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Fraudulent Conveyance Exposure Fraudulent Conveyance Exposure for Intercompany Loans and Guarantees

Navigating the Bankruptcy and Insolvency Risks of Intercorporate Obligations

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUES DAY, FEBRUARY 12, 2013

Today’s faculty features:

Kyung S . Lee, Partner, Diamond McCarthy, Houston Mark D. Bloom, S hareholder, Greenberg Traurig, Miami

• Dr. Kose John, S

pecial Consultant, NERA Economic Consulting, New Y

• rk
• Dr. Kose John, S

pecial Consultant, NERA Economic Consulting, New Y

• rk

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Fraudulent Conveyance Exposure for Intercompany Loans and Guarantees Stafford Webinar Presentation Sta

• d Web

a ese tat o February 12, 2013

• Dr. Kose John

S i l C l NERA E i C l i S pecial Consultant at NERA Economic Consulting (New York, New York) Kyung S . Lee Diamond McCarthy LLP Diamond McCarthy LLP (Houston, Texas) Mark D. Bloom and Ari Newman Greenberg Traurig, LLP g g, (Miami, Florida)

Intercompany/Inter-Estate Claims

• Generally, priority of intercompany claims

is dependent on whether the claim is dependent on whether the claim resembles or was intended to be debt, equity or preferred equity/subordinated debt debt

• Intercompany claims can be treated pari

passu in right of payment with third-party p g p y p y unsecured claims

• In many significant cases, intercompany

claims are ignored or disallowed either claims are ignored or disallowed either because of cost and difficulty reconciling such claims

6

Scheduling of Claims

• Bankruptcy Code § 521(1) requires the

d bt t fil h d l f t d debtor to file schedules of assets and liabilities

• If not noted as C U or D such creditor is
• If not noted as C, U or D, such creditor is

not required to file proof of claim and under Bankruptcy Rule 3003(b)(1), such h d li i f i id scheduling represents prima facie evidence

• f the validity and amount of the claim.

See, Bankruptcy Code §§ 1111(a), 501 and , p y ( ), 521(1).

7

Intercompany Claims: Debt or Equity

• Characterization of intercompany claims

affects the priority of recovery and thereby affects the priority of recovery and thereby the amount available to creditors

• Most bankruptcy cases dealing with

p y g characterization of obligations as debt or equity have done so in the context of inter- creditor disputes involving p g recharacterization of “third” party, non- debtor “loans rather than treatment of inter-debtor obligations” g

8

Is Loan “Debt” or “Equity”?

• Courts factors rely upon fall into 3 general

t i categories:

□

(i) the formality of the loan agreement (ii) th fi i l it ti f th i t th ti

□

(ii) the financial situation of the issuer at the time the creditor made the purported loan

□

(iii) the relationship between the debtor and creditor

9

Factors Courts Look at to Determine Whether Claim is Debt or Equity Whether Claim is Debt or Equity

• Names given to instrument
• Fixed maturity date and schedule of payments

Fixed maturity date and schedule of payments

• Fixed rate of interest and interest payments
• Source of Repayment
• Adequacy of capitalization
• Adequacy of capitalization
• Identity of interests between creditor and stockholder
• Security for the transfer
• Ability to obtain financing from outside lending institutions
• Ability to obtain financing from outside lending institutions
• Extent to which advances are subordinated to claims of outside creditors
• Extent to which advances were used to acquire capital assets

Si ki f d t id t

• Sinking fund to provide repayment
• Right to enforce payment of principal and interest
• Participation in management flowing as a result of the advance
• Intent of the parties
• Source of interest payments and payment of interest according to the terms of the loan

10

Is Intercompany Claim Debt or Equity?

• In re Radnor, 353 B. R. 820 (D. Del. 2006)(“
• verarching inquiry is Intent of

. . . overarching inquiry is . . . Intent of parties at the time of transaction . . . Through a common sense evaluation of the facts and circumstances surrounding a facts and circumstances surrounding a transaction.”)

