“Neither a borrower nor a lender be[.]”2
In a business context it is not always possible to heed this bit of advice. Borrowing and lending are common, and the commercial situations in which they occur and forms they take are varied. Those of us involved in the professional art (or is it a science?) of providing independent solvency and fairness opinions encounter borrowing and lending in merger transactions, standard financing and refinancing transactions, leveraged buyouts, restructurings/bankruptcies and many other contexts. In a merger or acquisition context, we are frequently requested to provide an objective, independent opinion as to the fairness of the consideration from a financial perspective. In standard refinancing, leveraged buyouts or similar transactions, we are often asked to analyze the financial standing of the borrower, the party incurring an obligation as in the form of a guaranty, or the party providing security, and to opine independently as to the solvency of that party at the time of and/or as a result of the proposed transaction. Some of these situations present more apparent risks and challenges than others; the recent trilogy of opinions in the TOUSA litigation, beginning with the Bankruptcy Court opinion3, illustrates such risks and challenges.
With various articles already written by lawyers about the Bankruptcy Court opinion in the TOUSA case, in hindsight it should have been easy to foresee the risks inherent in the transaction involving a group of new lenders (“Transeastern Lenders”). At the time the solvency opinion at issue in that case was delivered (summer 2007), the writing was on the wall for residential real estate developers, especially in South Florida. That, together with certain business decisions undertaken by TOUSA’s management; TOUSA’s already overleveraged financial situation; a several hundred million dollar judgment entered against TOUSA and one of its subsidiaries; a new loan (“Transeastern Loan”) supported by upstream guaranties and pledges by all of TOUSA’s subsidiaries, the proceeds of which would satisfy the settlement of that judgment; and the solvency opinion that was a pre-condition of that new loan, created a perfect storm of events that led to TOUSA’s Chapter 11 filing in January 2008.
In a third-party transaction, once it has been determined that within certain defined time periods before the filing of a bankruptcy petition a debtor did not receive reasonably equivalent value in exchange for a transfer made or an obligation incurred, such transfer or obligation may be avoided or set aside if one of three tests related to solvency at the time of the transaction is failed. TOUSA, said Bankruptcy Judge Olson, failed all three of those tests.4
The tests of solvency involve very detailed valuation analyses, and include (i) the balance sheet test, (ii) the cash flow test, (iii) the capital adequacy test, and, if applicable, (iv) the shareholder distribution test.
For the balance sheet test, valuation professionals review whether the fair value and present fair salable value of an entity’s aggregate assets exceed its aggregate liabilities (stated and contingent) on a going-concern basis. The value of the aggregate assets, as represented by the operating business earnings and cash flows, is determined using standard valuation methodologies such as the income (discounted cash flow) and market approaches, and is often tailored to consider industry-specific benchmarks and valuation metrics. Total liabilities (including both stated and contingent) are subtracted to determine the excess of assets over liabilities, also referred to as the equity cushion. This equity cushion is then assessed in the context of the economic and industry conditions and outlook, as well as by comparison with similar transactions.
For a cash flow test of solvency, the analyst must determine whether projected cash flow will be sufficient to repay debts and other obligations as they become due. In doing so, valuation professionals rely on cash flow projections supplied by the entity’s management. While the solvency analyst may be able to rely on the projections, the underlying assumptions are stress tested for reasonableness in light of economic, industry- and entity-specific factors.
In the capital adequacy test component of a solvency analysis, an entity must have “adequate capital,” or reasonable capital with which to conduct its business. Factors in this analysis include (i) the overall industry outlook and the entity’s position within that industry; (ii) company-specific performance; (iii) management’s experience within the company and the industry; (iv) the company’s access to the capital markets, including financing alternatives; (v) the quality of assets and maintenance programs for the assets; and (vi) sufficient cash flow from operations to pay debt and meet other obligations as necessary.
The TOUSA Bankruptcy Court opinion resulted from an adversary proceeding related to TOUSA’s Chapter 11 case. TOUSA’s Official Creditors’ Committee initiated the proceeding to avoid pre-bankruptcy indebtedness incurred via upstream guaranties and liens granted by certain subsidiaries of TOUSA to the Transeastern Lenders in connection the Transeastern Loan, the net proceeds of which were used to pay the judgment creditors of TOUSA. Only TOUSA and one of those subsidiaries were judgment debtors. None of the subsidiaries received any proceeds from the borrowings from the Transeastern Lenders. Six months later, TOUSA and many of its subsidiaries filed Chapter 11 petitions. The Bankruptcy Court opinion, which is intensely fact specific, is principally cited for the Bankruptcy Court’s determinations that the subsidiaries (a) had received little or no “reasonably equivalent value” in exchange for the amount of debt incurred, and (b) were (i) insolvent at the time of and as a result of the transaction, (ii) left with unreasonably small capital as a result of the transaction, and (iii) unable to pay their debts as they became due as a result of the transaction. To the extent that there were intangible benefits accruing to the subsidiaries, including the benefit of the enterprise avoiding default and bankruptcy for a period of time, Bankruptcy Judge Olson determined that defendants’ experts failed to quantify those intangible benefits. In familiar parlance, the transactions with the Transeastern Lenders, including the pledges, and the utilization of the net proceeds of the Transeastern Loan to pay the judgment creditors, were determined to have constituted avoidable “fraudulent transfers.”
