There are two types of fraudulent transfers under the Delaware Fraudulent Transfer Act. The first, actual fraud, requires actual intent to hinder, delay or defraud any creditor. Actual intent is very difficult to prove, and we don’t believe, it can be successfully argued here. The second, constructive fraud, requires the holders prove (1) that Dynegy Holdings made the transfer without receiving a reasonably equivalent value in exchange for the transfer AND (2)(A) Dynegy Holdings was insolvent at that time of the transfer, or (B) became insolvent as a result of the transfer, or (C) or was engaged in a transaction for which its remaining assets would be unreasonably small in relation to the Transaction.”

After the initial step of the reorganization, bondholders argued that the ring-fencing of CoalCo and GasCo amounted to a fraudulent conveyance – stripping assets owned by Dynegy Holdings which provided credit support. The Delaware Chancery Court was able to dismiss the fraudulent transfer claim based on the simple fact that the ring-fencing did “not contemplate a predicate transfer of property belonging to Dynegy Holdings” and that “*Dynegy Holdings+ will have the same indirect ownership interest in the physical assets after the Transaction as it did before.” However, now that CoalCo has been transferred to Dynegy, the assets clearly have been transferred out from under Dynegy Holdings. In exchange, Dynegy promised to make payments under the Undertaking Agreement as described above. If the Board’s $1.25B valuation of CoalCo is correct then Dynegy can argue that equivalent value was provided. On the other hand, bondholders may claim that the undertaking of Dynegy, a holding company with no operations, is less valuable than the CoalCo equity previously owned by Dynegy Holdings. Even if this argument is successful, bondholders still face the difficult challenge proving that the transfer triggered one of the insolvency prongs of the second part of the statute.

Should Dynegy Holdings file for bankruptcy, the Bankruptcy Code contains a similar analysis with respect to fraudulent transfers and “reasonably equivalent value” under Section 548. If less than reasonably equivalent value can be established, then the transfer can be avoided if the debtor was insolvent and certain other elements exist.

In our estimation, the success of the Exchange Offer hinges on whether the transfer of CoalCo was proper and whether the transfer can withstand legal challenge. Although we have not conducted a lengthy analysis to determine all the arguments available to bondholders in connection with a fraudulent conveyance claim, it does appear that bondholders would face a difficult challenge in court and therefore are likely to accept the exchange.

This week we are going to be discussing fraudulent conveyance. Section 548 of the bankruptcy code deals with transactions that are fraudulently made. While malicious transfers are also dealt with in the bankruptcy code (i.e. doing something purposefully to malign creditors), we are going to be focusing on the more “practical” kind of fraudulent conveyance.

Now, I know this is technical. And believe me, it will get more technical. But the concept of fraudulent conveyance is literally never more important than it is today. Why? The simple reason: The Tousa Ruling. Here is the relevant docket and the actual fraudulent conveyance ruling by the judge.

The ruling is 182 pages. I am not going to do it the mis-justice of simply summarizing it in a few lines. For those that really want to understand how judges make decisions in these sorts of cases, it is imperative you read the ruling.

To prove a transfer is fraudulent, one must not only prove the absence of reasonably equivalent value granted, but also that the entity doing the transfer was insolvent at the time. Section 548 of the bankruptcy code looks back 2 years – so in addition to the two concepts above, this transfer must have also happened in the last two years.

If you look at the docket mentioned above, you will see a litany of appeals and “clarifications of judgement and order” as well as “findings of fact” which are all actions that try to reverse this judge’s decisions. They are all fascinating reads. I am going to pull out 7 or 8 blocks of text from various filings and comment on them as I think that will enlighten the readers the most. But first, just a little background on the case.

In July of 2007, Tousa, a homebuilder, borrowed $500M and granted lenders security in all their assets. This capital was used to settle litigation against Tousa and one of its subsidiaries (Transeastern) because of a default at the Transeastern JV. The problem was, Tousa had other subsidiaries, that were not party to the litigation / lawsuit. Tousa, and subsidiaries subsequently filed for bankruptcy in January 2008. The creditor committee, i.e. those holding unsecured claims against Tousa, was seeking to avoid the $500M debt/lien obligation and avoid liens on a tax refund issued in 2007.

As a quick summary, and this is a broad based statement, but I am going with it: If a lien is shown to be “fraudulent”, that lien is effectively worthless. That means a secured creditor would now be an unsecured creditor. This is important because now instead of getting a piece of the pie after the secured lenders get paid off, everyone gets their fair share.