• The priority of intercompany claims will be

p y p y dependent on whether the claim resembles

• r was intended to be debt, equity or

preferred equity/subordinated debt p q y

11

Subordination of Intercompany Claims

• In addition to recharacterization,

intercompany claims may also be equitably intercompany claims may also be equitably subordinated under Bankruptcy Code §510(c) or applicable law

• Factors courts look to:

□

Has claimant engaged in some type of inequitable conduct (fraud, illegality, breach of fiduciary conduct (fraud, illegality, breach of fiduciary duties, undercapitalization, use of debtor as mere instrumentality or alter ego)

□

Has claimant caused inj ury to creditors or has his

□

Has claimant caused inj ury to creditors or has his conduct conferred an unfair advantage on the claimant

□

S ubordinate as long as it is not inconsistent with the

□

S ubordinate as long as it is not inconsistent with the provisions of the Bankruptcy Code

12

Elimination of Intercompany Claims

• Substantive consolidation is another way to

deal with intercompany claims deal with intercompany claims

• The idea is that related companies

liabilities are combined, eliminating intercompany claims and creating a larger intercompany claims, and creating a larger pool of creditors to vote on a single plan of reorganization

• While different depending on circuit the
• While different depending on circuit, the

general inquiry is whether creditors dealt with the entities as a single economic unit in extending credit or whether the affairs in extending credit or whether the affairs

• f the debtor are so entangled that

consolidation benefits all creditors

13

How are Intercompany Claims Created?

• Cash transfers between related entities
• Contribution of assets among entities
• Allocation of costs of doing business among

entities

• Allocation of tax benefits among parent and

subsidiaries subsidiaries

• Guarantee claims of parents and

subsidiaries subsidiaries

14

Fraudulent Transfer Issues that Arise Relating to Inter-Company Claims in Bankruptcy

S b idi t th b i f

• Subsidiary guarantees the borrowing of

Parent (Upstream Guaranty)

□

What value did S ub obtain by guaranteeing Parent bli ti ?

• bligation?

□

Was that value fair consideration or for reasonably equivalent value to the cost of the guaranty

• Difficult issues

R i d t i ti f h t th “ t” f th

□

Requires a determination of what the “ cost” of the guaranty

□

What + value did S ub confer upon Parent by signing the guaranty? the guaranty?

15

• Parent guarantees the debts of a Subsidiary

(d t t ) hil S b i l t (downstream guaranty) while Sub is solvent should not be a fraudulent conveyance

• A downstream guaranty however may
• A downstream guaranty however may

qualify as a fraudulent conveyance if the subsidiary is insolvent

• Not likely to find these guarantees qualify

as a fraudulent conveyance

16

I TOUSA A C

S d

In re TOUSA: A Case Study

Mark D. Bloom a

• Greenberg Traurig

333 SE 2nd Avenue Suite 4400 Suite 4400 Miami, FL 33131 bloomm@gtlaw.com

Background

• TOUSA, Inc. and its subsidiaries were one of the

largest residential homebuilders in the U S largest residential homebuilders in the U.S.

• In June 2005, TOUSA enters into a joint venture and

in connection therewith, borrows $675 million from h T L d ( h “T JV”) the Transeastern Lenders (the “Transeastern JV”).

• TOUSA, Inc. (Parent) guaranteed the obligations of

the Transeastern JV to the Transeastern Lenders.

• None of TOUSA Inc.’s subsidiaries were borrowers,

pledgors, or guarantors to the Transeastern Lenders.

18

Background

• Towards the end of 2006, the Transeastern JV fails and the

Transeastern Lenders sue TOUSA, Inc. on its guarantees (“Transeastern Litigation”).

• A significant judgment against TOUSA, Inc. would constitute a default

under various other financial obligations, including bond and other debt debt.

• TOUSA, Inc.'s subsidiaries were guarantors of those other financial
• bligations and had pledged their assets as security for some of those
• bligations.
• To avoid defaults under those other obligations, TOUSA, Inc. settled

the Transeastern Litigation on July 31, 2007 for over $421 million.

