Court's Broad Interpretation Of Definition Of "Securities Contracts" Promotes Expansive Scope Of Bankruptcy Code "Safe Harbor"

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Corporate/Commercial Law, Insolvency/Bankruptcy/Re-structuring, Corporate and Company Law, Insolvency/Bankruptcy, Securities
• Author: Mr Daniel Merrett and Mark Douglas
• Published date: 02 October 2023

Section 546(e) of the Bankruptcy Code's "safe harbor" preventing avoidance in bankruptcy of certain securities, commodity, or forward-contract payments has long been a magnet for controversy. Several noteworthy court rulings have been issued in bankruptcy cases addressing the application of the provision, including application to financial institutions, its preemptive scope, and its application to non-publicly traded securities.

One of the latest chapters in the ongoing debate was written by the U.S. District Court for the Southern District of Indiana in Petr v. BMO Harris Bank N.A., 2023 WL 3203113 (S.D. Ind. May 2, 2023), appeal filed, No. 23-1931 (7th Cir. May 17, 2023). The district court broadly construed the section 546(e) safe harbor to bar a chapter 7 trustee from suing under state law and section 544(b) of the Bankruptcy Code to avoid an alleged constructive fraudulent transfer made by the debtor shortly after it had been acquired in a leveraged buy-out ("LBO"). According to the district court: (i) all of the agreements related to the LBO acquisition "were securities contracts" for purposes of the section 546(e) safe harbor, which insulated from avoidance a transfer made by the debtor one month after the LBO to refinance a loan incurred as part of the transaction; (ii) the safe harbor is not limited to transfers involving publicly traded securities; and (iii) section 546(e) preempted the trustee's state law constructive fraudulent transfer claims.

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 transfer falling under the subsection's terms unless the transfer was made with actual intent to hinder, delay, or defraud creditors under section 548(a)(1)(A), as distinguished from constructively fraudulent transfers under section 548(A)(1)(B), where the debtor is insolvent at the time of the transfer (or becomes insolvent as a consequence) and receives less than reasonably equivalent value in exchange.

Section 101(22) of the Bankruptcy Code defines the term "financial institution" to include, in relevant part:

[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). "Customer" and "securities contract" are defined broadly in sections 741(2) and 741(7) of the Bankruptcy Code, respectively. Sections 101(51A) and 741(8) define the term "settlement payment."

According to the legislative history of section 546(e), the purpose of the safe harbor 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.

Notable Court Rulings

Many notable court rulings have addressed: (i) whether section 546(e) preempts fraudulent transfer claims that can be asserted by or on behalf of creditors by a bankruptcy trustee under state law; (ii) whether the section 546(e) safe harbor insulates from avoidance only transactions involving publicly traded securities; and (iii) whether a "financial institution" must be the transferor or ultimate transferee, as distinguished from an intermediary or conduit, for a transaction to be insulated from avoidance under the safe harbor.

Preemption. 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 Co. ("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...