TOUSA Ruling Bad News for the Savings Clause
The continued vitality of “savings clauses” in loan agreements designed to minimize the risk of a finding that a loan guarantor is insolvent in analyzing whether the loan transaction can be avoided as a fraudulent transfer was dealt a blow by a highly controversial ruling recently handed down by a Florida bankruptcy court. In the first test in the bankruptcy courts of the enforceability of savings clauses in “upstream guarantees,” the bankruptcy court in Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc. set aside as fraudulent conveyances obligations incurred and liens granted by subsidiaries of the debtor under certain loan agreements and related guarantees. In doing so, the court unequivocally invalidated savings clauses in upstream guarantees.
The ruling has been greeted by the lending community and commentators with a mixture of shock, dismay, disbelief, and resignation that yet another highly touted and common risk-mitigation technique has not proved to be as reliable as anticipated. If upheld on appeal and followed by other courts, the ruling may have a marked impact on lenders and debtors alike and may portend an increase in litigation against lenders that have insisted upon guarantees in loan transactions which include savings clauses.
TOUSA, Inc. (“Tousa”), and its subsidiaries are a large conglomerate of home-building companies. As did most other home builders, Tousa suffered in the recent economic downturn. As Tousa’s financial woes worsened, lenders (the “old lenders”) holding $675 million in secured debt (the “old loans”) at the parent level guaranteed by a Tousa subsidiary demanded repayment of the debt and ultimately sued to collect.
Tousa settled the litigation, agreeing to pay more than $421 million to the old lenders. To finance the settlement, Tousa entered into a loan transaction with new lenders (the “term lenders”) that provided the parent company with approximately $200 million in first-tier secured term loans and $300 million in second-tier secured term loans. The term lenders insisted that the term loans be guaranteed by Tousa subsidiaries that were not obligors in connection with the old loans or the settlement agreement. The term loans contained the following savings clause:
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 times.
Tousa and certain of its subsidiaries filed for chapter 11 protection in January 2008 in Florida. The official creditors’ committee commenced an adversary proceeding seeking to avoid the obligations incurred and liens granted by the guarantor subsidiaries in connection with the term loans as constructively fraudulent transfers under section 548(a)(1)(B) of the Bankruptcy Code and applicable state law. Among other things, the committee alleged that the subsidiaries were insolvent both before and after the term loan transaction.
The bankruptcy court ruled in favor of the committee, holding in a 182-page decision that, among other things, because savings clauses are unenforceable, the term lenders could not rely upon the clauses to show that the guarantor subsidiaries were solvent at the time they entered into the term loan transaction, which amounted to a fraudulent conveyance. The remedies granted by the court included: (i) avoidance of the claims of the term lenders against the guarantor subsidiaries, as well as the liens securing such claims; (ii) a directive that the term lenders disgorge any payments made by the guarantor subsidiaries in respect of the term loans; (iii) a directive that the old lenders disgorge funds received in connection with the settlement; (iv) an award of damages in favor of the guarantor subsidiaries in the amount of any diminution in the value of pledged assets subsequent to the term loan transaction; (v) an award of fees and costs to the creditors’ committee; and (vi) a directive that the term lenders’ professionals disgorge any fees paid by Tousa or its subsidiaries in connection with the term loan.
The Trouble With Savings Clauses
The bankruptcy court rejected the idea that the savings clauses prevented any finding of insolvency with respect to the guarantor subsidiaries for the following reasons:
· Because the guarantor subsidiaries were insolvent even before the term loan transaction and received no benefit from the loan, even if the savings clauses were enforceable, they would not have altered the insolvency finding. Even reducing the liabilities on the guarantees to nothing would still result in a finding of insolvency, and any liability imposed upon a guarantor subsidiary (or any lien securing such a liability) would be avoidable under section 548.
· Regardless of solvency, the savings clauses were unenforceable under section 541(c)(1)(B), which, according to the court, “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.’ ” Because the savings clauses were, on their face, “provision[s] in an agreement” that were “conditioned on the insolvency or financial condition of the debtor” and “effect[ed] forfeiture, modification, or termination of the debtor’s interest in property,” the clauses constituted unenforceable ipso facto clauses.