• TOUSA, Inc. and its subsidiaries (“Conveying Subsidiaries”)

b d l f $500 illi f N L d ( h “N L ”) borrowed a total of $500 million from New Lenders (the “New Loans”) to finance the Transeastern settlement, and both TOUSA and the Conveying Subsidiaries pledged substantially all of their collective assets to secure the New Loans. The Conveying Subsidiaries were joint obligors on these New Loans despite not being parties to the joint-obligors on these New Loans despite not being parties to the Transeastern Litigation.

19

TOUSA Files Bankruptcy and the Committee Files Suit Committee Files Suit

• TOUSA, Inc. and most of its subsidiaries,

i l di th C i S b idi i fil including the Conveying Subsidiaries, file for bankruptcy in January, 2008.

• In addition to its secured debt TOUSA owed
• In addition to its secured debt, TOUSA owed
• ver $1 billion in bond debt.
• The Official Committee of Unsecured

The Official Committee of Unsecured Creditors files an adversary proceeding on behalf of the Conveying Subsidiaries seeking to avoid the loan obligations and seeking to avoid the loan obligations and liens granted to the New Lenders and to recover over $400 million in payments made to the Transeastern Lenders.

20

The Committee’s Claims

• Loan obligations assumed and liens granted by

Conveying Subsidiaries in connection with New Loans were avoidable fraudulent transfers in accordance with 11 U.S.C. § 548

□

Obligations under New Loan rendered Conveying g y g S ubsidiaries insolvent

□

Conveying S ubsidiaries were not obligated on Transeastern Loan (and did not receive any portion of ( y p New Loans) so did not receive reasonably equivalent value

• Loan obligations assumed and liens granted were

Loan obligations assumed and liens granted were avoidable fraudulent transfers, and since transfers were made for the benefit of the Transeastern Lenders, they were recoverable pursuant to 11 y p U.S.C. § 550 (the “entity for whose benefit such transfer was made”)

21

The Lenders’ Defenses

• Solvency:

□

The Conveying S ubsidiaries were not insolvent before the Transeastern S ettlement and were not rendered insolvent by the settlement.

• Reasonably equivalent value
• Reasonably equivalent value

□

The Transeastern S ettlement staved off a TOUS A bankruptcy filing that would have triggered an event of default under Conveying S ubsidiaries’ financial obligations (bonds). Co vey g S ubs d a es a c al obl gat o s (bo ds).

□

S ettling Transeastern litigation brought value to entire enterprise, including the Conveying S ubsidiaries.

• Savings Clause:
• Savings Clause:

□

The New Loans contained “ S avings Clauses” that purported to reduce the obligations incurred and liens granted to the extent necessary to prevent the obligor’ s insolvency. y p g y

22

Bankruptcy Court Decision

• Official Comm. of Unsecured Creditors of

TOUSA I Citi N A I (I TOUSA, Inc. v. Citicorp N. Am., Inc. (In re TOUSA, Inc.), 422 B.R. 783 (Bankr. S.D. Fla.

2009). )

• The bankruptcy court ruled in favor of the

Committee in a 180-page opinion.

• Bankruptcy Court’s Findings:

□

TOUS A and its subsidiaries were insolvent even b f i i th N L before incurring the New Loans

□

Conveying S ubsidiaries received no direct benefits and, at most, minimal indirect benefits from the Transeastern S ettlement

23

Bankruptcy Court Decision

□

S avings clauses unenforceable because they were Conditioned on Insolvency in violation of §541(c)(1)(b) Conditioned on Insolvency in violation of §541(c)(1)(b) and “ too cute to be enforced.”

□

The Transeastern Lenders were the entities "for whose benefit the transfers were made“ and had a duty to benefit the transfers were made and had a duty to determine that Conveying S ubsidiaries had received fair value or that they were solvent before accepting settlement payment.

24

District Court Decision

• 3V Capital Master Fund Ltd v Official Comm. Of

Unsecured Creditors of TOUSA Inc (In re TOUSA Unsecured Creditors of TOUSA Inc (In re TOUSA, Inc.), 444 B.R. 613 (S.D. Fla. 2011).

