Commercial Paper Redemption 'Safe Harbored' from Preference Liability per Second Circuit Court of Appeals

Originally published July 11, 2011

Keywords: commercial paper redemption, Depositary Trust Company, DTC, safe harbor, bankruptcy filing

The US Court of Appeals for the Second Circuit recently held that redemptions of commercial paper made through the Depositary Trust Company (DTC) are entitled to the "safe harbor" protections afforded to settlement payments under Bankruptcy Code Section 546(e), and are, therefore, not preferential transfers, even though such payments were made prior to maturity.1 The Second Circuit is the first Circuit Court of Appeal to address the issue, which arises out of the Enron bankruptcy case.

Legal Framework

Generally, payments of antecedent debt made within 90 days of a bankruptcy filing are avoidable as preferential transfers under Bankruptcy Code Section 547. However, Bankruptcy Code Section 546(e) shields certain transactions from preference liability, including any "settlement payment...made by or to (or for the benefit of) a...stockbroker, financial institution, financial participant, or securities clearing agency...in connection with a securities contract...that is made before the commencement of the case, except under section 548(a)(1)(A) of this title."2 Bankruptcy Code Section 741(8) in turn defines a "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."

Congress enacted the 546(e) safe harbor in 1982 to protect the securities and commodities industries from the turmoil that would ensue if, after a large bankruptcy, financial firms were required to repay amounts they received in settled security transactions, putting the capital and liquidity of the firms, and ultimately the markets, at risk.3

Factual Background and Lower Court Analysis

In late October and early November of 2001, Enron drew down on its $3 billion lines of credit and used a portion of those funds to redeem more than $1.1 billion of its unsecured and uncertificated commercial paper prior to the paper's maturity. Enron redeemed the commercial paper at par, a considerably higher price than its market value at that time.4 Less than one month later, Enron filed for bankruptcy.

In the bankruptcy case, Enron challenged the payments as preferential transfers under Bankruptcy Code Section 547, arguing that it made the redemption payments under pressure...