Bankruptcy Judge Olson also conducted an extensive review of the solvency opinion obtained by TOUSA’s Board as a condition of the financing transaction, and analyzed the expert testimony offered at trial. Judge Olson essentially found that the solvency opinion was largely unpersuasive because, inter alia, it was (i) obtained from TOUSA’s pre-bankruptcy financial advisor using an inappropriate industry standard; (ii) prepared on a consolidated “common enterprise” basis rather than on a consolidating basis analyzing the financial impact of the transaction on each “conveying subsidiary” separately; (iii) prepared in an inordinately brief period of time; (iv) reliant on TOUSA’s stale projections and underlying assumptions, which the opinion provider had neither rolled forward nor stress tested; (v) prepared on a contingent fee basis, providing the opportunity for a larger potential fee if the opinion determined solvency; and (vi) prepared by an advisor without current homebuilding industry experience. Judge Olson made other noteworthy comments regarding the solvency opinion and expert testimony offered by the debtors, but those are beyond the point of this brief discussion.5 Additionally, as part of the relief ordered, the Judge determined that the proceeds of the Transeastern Loan were subject to a clawback, and that the Transeastern Lenders should compensate the debtor estates for the diminution in the value of the assets as a result of the pledges.
Judge Olson’s decision, of course, was appealed to the United States District Court for the Southern District of Florida. Among the issues presented on appeal (which did not include the solvency tests of Section 548 of the Bankruptcy Code) was that of need for quantification of the “indirect intangible benefits” that the Bankruptcy Court had determined were insufficient “value” and did not equate to “reasonable equivalent value” so as to support the transfers made and obligations incurred by the conveying subsidiaries.
In February 2011, District Judge Gold entered a decision6 determining that the Bankruptcy Court’s prior opinion should be “quashed in its entirety” and further determining such opinion to be “null and void” as to the Transeastern Lenders for numerous reasons, including that:
On a consolidated basis, the subsidiaries of TOUSA that executed the upstream guaranties and pledged their assets as security all received indirect intangible economic benefits from the Transeastern Lenders for the indebtedness and obligations incurred;
The Bankruptcy Court had too narrowly defined “value,” which under the Bankruptcy Code could include the opportunity to receive future indirect intangible economic benefits;
Indirect intangible economic benefits, including the ability to avoid default and bankruptcy if only for a brief time, can constitute “value” under the Bankruptcy Code;
The proper method of determining “value” for these purposes was not with reference to tangible property and marketable financial value, but rather by examining all aspects of the transaction and measuring the value of direct and indirect benefits and burdens to the debtor, including indirect economic benefits;
Such “value” need not be mathematically quantifiable for it to constitute “reasonably equivalent value;”
On a consolidated basis, the TOUSA subsidiaries received significant and reasonably equivalent value, including indirect economic but unquantifiable value, for their guaranties and pledges; and
Therefore, the Transeastern Lenders were immune from fraudulent transfer liability and the loan proceeds could not be clawed back.
Another appeal followed, this time to the 11th Circuit Court of Appeals. Again, the solvency tests and the solvency opinion were not a part of this appeal. The only valuation issue to be decided by the 11th Circuit was if the bankruptcy court had clearly erred in deciding that the subsidiaries did not receive reasonably equivalent value for their upstream guaranties and pledges by receiving an opportunity to avoid default and bankruptcy.
In May 2012, the 11th Circuit issued its opinion7, reversing the District Court in its entirety, affirming the liability findings of the Bankruptcy Court, and remanding the case back to the District Court for further proceedings consistent with the 11th Circuit’s opinion. Specifically, having reviewed the determinations of both lower courts de novo and the findings of the Bankruptcy Court for clear error, the Court found that the Bankruptcy Court did not clearly err when it found that TOUSA subsidiaries did not receive reasonably equivalent value for their guaranties and liens on their assets. The 11th Circuit did not decide “whether the possible avoidance of bankruptcy can be reasonably equivalent value because the Bankruptcy Court’s finding that even if all of the benefits of the transaction were legally cognizable, they did not confer reasonably equivalent value, and those findings were not clearly erroneous.”8 Effectively, the Court of Appeals said that by itself, the ability of the subsidiaries to avoid and/or delay default and bankruptcy did not by itself constitute “reasonably equivalent value.”