• Reverses and Quashes Bankruptcy Court Ruling
• There was no liability under Section 548 because:

□

The Transeastern S ettlement provided indirect benefits to the Conveying S ubsidiaries which included avoiding a to the Conveying S ubsidiaries, which included avoiding a default on bond and other financial obligations and temporarily avoiding bankruptcy. Additional indirect benefits can be recognized through enterprise theory.

□

The Conveying S ubsidiaries had no property interest in the New Loans such that the Transeastern Lenders did not receive any transfer from the debtor (Conveying b d d b l l S ubsidiaries) as required by S ection 548 (only applies to a transfer of “ an interest of the debtor” in property).

25

District Court Decision

□ Transeastern Lenders were not the entities “ for

whose benefit” the Conveying S ubsidiaries whose benefit the Conveying S ubsidiaries transferred liens to the New Lenders.

□ Even if Transeastern Lenders were “ immediate

f ” h k f l f lid transferees,” they took for value— payment of valid antecedent debt— and there was no evidence of bad

• faith. The Bankruptcy Court’ s standard for lender

diligence in connection with accepting payment diligence in connection with accepting payment deemed "patently unreasonable and unworkable.“

□ The District Court did not reach the savings clause

issue.

26

Eleventh Circuit Decision

• Senior Transeastern Lenders v. Official

C f U d C dit (I

• Comm. of Unsecured Creditors (In re

TOUSA, Inc.), 2012 W.L. 1673910 (11th Cir.

May 15, 2012). y , )

• Two Issues on Appeal:

□

Whether Bankruptcy Court clearly erred in finding p y y g that Conveying S ubsidiaries did not receive reasonably equivalent value.

□

Whether Transeastern Lenders were entities “ for

□

Whether Transeastern Lenders were entities for whose benefit” the Conveying S ubsidiaries transferred the liens.

27

Eleventh Circuit Decision

• District Court Reversed

□

Bankruptcy Court did not commit “ clearly error” in finding subsidiaries did not receive reasonably equivalent value; and

□

Transeastern Lenders were entities “ for whose benefit” the liens were granted

28

Eleventh Circuit Decision

• Reasonably Equivalent Value

□

The bankruptcy record supported that the value to the Conveying S ubsidiaries considered as a whole, “ fell well short of reasonably equivalent value”

• Minimal value to Conveying S

ubsidiaries “ far out-weighed any perceived benefits.”

• Transeastern S

ettlement and New Loans did more harm than good and “ at most delayed the inevitable” good and “ at most delayed the inevitable”

□

Avoidance of bankruptcy has very limited value -- “ The

• pportunity to avoid bankruptcy does not free a company

to pay any price or bear any burden After all ‘ there is 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)

29

Eleventh Circuit Decision

• The New Loans were “for the benefit of”

th T t L d the Transeastern Lenders

□

Transeastern Lenders were “ initial transferees” A t t d i ti ith N L

□

Agreements executed in connection with New Loans expressly provided that the loan proceeds were to be used to fund the Transeastern S ettlement

□

TOUS A subsidiaries not initial transferees because

• f a lack of any control over the funds

30

Eleventh Circuit Decision

• Reasonable to expect “some” diligence

f dit b i id h d d f from creditors being repaid hundreds of millions of dollars

• In response to Transeastern Lenders’
• In response to Transeastern Lenders

argument that the Bankruptcy Court exercised hindsight bias, the Eleventh Ci i d Circuit noted:

□

“ In contrast with the surprise attack at Pearl Harbor, the warnings about the collapse of TOUS A Harbor, the warnings about the collapse of TOUS A made that event as foreseeable as the bombing of Nagasaki after President Truman’ s ultimatum”

31

Eleventh Circuit Decision

• Remanded to the District Court to consider

th f ll i i the following issues:

□ Remedies –

• In light of the District Court’ s reversal

and quashing of the Bankruptcy Court’ s decision, q g p y , the District Court did not address the remedies imposed by the Bankruptcy Court.

