January 2008, Tousa filed for Chapter 11 bankruptcy. However, the bondholders sued and claimed that the $500 million secured loan that Tousa took out to secure the pre-Chapter 11 bankruptcy deal put the creditor’s money at unnecessary risk.
In 2009, after a 13-day trial, U.S. Bankruptcy Judge John Olson made a ruling which held that Tousa was already insolvent at the time of making the pre-Chapter 11 deal, and it put its subsidiaries at the mercy of bank lenders. The judge ruled that the deal was a fraudulent conveyance and the $421 million be returned to creditors.
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The banks and other secured lenders made their move in the district court and in 2011, U.S. District Judge Alan Gold, held that the bankruptcy court was wrong and the judgment of the lower court was “inhibitory of contemporary financing practices.”
However, the 11th Circuit, on Tuesday, cast a shadow on those “contemporary financing practices” and held that when a company was already essentially insolvent and headed towards inevitable bankruptcy, a deal made only to satisfy secured lenders was against the interest of creditors in an unfair manner. In a case where “the almost certain costs of the transaction … far outweighed any perceived benefits,” under the given circumstances, such a deal was fraudulent. In response to the argument of the lenders that they were not required to investigate how Tousa was securing the loan, the court said “every creditor must exercise some diligence when receiving payment from a struggling debtor.”
