Originally published December 2, 2009

Keywords: savings clauses, US Bankruptcy Court, Florida, fraudulent transfer provisions, Bankruptcy Code

To promote equal treatment of creditors, the US Congress has armed debtors with the power to bring suit to recover a variety of pre-bankruptcy transfers. Prominent among these is a debtor's ability under Section 548 of the Bankruptcy Code to recover constructively fraudulent transfers — i.e., transfers made without fair consideration when a debtoris insolvent.

A recent decision from the US Bankruptcy Court for the Southern District of Florida, in an adversary proceeding arising out of the bankruptcy case of defunct homebuilder TOUSA, Inc. (TOUSA), highlights the potentially broad reach of the fraudulent transfer provisions of the Bankruptcy Code.1

In the underlying adversary complaint, the Official Committee of Unsecured Creditors of TOUSA, Inc. (the "Committee") sought to invalidate the claims and liens of certain secured lenders who had advanced $500 million to TOUSA under certain July 2007 term loan agreements (the "Term Loans"). TOUSA, in turn, used $420 million of the proceeds of the Term Loans to settle then-pending litigation with Transeastern Properties Inc., which related to a failed joint venture among Transeastern, TOUSA and one of its subsidiaries, TOUSA Homes LP. A number of other TOUSA subsidiaries (the "Subsidiaries") became co-borrowers under the Term Loan facilities and pledged substantially all of their assets in support thereof, even though they were not defendants in the joint venture litigation and did not otherwise obtain any direct benefits under the Term Loans.

After conducting an evidentiary hearing on the merits of the Committee's claims, the Bankruptcy Court ultimately found that the obligations of the Subsidiaries, and their related grant of liens, were avoidable as fraudulent transfers. As a result, the court ordered, among other things, that (i) the Term Loan lenders were required to disgorge the principal and interest payments they had received on the loans and (ii) their related liens on certain tax refund proceeds would be avoided.

The central holding of the case, at least in light of the Bankruptcy Court's findings of fact, is neither remarkable nor groundbreaking; the court found that the Subsidiaries were insolvent at the time of the transfers and, because they were not defendants in the settled litigation and did not obtain the benefit of any loans advanced by the Term Loan lenders, arguments that the Subsidiaries received reasonably equivalent value in exchange for becoming co-borrowers and pledging their assets in support of the Term Loan obligations were difficult to muster. But, in an unusual aspect of the opinion, the Bankruptcy Court went on in dicta to suggest that so-called "savings clauses" — provisions commonly included in intercorporate guaranties of commercial loans to limit the amount of such guaranty claims to the extent necessary to eliminate any potential fraudulent transfer liability — are per se unenforceable. Although the court did not need to reach this issue to invalidate the underlying claims and liens, the TOUSA decision nonetheless is one of only a few that address the efficacy of savings clauses in any detail, and thus the decision may have wide-ranging implications.2

Fraudulent Transfer Law and the Evolution of Savings Clauses

Fraudulent transfer law, as codified under Section 548 of the Bankruptcy Code, allows a debtor to avoid certain pre-petition transfers of its interest in property as constructively fraudulent if the debtor received less than reasonably equivalent value in exchange for the transfer and one of the following tests is met: (i) the debtor either was insolvent at the time of the transfer or became insolvent as a result of such transfer;3 (ii) the debtor incurred, or intended to incur, debts beyond its ability to pay; or (iii) the debtor was left with "unreasonably small capital" after the transfers in question.

One common area of fraudulent transfer litigation involves intercorporate guaranties. Such guaranties, which are routine in modern financing transactions, frequently are required by lenders to allow members of a consolidated corporate group to secure borrowing as a single unit. In many instances, the parent or holding company seeks to offer secured guaranties from affiliates and subsidiaries, particularly if the parent or holding company's balance sheet is insufficient to support the loan. Similarly, lenders view the additional collateral and independent obligations of the guarantors as reducing their credit risk.

However, upstream guaranties, or guaranties by a subsidiary of the obligations of its direct or indirect corporate parent, frequently are later attacked as fraudulent transfers. Such guaranties are particularly vulnerable because (i) the loan to the parent is not considered, without more, to provide value to the subsidiary, and the subsidiary often does not receive significant or obvious direct benefits from the financing transaction, and courts sometimes are reluctant to characterize so-called indirect benefits (such as a lower cost of credit and synergies within the corporate group) as reasonably equivalent value; and (ii) the obligation incurred, at least in absolute terms, often significantly exceeds the equity value of the available assets of such subsidiary guarantor, and thus implicates questions of solvency.