□

Issues of j udicial assignment and consolidation

□

Issues of j udicial assignment and consolidation.

32

Follow Up

• Eleventh Circuit denied en banc rehearing

f TOUSA l

• f TOUSA appeal.
• On remand, case was re-assigned to, and

consolidated nine separate appeals before consolidated nine separate appeals before, Judge Michael Moore (no, not that Michael Moore).

• Briefing was completed a few weeks ago.

33

Intercompany Loans and G V l i I Guarantees: Valuation Issues

Kose John

• se Jo

NERA Economic Consulting kj h t d kj ohn@ stern.nyu.edu

Overview

• Economic Perspective on the

p valuation of risky debt, and that

• f intercompany guarantees

p y g

• Effect of Fraudulent Conveyance
• n creditor outcome
• n creditor outcome
• Not to be construed as legal

d i advise

35

Basics

• Default risk and valuation of

risky debt

• Two approaches in the finance

Two approaches in the finance literature St t l M d l

• Structural Models
• Reduced-Form Models

36

Structural Models

• APPROACH: Likelihood of borrower default
• ver the horizon is modeled using the

borrower’s capital structure the covenants borrower s capital structure, the covenants, intercompany guarantees, the guarantor’s capital structure, the asset value process of h b h l f h the borrower, the asset value process of the guarantor, and the degree of recourse implied by the guarantee. p y g

• Starting point: Merton (Journal of

Finance,1974).

• Implemented using equity market

information

37

Merton Model

A fi t f ll t h ti

• Assumes firm assets follow a stochastic

process

• Zero coupon debt of face value D due at
• Zero coupon debt of face value D due at

maturity date T.

{

D if VT > D

• Bondholders receive {
• Bondholders receive D – max {D - V }

VT Otherwise

• Bondholders receive D – max {D - VT }
• The risky debt is equivalent to a portfolio of:

Long default risk free bond paying D at time

• Long default-risk-free bond paying D at time

T.

• Short a put option on the firm’s assets with

Short a put option on the firm s assets with strike D and maturity T

38

Implications

• Therefore, the value of risky debt B*
• B* = B – P
• Spread on the risky debt is completely determined by

the value of the put option P. Any factor that increases the value of the put option increases the spread and reduces the value of the risky debt.

• Decrease in the firm’s assets increases the value of

the put, and reduces the value of the debt (increases the put, and reduces the value of the debt (increases the spread). If the firm sells assets for less than “equivalent value”, reducing the effective value of assets, leads to an increase in the value of the put p and hence a reduction in the value of debt.

• Increase in the volatility of the firm assets increases

the value of the put and reduces the value of the the value of the put, and reduces the value of the debt (increases the spread).

39

Value of an absolute guarantee

• Value of risky debt B*
• B* = B – P
• Assume that our loan now is guaranteed by another

company with sufficient unencumbered assets. The level of assets of the guarantor are such that with the guarantee the originally risky debt is effectively “riskless”. (We call this a “Absolute” guarantee. Since the guarantee increases the value of the risky d bt f B* t B th l f th t i debt from B* to B, the value of the guarantee is B – B* = P.

• Hence Value of an Absolute guarantee = P the
• Hence, Value of an Absolute guarantee = P, the

value of the put.

40

Value of a loan guarantee

I th l f i t

• In the more general case of an intercompany

guarantee, it is not absolute. The guarantor has assets of value VG and debt of face value

G

• DG. Also assume that the guarantor’s debt has

priority over the guaranteed debt. Under these assumptions the debt with the these assumptions, the debt with the guarantee will have a value, BG* = B – PG Where the value of a put option PG with p p

G

underlying assets, (VT + VG – DG ) and strike price D. The value of the guarantee is the increase in value of the debt with the guarantee: increase in value of the debt with the guarantee: BG* - B* = (B – PG ) - (B – P) = P – PG

• Hence, the value of the guarantee is the

e ce, t e value o t e gua a tee s t e reduction in the value of the put (= P – PG ) due to the guarantee.

