Safe Harbor Redux: The Second Circuit Revisits The Bankruptcy Code’s Protection Against Avoidance Of Securities Contract Payments

"Safe harbors" in the Bankruptcy Code designed to minimize "systemic risk"—disruption in the securities and commodities markets that could otherwise be caused by a counterparty's bankruptcy filing—have been the focus of a considerable amount of judicial scrutiny in recent years. The latest contribution to this growing body of sometimes controversial jurisprudence was recently handed down by the U.S. Court of Appeals for the Second Circuit. The ruling widens a rift among the federal circuit courts of appeal concerning the scope of the Bankruptcy Code's "settlement payment" defense to avoidance of a preferential or constructively fraudulent transfer. In Official Committee of Unsecured Creditors v. American United Life Insurance Co. (In re Quebecor World (USA) Inc.), 2013 WL 2460726 (2d Cir. June 10, 2013), the Second Circuit held that securities transfers may qualify for this section 546(e) safe harbor even if the financial institution involved in the transfer is "merely a conduit." The court affirmed dismissal of the $376 million suit brought by an official creditors' committee on behalf of the bankruptcy estate against a group of insurer-investors.

Section 546: Limitations on Avoiding Powers

The Bankruptcy Code empowers a bankruptcy trustee or chapter 11 debtor in possession ("DIP") to invalidate certain transfers (or obligations incurred) by a debtor during prescribed periods immediately prior to (and even after) filing for bankruptcy protection. Among these are the ability to "avoid" transfers that are fraudulent by design or because an insolvent transferor did not receive fair consideration in exchange (sections 544 and 548), the power to avoid transfers that prefer one creditor over others (section 547), and the ability to avoid postbankruptcy transfers that are not authorized by the Bankruptcy Code or the court (section 549). Section 546 of the Bankruptcy Code, however, imposes important limitations on the rights and powers granted to the trustee or DIP elsewhere in the Bankruptcy Code. These include, among others, statutes of limitations for avoidance actions (section 546(a)), limitations based upon the perfection rights afforded under applicable nonbankruptcy law to entities with interests in the debtor's property (section 546(b)), and limitations based upon reclamation rights arising under applicable nonbankruptcy law (sections 546(c) and 546(d)). The restrictions also include provisions prohibiting avoidance in most cases of: (i) transfers that are margin or settlement payments made in connection with securities, commodity, or forward contracts (section 546(e)); (ii) transfers made by, to, or for the benefit of a repo participant or financial participant in connection with a repurchase agreement (section 546(f)); (iii) transfers made by, to, or for the benefit of a swap participant or financial participant under or in connection with a prepetition swap agreement (section 546(g)); and (iv) subject to certain exceptions, transfers made by, to, or for the benefit of a "master netting agreement participant" under certain circumstances (section 546(j)). Section 546(e), which creates a safe harbor for margin or settlement payments, provides as follows:

Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title. Prior to the enactment of the Bankruptcy Code in 1978, U.S. bankruptcy law did not protect margin or settlement payments from avoidance, and such payments were held to be avoidable. Lawmakers changed this by enacting section 764(c) of the Bankruptcy Code as part of the Bankruptcy Reform Act of 1978. That provision, which applied only in commodity-broker liquidation cases under chapter 7, prohibited a trustee from avoiding a transfer that was: (i) a margin payment or a deposit with a commodity broker or forward-contract merchant; or (ii) a settlement payment by a clearing organization. Its purpose was to facilitate prebankruptcy transfers, promote customer confidence in commodities markets, and ensure the stability of those markets. Section 764(c) was repealed in 1982 and replaced by a provision that was designated subsection (e) of section 546 in 1984. Section 546(e) clarified prior section 764(c) and made it applicable to both the...