Which Hat Hides The Ball?: Courts Test Extent Of Safe Harbor Protections In Financial Transactions

When a legal right depends on the capacity in which a party purports to act, it won't be long before the lawyers are talking about "hats." In two bankruptcy cases now pending before the Second Circuit, the hat in question is that of the trustee under section 546 of the Bankruptcy Code and the right in question is the right to seek avoidance of a fraudulent transfer within the "safe harbor" provisions of section 546. The purpose of the safe harbors is to provide stability and certainty in markets for financial instruments like securities and swap agreements by confining the bankruptcy avoidance risk to cases of actual fraud. Thus, section 546 bars the "trustee" from bringing an avoidance action based on constructive fraud (which does not require a fraudulent state of mind), whether asserted under the Bankruptcy Code or state creditor protection laws. Section 546 is silent as to actions brought by persons other than the "trustee," leaving open the question whether creditors may still invoke state law rights to seek avoidance without a showing of actual fraud.

In Whyte, accepting creditors under a plan were required to assign their claims to the trustee, who then asserted state law constructive fraud claims in her capacity as assignee of creditor rights, asserting that the actual fraud limitation of section 546 became irrelevant when she switched hats. Judge Rakoff held that the section 546 safe harbors were not negated by this "clever argument," and that the state claims were impliedly preempted - otherwise the section 546 safe harbors would be rendered a "nullity." Whyte v. Barclays Bank PLC, 494 B.R. 196, 199-200 (S.D.N.Y. 2013). By contrast, in Tribune, Judge Sullivan found that the trustee hat carries with it the exclusive right to challenge a transaction unless this right is abandoned by the bankrupt estate. In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310, 320-21 (S.D.N.Y. 2013). At the same time, while noting that the filing of a bankruptcy petition can create "powerful magic," Judge Sullivan did not find preemption of state law creditor claims, because section 546 refers only to the disability of the trustee, leaving creditor claims unaffected. Id. Judge Sullivan also distinguished Whyte as holding merely that a party "could not simply take off its trustee hat, put on its creditor hat, and file an avoidance claim." Id. at 319.

Both cases have been appealed, and the Second Circuit will be confronted with complex arguments...