41

Implications

B i i th i f th l f th

• By examining the expression for the value of the

guarantee, can see that factors that increase PG will decrease the value of the guarantee and hence decrease the value of guaranteed debt decrease the value of guaranteed debt.

• An increase in the guarantor’s debt will decrease the

value of the guarantee.

• A decrease in the value of the guarantor’s assets will

increase PG and hence reduce the value of the guarantee (and the value of the guaranteed debt). g ( g )

• If the guarantor sells its assets for less than

“equivalent value”, reducing the effective value of the guarantor’s assets leads to an increase in the value of guarantor s assets, leads to an increase in the value of the put PG and hence a reduction in the value of the guaranteed debt.

42

Extensions

• Default only at maturity
• No covenants, No coupons
• No deviations from Absolute Priority Rule
• No renegotiation of debt

g

• No guarantees
• Liquidation and transfer is costless

Liquidation and transfer is costless

• Several Extensions
• Delianedis-Geske (1998) UCLA-WP

Delianedis Geske (1998) UCLA WP

• The Moody’s KMV model: Based on Merton

(1974) model ( ) http://www.moodyskmv.com

43

Reduced Form Models

• APPROACH: A process is posited for the

default likelihood that is then calibrated to the prices of debt securities and credit the prices of debt securities and credit derivatives.

• Implemented using debt market and credit

Implemented using debt market and credit derivative data.

• Litterman-Iben (1991, Journal of Portfolio

Management).

• Duffie-Singleton (1999, Review of Financial

St di ) Studies)

• My opinion, given all necessary data is

available structural models are superior available, structural models are superior for valuing complex debt and intercompany guarantees.

44

Who gets what value?

W d b fi d t fi

• We assumed borrower firm and guarantor firm

are independent.

• The value of the guarantee is (P P )
• The value of the guarantee is (P – PG)
• Debt with guarantee is higher in value by

(P P ) (P – PG)

• If debt is correctly priced, the debt holders pay

the borrowing firm the higher price the borrowing firm the higher price.

• After the guarantee, the equity of the guarantor

firm would be of lower value by (P – PG). y (

G)

• The borrowing firm should pay (P – PG) to the

equity holders of the guarantor firm equity holders of the guarantor firm (P – PG), the value of the guarantee.

45

Parent-Subsidy Guarantees

• Thus far, we assumed borrower firm and guarantor

Thus far, we assumed borrower firm and guarantor firm are independent.

• Consider the case where the guarantor is the

parent firm and the borrower is a subsidiary.

• Ownership structure would matter for the

allocation of the value of the guarantee (P P ) allocation of the value of the guarantee (P – PG)

• Debt holders pay the subsidiary firm the higher

price. price.

• After the guarantee, the equity of the parent firm

would be of lower value by (P – PG).

• If the subsidiary is fully owned, the increase in the

value of the sub equity will offset the reduction in the value of the parent equity. p q y

• No explicit payment for the guarantee is

necessary.

46

Parent-Subsidy Guarantees (Cont’d)

O th th h d if b idi i t f ll

• On the other hand, if subsidiary is not fully
• wned, the parent equity holders will only be

partially compensated by the increase in value of p y p y sub equity from the guarantee. An explicit payment is necessary to compensate the equity holders of the parent firm holders of the parent firm.

• A parallel analysis will do for the case of the

parent debt being guaranteed by the subsidiary p g g y y assets.

• Again, ownership structure would matter for the

allocation of the value of the guarantee (P – PG)

47

Parent-Subsidy Guarantees (Cont’d)

• In the case of a fully owned subsidiary, the

loss in value of the sub equity due to the guarantee is offset by the gain in value guarantee is offset by the gain in value resulting from the guarantee enjoyed by the parent equity (given the debt holders pay h h h h l f d b the parent the higher value of debt reflecting the subsidiary guarantee). No explicit payment for guarantee is necessary. p p y g y

• On the other hand, if subsidiary is not fully
• wned, the subsidiary equity holders will
• nly be partially compensated for the loss in

value and an explicit payment is necessary.

48