In 2019, the U.S. Court of Appeals for the Second Circuit made headlines when it ruled that creditors' state law fraudulent transfer claims arising from the 2007 leveraged buyout ("LBO") of Tribune Co. ("Tribune") were preempted by the safe harbor for certain securities, commodity or forward contract payments set forth in section 546(e) of the Bankruptcy Code. In In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), petition for cert. filed, No. 20-8-07102020, 2020 WL 3891501 (U.S. July 6, 2020) ("Tribune 2"), the Second Circuit concluded that a debtor may itself qualify as a "financial institution" covered by the safe harbor, and thus avoid the implications of the U.S. Supreme Court's decision in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), by retaining a bank or trust company as an agent to handle LBO payments, redemptions, and cancellations.
Picking up where the Second Circuit left off, the U.S. Bankruptcy Court for the Southern District of New York held in Holliday v. K Road Power Management, LLC (In re Boston Generating LLC), 617 B.R. 442 (Bankr. S.D.N.Y. 2020), that: (i) section 546(e) preempts intentional fraudulent transfer claims under state law because the intentional fraud exception expressly included in section 546(e) provision applies only to intentional fraudulent transfer claims under federal law; and (ii) payments made to the members of limited liability company debtors as part of a pre-bankruptcy recapitalization transaction were protected from avoidance under section 546(e) because for that section's purposes the debtors were "financial institutions," as customers of banks that acted as their depositories and agents in connection with the transaction.
The U.S. District Court for the Southern District of New York joined the Tribune 2 bandwagon in In re Nine W. LBO Sec. Litig., 2020 WL 5049621 (S.D.N.Y. Aug. 27, 2020), appeal filed, 20-3290 (2d Cir. Sept. 25, 2020). The court dismissed $1.1 billion in fraudulent transfer and unjust enrichment claims brought by a chapter 11 plan litigation trustee and an indenture trustee against shareholders, officers, and directors of women's clothing retailer Nine West Holding Inc. ("Nine West"). Citing Tribune 2, the district court ruled that the payments were protected by the section 546(e) safe harbor because they were made by a bank acting as Nine West's agent. According to the court, "When, as here, a bank is acting as an agent in connection with a securities contract, the customer qualifies as a financial institution with respect to that contract, and all payments in connection with that contract are therefore safe harbored under Section 546(e)."
Further developments on this issue are likely—the U.S. Supreme Court has been asked to review Tribune 2, and Nine West has been appealed to the Second Circuit.
The Section 546(e) Safe Harbor
Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, which include the power to avoid certain preferential and fraudulent transfers. Section 546(e) provides that the trustee may not avoid, among other things, a pre-bankruptcy transfer that is a settlement payment "made by or to (or for the benefit of) a … financial institution [or a] financial participant …, or that is a transfer made by or to (or for the benefit of)" any such entity in connection with a securities contract, "except under section 548(a)(1)(A) of the [Bankruptcy Code]." Thus, the section 546(e) "safe harbor" bars avoidance claims challenging a qualifying transfer unless the transfer was made with actual intent to hinder, delay, or defraud creditors under section 548, as distinguished from being constructively fraudulent because the debtor was insolvent at the time of the transfer (or became insolvent as a consequence) and received less than reasonably equivalent value in exchange.
Section 101(22) of the Bankruptcy Code defines the term "financial institution" to include:
[A] Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity and, when any such Federal reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer (whether or not a "customer", as defined in section 741) in connection with a securities contract (as defined in section 741) such customer….
11 U.S.C. § 101(22) (emphasis added). "Customer" and "securities contract" are defined broadly in sections 741(2) and 741(7) of the Bankruptcy Code, respectively. Section 741(8) defines "settlement payment" as "a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade." A similar definition of "settlement payment" is set forth in section 101(51A).
The purpose of section 546(e) is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982). The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id.
In Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 818 F.3d 98 (2d Cir. 2016) ("Tribune 1"), the U.S. Court of Appeals for the Second Circuit affirmed lower court decisions dismissing creditors' state law constructive fraudulent transfer claims arising from the 2007 LBO of Tribune. According to the Second Circuit, even though section 546(e) expressly provides that "the trustee" may not avoid certain payments under securities contracts unless such payments were made with the actual intent to defraud, section 546(e)'s language, its history, its purposes, and the policies embedded in the securities laws and elsewhere lead to the conclusion that the safe harbor was intended to preempt constructive fraudulent transfer claims asserted by creditors under state law.
Prior to the Supreme Court's ruling in Merit, there was a split among the circuit courts concerning whether the section 546(e) safe harbor barred state law constructive fraud claims to avoid transactions in which the financial institution involved was merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. For its part, the Second Circuit ruled that the safe harbor applied under those circumstances in In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013). The Supreme Court resolved the circuit split in Merit.
In Merit, a unanimous Supreme Court held that section 546(e) does not protect transfers made through a "financial institution" to a third party, regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, the relevant inquiry is whether the transferor or the transferee in the transaction sought to be avoided overall is itself a financial institution. Because the selling shareholder in the LBO transaction that was challenged in Merit as a constructive fraudulent transfer was not a financial institution (even though the conduit banks through which the payments were made met that definition), the Court ruled that the payments fell outside of the safe harbor.
In a footnote, the Court acknowledged that the Bankruptcy Code defines "financial institution" broadly to include not only entities traditionally viewed as financial institutions but also the "customers" of those entities, when financial institutions act as agents or custodians in connection with a securities contract. The selling shareholder in Merit was a customer of one of the conduit banks, yet never raised the argument that it therefore also qualified as a financial institution for purposes of section...
