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Bank Lenders Aren't First in Line in Chapter 11 Bankruptcy: 11th Circuit

By Edward Tan, JD on May 24, 2012 6:04 AM

Bank lenders can't be put first by companies headed towards Chapter 11 bankruptcy. The 11th Circuit Court of Appeals ruling has set an important new precedent bound to send ripples through the lending industry.

The decision came following a long legal battle between homebuilding company TOUSA, its hedge fund debt holders, and Citigroup. The case had been heard by a bankruptcy judge and a district court. There was $421 million hanging in the balance. In the end, the appeals court ruled the Citigroup loans incurred by TOUSA to fight off bankruptcy were avoidable as fraudulent transfers.

It was a complicated fight, to say the least, but what does it mean for companies facing Chapter 11 and creditors?

The decision has some far reaching implications for the loan world. However, the best way to understand them is by looking at the case's history.

TOUSA was one of the largest homebuilders in the country. However, to get there it had to borrow a lot of money. Eventually it was over a billion dollars in debt and had defaulted on its loan obligations. TOUSA eventually settled with its creditors for $421 million.

The problem was they didn't have the money to pay that either. Facing bankruptcy, TOUSA and its subsidiaries took out loans from Citigroup to pay the settlement. However, Citigroup was no dummy and ensured their loans had first-priority liens.

You can imagine what happened next. TOUSA filed for Chapter 11. And a battle ensued between Citigroup and TOUSA's hedge fund debt holders.

The hedge fund argued that Citigroup's loans were fraudulent transfers because they weren't given to benefit TOUSA's subsidiaries. Instead, they were used to pay the $421 million settlement. Ultimately, the appeals court agreed.

Bottom line, bank lenders now face the risk that upstream guarantees from subsidiaries could be invalidated in the future. To avoid this costly mess, it seems like the 11th Circuit Court of Appeals' decision suggests lenders need to ensure its loans will actually benefit the guarantor. Banks need to check guarantors are solvent, especially those facing Chapter 11 bankruptcy.

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