As a result, in order to obtain the greatest possible benefit of an upstream guaranty, a lender frequently will require that the guaranty include a so-called "savings clause" (also sometimes referred to as a "solvency cap") that attempts to limit the subsidiary's contractual exposure on the guaranty to an amount that is not greater than the amount that would have rendered it insolvent at the time of the guaranty.

For example: a subsidiary having $100 million in assets and $90 million in liabilities delivers a guaranty of a loan to its corporate parent. If the guaranty is found to have created actual liability at the subsidiary level in excess of $10 million, and the subsidiary did not receive reasonably equivalent value, the upstream guaranty and any related pledge of assets could be avoided in total as a constructively fraudulent transfer. But, if the guaranty had an enforceable savings clause, the lender would retain a secured claim against the subsidiary for up to $10 million (i.e., the maximum amount of the liability that would not have rendered the subsidiary insolvent at the time of transfer). As a result, the subsidiary's other creditors would not be harmed by the provision of the guaranty, and the guaranty would not be avoidable as a fraudulent transfer.

In practice, savings clauses do not, and cannot, prevent litigation as to whether a guaranty or related pledge of collateral is avoidable under fraudulent transfer law. However, such clauses are typically included under the theory that they will allow lenders to receive a portion of the contracted-for consideration (particularly in a situation where the guaranteed obligations are substantial) rather than having the enforceability of such obligations become an "all-or-nothing" issue, depending on how the solvency question is resolved in subsequent litigation.4

The TOUSA Court's Analysis

In the TOUSA case, the Committee alleged that the obligations incurred and liens granted by the Subsidiaries were fraudulent transfers because the Subsidiaries had not received reasonably equivalent value for the transfer and were insolvent as of the date that the liens were granted. Based on a variety of fact and expert testimony, the Bankruptcy Court ultimately agreed with the Committee and found that the Subsidiaries were insolvent (and had unreasonably small capital) both before and after the Subsidiaries incurred obligations under the Term Loan facilities. Among the facts that appear to have swayed the court was its finding that the administrative agent for the Term Loan Facilities "harbored significant doubts about TOUSA's solvency," and so purposely avoided a going concern analysis.

Because the Bankruptcy Court concluded that the Subsidiaries were insolvent prior to granting the liens, the court did not need to reach the question of whether the savings clauses were operative and would have preserved some portion of the Subsidiaries' obligations to the Term Loan Lenders. Indeed, as the court itself recognized, because the Subsidiaries were insolvent on day one, the liens could not "be enforced at all" (emphasis in original) and therefore "the savings clauses have no effect." Despite this ruling, however, the court went on to provide, in detail, its views on the enforceability of the savings clauses at issue in the case. In a series of strongly worded passages rebuking the lenders for including such provisions, the Bankruptcy Court attacked savings clauses as "a frontal assault on the protections that [Section] 548 provides," "entirely too cute to be enforced" and "inherently distasteful."

First, the court opined that savings clauses were an improper attempt to contract around the Bankruptcy Code. The court's conclusion arguably expands the scope of Section 548 beyond its intended purpose. As noted above, fraudulent transfer law is a creditor remedy that is intended to protect against incurrence of obligations that reduce creditors' ability to recover their claims against the debtor. Creditors, though, have no right to the residual equity in a corporation, nor to require that the debtor maintain some equity cushion to ensure payment of their claims in full at a later date.

In recognition of this basic principle of corporate law, savings clauses are intended to allow debtors to incur obligations up to the point of insolvency. Put another way, practitioners typically have viewed savings clauses as not contracting "around" the Bankruptcy Code, but instead as contracting to permit a debtor to obligate itself to the fullest extent permitted by fraudulent transfer law principles, as codified in the Bankruptcy Code and applicable state law.5

The court also found the particular savings clauses in the Term Loans unenforceable under a basic contract law analysis. Among other things, the court concluded that the liens were unenforceable because the terms of the savings clauses were inherently indefinite. The provision at issue stated as follows:

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.

