Tuesday, November 10, 2009

Bondholders Extract Revenge on Fee-Hungry Bankers

Posted on Bloomberg by David Reilly:

Companies in dire straits often roll the dice in a bid to stave off bankruptcy. The problem is that last-ditch efforts to raise new funds or restructure often come at the expense of bondholders.

Struggling companies, their advisers and lenders should think twice about such strategies after an almost $700 million judgment last month against Citigroup Inc., Bank of America Corp., Wells Fargo & Co. and other lenders, in connection with the bankruptcy of homebuilder Tousa Inc.

With bankruptcies rising, the decision may push creditors in other cases -- those of Tribune Co., Lyondell Chemical Co. and CIT Group Inc., for example -- to pursue more aggressively what are called fraudulent conveyance claims.

The Tousa case has caused the legal and bankruptcy communities to sit up and take notice because fraudulent conveyance claims rarely result in a sizeable judgment. Such claims seek to claw back money for a bankrupt entity by claiming a transaction was fraudulent because, while insolvent, it had transferred funds or assets without receiving something of equivalent value.

Fraudulent conveyance claims are usually settled or fizzle because they face a tough road at trial, essentially requiring a bankruptcy judge to play Monday-morning quarterback.

The Tousa case has turned that thinking on its head.

“This case will undoubtedly embolden people in other cases, like Tribune,” said Douglas Baird, a University of Chicago law professor.

Tribune Creditors

Creditors of Tribune have alleged that fraudulent transfers took place as part of that company’s $8.3 billion going-private buyout. Tribune Chairman and Chief Executive Officer Sam Zell has denied the allegations, telling Bloomberg News, “In this particular case, I don’t think it’s valid, but ultimately it becomes a basis for negotiations.”

Baird said the Tousa decision will make such negotiations tougher. “I can go back to a lender and say that there’s a serious fraudulent conveyance risk here, and they’d say those claims never get anywhere,” Baird said. “If I say that someone just got tagged to the tune of half a billion dollars, this becomes a real risk.”

The Tousa decision also offers a window to some behavior that marked deal-making in the waning days of the credit and housing bubbles.

One example: AlixPartners LLP, the firm issuing a solvency opinion for Tousa, was to receive $2 million for a favorable opinion, and less than half that for an adverse one. Guess how that worked out.

Citigroup, Wells Fargo

Banks such as Citigroup, Bank of America and Wells Fargo, as well as other lenders, are appealing the Tousa decision. Last week, U.S. Bankruptcy Judge John K. Olson ordered them to post bonds of about $700 million while pursuing the appeals.

Tousa is a Hollywood, Florida-based homebuilder that expanded earlier this decade through a series of acquisitions, taking on $1 billion in debt.

In 2005 the company entered into a joint venture to buy Transeastern Properties Inc.’s homebuilding business. Tousa issued unsecured guarantees related to more than $500 million in borrowing by the venture, which quickly ran into trouble.

Tousa faced claims due to its guarantees and in January 2007 agreed to pay more than $421 million. Tousa didn’t have that kind of cash, though, and its business was rapidly souring as the housing meltdown began.

Secured Debt

To finance the settlement, Tousa issued $500 million in new, secured debt on July 31, 2007. This was secured by Tousa subsidiaries that weren’t at risk from the failed joint venture. Those units were home to most of the company’s assets, meaning claims from the new lenders would compete with those of existing bondholders.

Six months later, in January 2008, Tousa filed for bankruptcy. The company’s existing bondholders cried foul.

They claimed the 2007 financing had fraudulently transferred value from the subsidiaries, which didn’t see any money from the deal and weren’t on the hook for the joint venture’s failure. The bondholders also argued that the subsidiaries were insolvent both before and after the new round of financing.

Judge Olson agreed. His decision noted that banks and other lenders involved ignored ample evidence in early 2007 that Tousa was in bad shape and that taking on more debt wouldn’t benefit the company. He also found that:

Layers of Fees

-- Those involved with the financing had big incentives to get the deal done, no matter the risks. Half the chief executive’s target incentive bonus of $4.5 million was contingent on the deal’s completion. So too was a $3.5 million fee for the company’s investment bankers, Lehman Brothers Holdings Inc., along with a $2.9 million financing fee. And Citigroup “saw the proposed new financing as a highly attractive opportunity for fees,” the judge wrote. It ultimately collected $15 million.

-- Citigroup bankers arranging the financing knew early on that Tousa was in trouble. The judge noted that after looking over financial models for Tousa, a Citigroup banker wrote in an e-mail, “I don’t think the downside model should be shown to anyone outside of here. It’s too scary.”

-- The company’s board was warned in a letter from Capital Research and Management Company, an investor in Tousa’s existing bonds, that the new financing could put Tousa into the “zone of insolvency” and that it might be a “fraudulent transfer.”

-- Some lenders swallowed whatever management fed them, failing to question housing-market forecasts. That failure, Olson wrote, “was the result of either gross negligence or a willful decision -- motivated by a desire to generate fee income -- to turn a blind eye toward the obvious reality that Tousa was in a death spiral.”

Now, Tousa’s bondholders have rightfully gotten some revenge, while fee-hungry bankers and lazy lenders have been warned.

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