· The term lenders’ efforts to use the savings clauses to “contract around” the Bankruptcy Code were invalid. If enforced, the clauses would nullify the protection provided by section 548(a)(1)(B) and the limits that section 548(c) places on the ability of good-faith transferees to retain property “to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.” The only purpose of the savings clauses would be to ensure that a transferee could preserve its claim “to every last penny of the debtor’s remaining assets without providing reasonably equivalent value” to the detriment of other creditors in the case that would otherwise receive a greater distribution. Savings clauses, the court wrote, are “a frontal assault on the protections that section 548 provides to other creditors. They are, in short, entirely too cute to be enforced.”
· The savings clauses were unenforceable as a matter of contract law because the existence of multiple savings clauses executed contemporaneously, “each of which purport to reduce obligations after accounting for all other obligations,” made it impossible to determine the extent of an obligation arising from application of any particular savings clause. Such a moving target created an insoluble circular problem, creating inherently indefinite contract terms that are unenforceable as a matter of contract law.
· The parties to the term loans failed to take steps required under the loan agreement to modify the guarantor subsidiaries’ obligations (i.e., written and signed amendments reducing the principal amount of the loan or releasing any borrower from its obligations).
The bankruptcy court’s ruling in TOUSA is on appeal, the court on October 30, 2009, having conditioned the issuance of a stay pending appeal on the posting of a $700 million bond. Whether or not it withstands appellate scrutiny, the decision has thrown a formidable wrench into the works of the lending industry. Lenders unable to rely on savings clauses to minimize avoidance exposure may be reluctant to extend credit in a market that is already tight. At the very least, lenders are likely to insist upon alternative forms of credit enhancement to supplant upstream guarantees fortified with savings clauses. All of this is decidedly unwelcome news to companies struggling to line up financing necessary to restructure or reorganize businesses. It also remains to be seen whether other courts will adopt the same approach to this controversial issue.
Several aspects of the court’s ruling in TOUSA may be the focus of argument on appeal. For example, the court’s analysis of section 541(c)(1)(B)’s invalidation of ipso facto clauses omits language from the section making it applicable only to provisions that are conditioned on the insolvency or financial condition of the debtor “on the commencement of the [bankruptcy case].” The savings clauses in TOUSA were not conditioned on the commencement of the chapter 11 cases by Tousa or its guarantor subsidiaries.
In addition, the court’s holding that a savings clause represents an invalid attempt to “contract around” the Bankruptcy Code likely will be disputed. The Bankruptcy Code does not include any provision that prohibits lenders and borrowers from agreeing to reduce the maximum liability under a loan guarantee if it turns out that the guarantors are unable to satisfy the obligation. The bankruptcy court’s after-the-fact decision to modify the terms of arm’s length commercial negotiations, and thereby deprive the lenders of the benefit of their bargain, will undoubtedly be challenged on appeal.
Another possible challenge might involve the court’s finding that the savings clauses were unenforceable because “the liabilities under the term loans are inherently indeterminate” due to the “interaction between the two savings clauses.” Although it may have been difficult to value the guarantor subsidiaries’ assets and liabilities giving effect to the savings clauses, a reasonable estimate would certainly appear to be possible.
Finally, the bankruptcy court’s determination that the clauses were ineffective because necessary actions were never taken under the express terms of the loan agreements is in dispute. The savings clauses did not purport to reduce the principal amount of the term loans or release any borrower from its obligations, such that they would be effective only upon written notice. Instead, the loan documentation provided that the savings clauses were to take effect automatically.
The tone of the TOUSA decision suggests that the bankruptcy court was particularly unsettled by the conduct of Tousa and the lenders. Among other things, the court found that employees, officers, directors, and advisors knew or should have known that Tousa was in dire financial straits and that both Tousa and its guarantor subsidiaries were insolvent prior to the term loan transaction, but that various parties proceeded with the transaction in order to reap outsized fees and bonuses. As such, we are left to speculate whether the court would have reached a different conclusion under different circumstances.
Official Committee of Unsecured Creditors of TOUSA, Inc. v. Citicorp North America, Inc., 2009 WL 3519403 (Bankr. S.D. Fla. Oct. 30, 2009).