According to the court, the specific language of the foregoing savings clause in each of the Term Loan facilities required a determination of the ultimate liabilities under the other facility, thereby creating a "circular problem that has no answer." The court's conclusion appears to misconstrue the plain language of the provision, which simply would have reduced the obligations of any specific borrower to such amount as would not have rendered it insolvent.

Of course, in a case where the Subsidiaries were not insolvent as of the date of the transaction, the court is surely right that to perform the calculation might have been quite difficult (particularly given the issue of quantifying any indirect benefit to the Subsidiaries, as well as the inherent difficulties in determining the contingent value of rights of contribution and subrogation against co-borrowers on the asset side of the ledger). But, the court's notion that the calculation is circular, inherently indefinite and "utterly impossible to determine" is difficult to follow.

Finally, the court went on to note that the savings clause would effect an unauthorized amendment to the Term Loans by reducing the amount of the liens. The court reasoned that because unwritten amendments are prohibited by the Term Loan agreements, and because the savings clauses would effect unwritten amendments, the savings clauses could not be enforced. This aspect of the decision is again difficult to square with the plain language of the savings clauses, which were agreed to by the parties in the first instance and provided that the liens and related obligations would be "automatically amended" if such provisions needed to be given effect.

Conclusion

Because the TOUSA opinion is one of very few published decisions addressing the enforceability of guaranty savings clauses, it warrants a careful reading. In particular, it should give lenders pause before assuming that any upstream guaranty will be enforceable by virtue of its inclusion of a savings clause, particularly one obtained from a subsidiary whose solvency or financial viability is in question. And it remains the case that such clauses are no substitute for careful due diligence relating to the solvency of all borrowers and guarantors of a loan to a consolidated corporate enterprise.

Nonetheless, nothing in the decision suggests that lenders should discontinue the use of savings clauses. At worst, such clauses will be found unenforceable; in the best case, they preserve value for the lenders in subsequent litigation. And while it remains to be seen whether the TOUSA court's analysis will gain widespread acceptance, it is possible that the decision will remain an outlier, both because of the rather unique factual posture of the case and because of questions as to the soundness of the legal analysis in the opinion itself.

Footnotes

1. Committee of Unsecured Creditors of TOUSA Inc. v. Citicorp North America, Inc. (In re TOUSA Inc.), Adv. Pro. No. 08-135-JKO (Bankr. S. D. Fla. Oct. 13, 2008).

2. The court in Official Committee of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Technologies, Inc.), 299 B.R. 732, 748 (Bankr. D. Del. 2003), also discussed savings clauses in dicta. Ruling on the lender defendants' motion to dismiss, the court explained, "[T]he savings clause, if enforceable, merely saves a portion of the transfer of collateral that might be avoided in its entirety ... [and] limits the fraudulent transfer claim to the exact amount that would render the Debtors insolvent.... The [l]enders fail to cite any decision in support of the efficacy of the 'savings clause.'" Id.

3. For the purposes of Section 548, insolvency is typically determined by comparing assets and liabilities under the balance sheet test. Section 548 also permits recovery of actually fraudulent transfers (i.e., transfers made by the debtor with the actual intent to hinder, delay or defraud creditors).

4. On the other hand, a downstream guarantee, in which a parent guarantees its subsidiary's obligation, generally is not at risk of attack on fraudulent transfer grounds. In a downstream guarantee, a parent company receives reasonably equivalent value for the exchange because it holds the equity of the subsidiary company. See, e.g., In re W.T. Grant Co., 699 F.2d 599 (2d Cir. 1983); Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979 (2d Cir. 1981).

5. The TOUSA court appears not to have considered the widespread use of savings clauses. In this regard, to the extent the decision were to become widely adopted by other courts, it likely would have a substantial negative effect on the availability and cost of credit to be provided to companies within corporate groups, as deals would become more difficult to document and close, and there would be increased need to quantify and document the direct benefit received by any guaranteeing subsidiaries.

Learn more about our Restructuring, Bankruptcy & Insolvency and Leveraged Finance practices.

Visit us at www.mayerbrown.com.

Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Copyright 2009. Mayer Brown LLP, Mayer Brown International LLP, and/or JSM. All rights reserved.