Tousa ruling will prompt more challenges to loans, analyst predicts

By Stephanie N. Rotondo

Portland, Ore., Oct. 19 – More pre-bankruptcy loans are likely to be challenged in court following the recent decision regarding fraudulent transfer made by the bankruptcy judge overseeing Tousa Inc.’s case, according to Richard Tilton, bankruptcy lawyer and analyst with research firm Covenant Review.

The decision “may have an important bearing on Lyondell Chemical Co. (fraudulent conveyance complaint being litigated), Tribune (grounds for fraudulent conveyance complaint being investigated), and other cases filed (and to be filed) where lenders and bondholders have a good incentive to challenge how loans were made and how the proceeds were distributed,” Tilton wrote in a report on the case.

Companies, lenders face more risks

Based on the ruling in the Tousa case, there are several risks facing companies and lenders alike, Tilton claims.

While the concerns are not new, the ruling reinforces what has already been a growing trend.

In his report issued Friday, Tilton wrote “underwriters and issuers often cite the possibility of a fraudulent transfer in the lengthy boilerplate Risk Factors of their offering documents. We often hear investors refer to the ‘theoretical’ risk of fraudulent transfers, but well after the loans have been made.

“Yet the risks are becoming more real all the time, particularly when subsidiaries become obligors for loans but get none of the proceeds and no financial or other benefits.”

With judge John Olson’s decision pointing the way forward, other companies facing similar charges – such as Lyondell and Tribune – could see their defensive arguments unravel.

“It is more and more prevalent that people who are at the bottom of the waterfall are saying ‘That LBO you did was fraudulent…and that is why we are in bankruptcy now’,” Tilton said in an interview with Prospect News. “It’s not surprising, I think we’ll see more of them.”

What Tilton is forecasting is a time where either some types of financing will not get done outside of bankruptcy or where deals are done, and lawsuits subsequently filed.

“We’ll see more [cases involving] deals where companies were solvent, but not by a lot,” he said. “I think we’ll see more deals like that challenged.”

‘No benefit’ to dividend deals

For example, Tilton noted the recent return of debt issues with proceeds slated for dividend payments to sponsors. In those instances, the companies themselves are “getting no benefit” – one of the key factors in proving fraudulent transfer.

“With those transactions, investors definitely need to be more skeptical,” he said.

To Tilton, that means certain things should be eliminated from balance sheets, such as intercompany loans and equity interests, when buyers are doing their credit analysis.

Waiting for bankruptcy

In other scenarios, lenders might chose to forgo rescue financings altogether, thereby forcing some companies to enter bankruptcy.

“It is much easier to get loans as debtor-in-possession financing,” Tilton explained. And, in that instance, the risk of fraudulent transfer is minimized, as lenders “will have a court order that protects [them].”

New challenges for distressed borrowers

But for companies that still try to get funds outside of bankruptcy, there will be additional hurdles.

“It will be harder to finance because loan documentation and the use of proceeds will have to address things that come up in a fraudulent dispute,” he said. At the same time, “lenders will want to make sure their due diligence is adequate to address those risks.

“Solvency certificates may have little or no value in protecting lenders,” he added.

Tilton also noted that a fraudulence dispute does not have to be brought right away. Under state laws, there is a four-year statute of limitations, while bankruptcy law allows for a two-year look back.

“So that risk window is long,” he said.

And, while he concedes that the Tousa case was “a little bit unusual,” in that the borrowers were ruled by the court to be insolvent even before the loan was made, it could still pave the way for more cases to be brought by investors.

“The Tousa assumptions [by management] probably were ridiculous,” he said. “The internal documentation shows that it was a bad transaction and made the decision very easy for the judge.”

Still, “every case presents the possibility that a judge will look back in hindsight and say the assumptions were” incorrect or, as previously stated, ridiculous.

Tousa ‘overleveraged’ after loan

The Tousa decision came out of a loan the Hollywood, Fla.-based homebuilder received on July 31, 2007 for $500 million, made to its subsidiaries. In return, Tousa and some of its units granted liens on nearly all of their assets. Proceeds were used to settle a lawsuit stemming from a default on debt taken out to finance its Transeastern Properties Inc. joint venture.

The loan was made up of a $200 million first-lien term loan and a $300 million second-lien term loan. Citibank acted as administrative agent for the both tranches at first, though Wells Fargo Bank later replaced Citi on the second portion.

According to Tilton, mid-level managers of Tousa had informed higher-ups that “the transaction would leave the company overleveraged and without access to the capital markets.” Indeed, by Aug. 8, the company’s chief executive officer, Steve Wagman, was concerned about covenant violations and soon decided he was unable to issue a solvency certificate, as Tousa was already in violation of several terms.

It was around that same time that the housing bubble popped and Tousa quickly started to circle the drain.

“In our lousy economy, it collapsed so much that all these risks that were there were magnified,” Tilton said.

Nearly six months to the day after Tousa received the $500 million loan, it had filed for Chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of Florida. Tousa’s official committee of unsecured creditors soon filed a lawsuit alleging fraudulent transfer regarding the Transeastern loan.

Judge orders repayment

On Oct. 14, Olson, the judge overseeing the bankruptcy case, ruled in favor of the creditor group and ordered lenders associated with the $500 million loan to eliminate $403 million of the loan, including principal, expenses and fees paid in relation to the loan. The lenders also have to pay 9% interest per annum on the amount owing.

Olson opined that the subsidiaries “did not receive reasonably equivalent value in exchange for the liens granted,” as many of the subsidiaries had little to nothing to do with the joint venture. Olson also declared that the units were “insolvent both before and after the transaction,” and were left with “unreasonably small capital with which to operate their businesses” as a result of the transaction.

Olson also berated Citi for its role, claiming that the bank’s due diligence “failed to uncover the privately-held views of Tousa’s senior management, which were considerably more pessimistic than Tousa’s projections used to support the July 31 transaction.”

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