The rules about who gets paid first when a company is in bankruptcy traditionally have been rigid. First in line are secured creditors, which are those who loaned money secured by collateral. Second are those who loaned money or provided goods or services with nothing more than promises of repayment--unsecured creditors. Last are stockholders.
But a pair of judges' recent rulings have pushed secured lenders behind unsecured creditors in instances where the courts thought lenders acted irresponsibly during the real estate boom, loaning money that they should have known couldn't be paid back. The rulings have bankruptcy attorneys and advisors on alert for what could signal a sea change in bankruptcy law.
"It's becoming more common," for judges to push secured creditors further back in the line to be paid when they think they bear some responsibility for the company's poor financial situation, said Brad Foster, managing director in FTI's Miami-based corporate finance practice. "It used to be when you were a first-lien holder you were golden, but the judges take a very dim view on situations [where a loan] creates insolvency."
In mid-October, a judge overseeing the Chapter 11 bankruptcy of TOUSA, a Florida-based home builder, decided lenders to that company did just that. And he required the company's secured lenders and other lenders to give back roughly $600 million in loan proceeds and fees to the company. That money is to be used to pay off unsecured lenders, particularly bondholders.
Judge John K. Olson of the U.S. Bankruptcy Court's Southern District of Florida ruled that lenders "did not act in good faith and were grossly negligent" when they loaned money to TOUSA to pay off an earlier loan that the company took to buy Transeastern, a Florida-based land developer, in August 2005.
He said a group of investors syndicated by Citicorp should have known that the company was already insolvent when it loaned TOUSA roughly $500 million in 2007 to pay off a an earlier loan made by a Deutsche Bank-led investor syndicate. That syndicate had already loaned TOUSA money in 2005 to buy Transeastern's land assets in a joint venture. TOUSA was behind in loan payments to Deutsche Bank, which had sued the company and demanded re-payment.
Olson ruled that the Citicorp loan made to pay off Deutsche Bank's earlier loan was a fraudulent conveyance of the company's assets and ordered the Deutsche Bank syndicate to "disgorge" roughly $483 million to a special account. Citicorp's loan to TOUSA was wiped out, and it was ordered to pay interest and professional fees.
The judge's decision drew the attention of bankruptcy professionals, including Larry Comegys, managing director of Algon Group, a financial advisory firm. "It kind of opens the floodgates," he said.
There are many deals underwritten at the peak of the market that have since gone south. Unsecured creditors would traditionally expect to get little to nothing for their investment. But now, they potentially could recoup more if Judge Olson's ruling is copied by others, said Comegys.
"I think I can guarantee you that lots of lawyers are examining this really closely to see if it can be applied to any number of deals that happened at the time," he added.
The TOUSA ruling doesn't stand alone as a potential game-changer.
U.S. Bankruptcy Judge Ralph B. Kirscher of the Montana District took a decidedly dim view of Credit Suisse when he ruled in May to subordinate $232 million in debt to a Credit Suisse-assembled syndicate of lenders beneath unsecured creditors in the Yellowstone Mountain Club bankruptcy.
In the ruling, Kirscher said: "Credit Suisse's actions in the case were so far overreaching and self-serving that they shocked the conscience of the Court."
The judge's ruling said Credit Suisse loaned Yellowstone far more money than the company needed and allowed the owner to use the proceeds in other ventures. The loan was made by Credit Suisse and then syndicated out to hedge funds, which bore the risk of default.
"The only plausible explanation for Credit Suisse's actions is that it was simply driven by the fees it was extracting from the loans it was selling and letting the chips fall where they may," Kirscher's ruling said.
Kirscher's ruling was later vacated at the request of the unsecured creditors who it benefited. The unsecured creditors got an even better deal by agreeing to have the ruling vacated, said J. Thomas Beckett, the Salt Lake City-based attorney for Yellowstone's unsecured creditors committee.
Even though the judge's decision was vacated, it will still have an impact on other judges' decisions down the line when they see a case where they think a lender has been negligent, Beckett said.
"Everybody and his dog knows about the Yellowstone decision and now the TOUSA decisions," he said.
Teresa Burney is a senior editor for BUILDER and BIG BUILDER magazines.