A simple example will suffice:

Say a company has $100M in assets. This company also has $100M in debt secured against those assets and $100M of unsecured debt. With a simple bankruptcy waterfall we see that the secured lenders will get 100% of their claim ($100M of assets / $100M of secured debt) and unsecured creditors will get 0% of their claim ($0M of remaining assets / $100M of unsecured claims).

Now lets say those liens are worthless. The $100M of assets would now be split between $200M of unsecured claims ($100M voided secured debt + $100M of unsecured debt) with a recovery of 50 cents on the dollar for each. With liens, unsecured lenders are getting donuts. Without the liens, they are getting 50 cents on the dollar back.

In this 182 page ruling, the judge lays out the case/reasoning behind the claims he is postulating. For example, he lays out the housing downturn and the effect it had on Tousa’s business, including management communication with advisers and investors at the times. My favorite:

In a May 25, 2007 email to himself, Wagman stated that TOUSA “will fail” to satisfy covenants in its bond indentures “into late 2008 or 2009. Not even close.” Ex. 2113 at 1-2 (emphasis added). He noted the view of the rating agencies that the homebuilding industry was “grim and getting grimmer,” with downward pressure on prices and margins. He wrote, “As CFO, and in light of all of this market uncertainty, I have absolutely no desire to fly this plane too close to the ground, achieve some from [sic] of consensual settlement today and crash within the upcoming year. That would be a clusterf*ck.”

I really hope I’m not the only one that thinks this line is incredible.

The judge continues discussing “contemporaneous evidence” suggesting that the Tousa subs were insolvent at the July transaction, they were left MORE insolvent as a result of said transaction, left them too small a capital base, and left them unable to pay their debts as they matured.

For example: “Prior to the July 31 transaction, Citi harbored significant doubts about TOUSA’s solvency, but – motivated by the prospect of substantial fee income – pressed forward nonetheless” … Quoting from the ruling

“Citi saw the proposed new financing as a highly attractive opportunity for fees. In a March 23, 2007 email, Citi employees discussed their strategy of structuring the deal so that, even in a worst-case scenario, Citi would lose less than its fees. Citi ultimately collected approximately $15 million in fees for the transaction, including funds paid to its advisers by TOUSA. Citi was keenly aware of its ultimate goal. In early March 2007, when TOUSA requested an amendment of the Revolver to relax the interest coverage ratio and avoid a going concern opinion from its auditors, Citi assented to modifying the covenants because “[a] going concern [opinion] would not be

particularly helpful in putting in place the $1.2B financing we’re working on, as you know, and for which we are slated to earn roughly $8mm in fees.”

The judge goes on like this for quite some time, getting into things as deep as not being able to trust a certain expert’s witness testimony or the use of certain discount rates when doing a valuation. Deep deep stuff.

Moving to the “Conclusions of Law” section where the judge lays out his ruling in relation to the bankruptcy code, we can start to figure out what all this fraudulent transfer talk really means. For example

“Section 548(a)(1)(B) permits the avoidance of any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred within 2 years before the date of filing of the petition, if the debtor voluntarily or involuntarily received less than a reasonably equivalent value in exchange for such transfer or obligation and (A) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation, (B) was engaged in a business or transaction, or was about to engage in a business or transaction, for which any property remaining with the debtor was an unreasonably small capital; or (C) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured. 11 U.S.C. § 548(a)(1)(B).”

And using the law, the judge discusses the evidence and arguments laid out (like in the examples above) to show that point A, B, and C of USC 548(a)(1)(B) was indeed the case at Tousa. This continues going deeper and deeper, digging into what “unreasonably small capital” means for example, or how the inability to pay debts can be shown. This is great learning for all those interested.

In the end, the judge ruled that all claims of the First and Second Lien Lenders (from the July 2007 transaction) and all liens granted by the subsidiaries are to be avoided and disallowed (i.e. everyone is unsecured). ALSO, the judge ruled that the Transeastern lenders (that had gotten paid back with the $500M July 2007 deal) need to disgorge to the subsidiaries $403M plus interest. Yes, you thought you got paid out, but now I want the money back. And to knock them in the teeth, the tax refund liens were also disgorged.

Now, as I mentioned, everyone is appealing this thing. Everyone. And tomorrow, we will look at their reasoning and the arguments they are making. This fraudulent conveyance case has wide reaching implications for distressed debt investors in the future (and current cases as well). We will also discuss that tomorrow.