What’s next? The request that the full 11th Circuit rehear this case was subsequently denied, so as of now the Court of Appeals decision, which reversed the District Court in its entirety and remanded to that Court, stands. The next step is what the District Court will do on the remand - this is the “gift that keeps on giving,” so stay tuned.
When we first published this article in its original form, the Bankruptcy Court’s opinion had recently been issued. We wrote then that even though it could not be predicted with certainty what the result of subsequent appeals would be, even if the Bankruptcy Court’s decision were to be reversed in its totality, there are nonetheless lessons to be learned from TOUSA (beyond “Florida, Florida, Florida”)9 that should be remembered by those seeking and providing solvency opinions in these types of transactions. Having now witnessed the tortured course of the TOUSA appeals process (a second appeal from Judge Olson’s original opinion remains undecided)10, these lessons remain:
An independent solvency opinion is a critical condition for a Board when it is engaged in a refinancing, restructuring or transaction of the nature described in the TOUSA case.
The fees paid to the independent solvency opinion provider should not be contingent upon a preordained result.
A favorable solvency opinion is not an insurance policy. Just as comprehensive loan documentation and myriad financial covenants will not collect your loan, a solvency opinion without a proper independent analysis and without adherence to industry standards with respect to valuation methodology will not provide the protection desired.
To have evidentiary value, the solvency opinion should be based on accepted and industry-appropriate methodologies and metrics.
A solvency opinion must incorporate the best available and most up-to-date financial, economic and industry information, conditions and outlook. An opinion provided in isolation can lead to the wrong conclusion.
A solvency opinion may need to take into consideration an analysis of subsidiary entities that provide cash flow or assets that support or possibly guarantee parent-level debt. The analysis may also need to take into consideration whether reasonably equivalent value is received by each subsidiary entity supporting and/or guaranteeing the debt of a parent.
“Neither a borrower nor a lender be [.]” All quotes are taken out of context, and this admonition from an old busybody to his young, impetuous son is no exception. In today’s business environment, however, the results of a borrower default can be even more drastic than Polonius imagined. Due to a number of recent court decisions, including the TOUSA trilogy of cases discussed here, the spotlight on lenders is now brighter than ever, and it is focused not only on the solvency opinion and its provider but also on all parties involved in the underlying transaction and on the entire transaction of which it is a part. Borrowers and lenders need to understand that a solvency opinion is only as good as the analysis that supports it and the integrity of the entire process of that transaction.
About American Appraisal:
American Appraisal, the world’s only glocal valuation firm™, is a leading valuation and related advisory services firm that provides expertise in all classifications of tangible and intangible assets. It comprises 900 employees operating from major financial cities throughout Asia-Pacific, Europe, the Middle East, and North and South America. Our portfolio of services focuses on four key competencies: Valuation, Transaction Consulting, Real Estate Advisory and Fixed Asset Management.
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1This is a revised and updated version of an article originally written and posted to the American Appraisal website (www.american-appraisal.com) in 2009, subsequent to the bankruptcy court opinion cited in endnote 3.
2Shakespeare’s Hamlet, act 1, scene 3
3Official Committee of Unsecured Creditors of TOUSA, Inc., et al., Debtors, v. Citicorp North America, Inc., et al. (In re TOUSA), 422 B.R. 783 (Bankr. S.D. Fla. 2009).
4See 11 U.S.C. Sections 548 and 550.
5Also beyond our scope is a discussion of the remedies and sanctions imposed by the Bankruptcy Judge and his determination regarding the unenforceability of the “savings clauses” in the subsidiary guaranties.
63V Capital Master Fund Ltd., v. Official Committee of Unsecured Creditors of TOUSA, Inc., 444 B.R. 613 (S.D. Fla 2011).
7Senior Transeastern Lenders v. Official Committee of Unsecured Lenders, (in Re TOUSA, Inc), 11th Circuit, 11-11071.
811th Circuit, at 29
9Tim Russert, Election Night, 2000
10A second appeal of Bankruptcy Judge Olson’s decision, by a different set of lenders, was also filed and was assigned to a different District Court Judge. Although both appeals were argued at the same time before both judges, the second Judge has yet to produce an opinion.