Two United States courts recently issued decisions involving the scope of the Bankruptcy Code’s safe-harbor provision in section 546(e) related to avoidance actions. In one, in the Second Circuit, the court took a broad approach to protect the financial markets, whereas the Seventh Circuit interpreted that statute more narrowly. The Supreme Court is now well-positioned to bring greater clarity to this important area of law.

How secure is the Bankruptcy Code safe harbor that provides a defense to fraudulent transfer claims? The answer may depend on where a bankruptcy case is filed. A statutory “safe harbor” is intended to give shelter from the application of certain of the statute’s debtor-friendly remedies. With such a purpose in mind, Congress amended the Bankruptcy Code in 1982 to create a safe harbor to protect the commodities and securities markets from disruption in the event of a major bankruptcy affecting those industries. But, the safe harbor that Congress added in Bankruptcy Code section 546(e) – which essentially provides a defense to the clawback claims of debtors and trustees, where the underlying transaction is a commodity contract, forward contract, repurchase agreement, security contract, swap or master netting agreement – makes no reference either to these financial markets or to market disruptions. The language of the statute makes the defense against fraudulent transfer claims applicable to a wide range of transactions across industries. Over the past several years, several circuit courts have struggled to reconcile the broad statutory language with its core purpose without undermining the specific avoidance powers in chapter 5 of the Bankruptcy Code. A pair of recent decisions in July 2016, one from the Seventh Circuit and the other from a bankruptcy court in the Second Circuit, illustrate how irreconcilable interpretations deprive financial markets of the certitude that motivated Congress.

Calm Waters in the Second Circuit The United States Bankruptcy Court for the Southern District of New York, presiding over an adversary proceeding in the Lyondell bankruptcy case, held that In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98 (2d Cir. 2016) (“Tribune”) required it to rule that section 546(e) bars state law fraudulent transfer claims. Weisfelner v. Fund 1 (In re Lyondell Chemical Company), No. 09-10023, 2016 Bankr. LEXIS 2734 (Bankr. S.D.N.Y. July 20, 2016).

Following years of litigation, the defendants filed a motion to dismiss the last remaining claim of the creditor trustee of a trust under the confirmed plan of reorganization for Lyondell and its affiliated debtors. The claim consisted of a state-law constructive fraudulent transfer claim to avoid and recover payments made to former shareholders of Lyondell for their stock in connection with the 2007 merger between Lyondell and Basell AF S.C.A.

The defendants argued that the payments sought to be avoided were made to the defendant-shareholders for their Lyondell stock and constituted “settlement payments,” or payments “in connection with a securities contract,” made by or to a financial institution, and that these payments were therefore protected under the safe harbor of section 546(e) of the Bankruptcy Code. On the other hand, the trustee argued that the safe harbor’s reference to a “trustee” must be read to exclude actions like these, where the plaintiff purports to stand in the shoes of the debtor’s creditors and not as the statutory representative of the bankruptcy estate.

Section 546(e) of the Bankruptcy Code provides, in relevant part, that:

[T]he trustee may not avoid a transfer that is a margin payment . . . or settlement payment . . . 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 . . . .[emphasis added]

11 U.S.C. § 546(e).

The bankruptcy court observed that the Second Circuit discussed the scope of the section 546(e) safe harbor provision in Tribune. In Tribune, the Second Circuit, in addressing facts similar to Lyondell, held that state law constructive fraudulent transfer claims brought by creditors against the debtor’s former shareholders to recover amounts they received in connection with a prepetition leveraged buyout (“LBO”) were preempted by section 546(e) of the Bankruptcy Code. Id. at 124. The Second Circuit rejected the notion that section 546(e) does not apply “when monetary damages are sought only from shareholders, or an LBO is involved,” and instead confirmed that “Section 546(e)'s language clearly covers payments . . . by commercial firms to financial intermediaries to purchase shares from the firm's shareholders.” Id. at 120 (citations omitted). Under Tribune, payments made in connection with transactions involving an LBO are no different in the eyes of the statute. See id. at 122.

The bankruptcy court followed Tribune, holding that “‘[s]ection 546(e) clearly covers payments . . . by commercial firms to financial intermediaries to purchase shares from the firm’s shareholders.’” Lyondell, 2016 Bankr. LEXIS 2734, at *10 (quoting Tribune, 818 F.3d at 120). “Moreover, the Second Circuit expressly stated that the extraordinary breadth of section 546(e) covers cash out payments to shareholders in an LBO.” Id. (quoting Tribune, 818 F.3d at 122). Accordingly, the bankruptcy court ruled that section 546(e) of the Bankruptcy Code barred the trustee’s constructive fraudulent conveyance claims and granted the defendants’ motion to dismiss. Lyondell continues the Second Circuit’s trend of broadly interpreting the section 546(e) safe harbor.

Not-So-Smooth Sailing in the Seventh Circuit Evincing a narrower approach to the scope of safe harbor protections on this issue, the United States Court of Appeals for the Seventh Circuit held that the section 546(e) safe harbor does not protect transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), where the entity is neither the debtor nor the transferee, but only the conduit. FTI Consulting v. Merit Mgmt. Group, No. 15-3388, 2016 U.S. App. LEXIS 13705 (7th Cir. Ill. July 28, 2016).

In 2003, Valley View Downs was in competition with another racetrack, Bedford Downs, for the last harness-racing license in the state. Both racetracks wanted to operate “racinos” – combination horse track and casinos – and both needed the license to do so. Valley View and Bedford agreed that Valley View would acquire all Bedford shares in exchange for $55 million. The exchange of the $55 million for the shares was to take place through Citizens Bank of Pennsylvania, the escrow agent. Valley View borrowed money from Credit Suisse and other lenders to pay for the shares. After the transfer, Valley View obtained the harness-racing license, but it failed to obtain the needed gambling license. This led Valley View to file for chapter 11 bankruptcy.

The trustee of the litigation trust created in Valley View’s bankruptcy commenced an action against Merit Management Group, a 30 percent shareholder in Bedford. The trustee alleged that Bedford’s transfer to Valley View and then from Valley to Merit of approximately $16.5 million (30 percent of the $55 million), was avoidable under sections 544, 548(a)(1)(b), and 550 of the Bankruptcy Code. Merit argued that the payments were protected under section 546(e) of the Bankruptcy Code, because the transfers were “made by or to” a financial institution when the funds passed through Citizens Bank and Credit Suisse. The district court agreed with Merit and the trustee appealed.

The Seventh Circuit ruled that because sections 544, 547, and 548 of the Bankruptcy Code establish that only transfers “made by the debtor” prior to the bankruptcy petition are avoidable, transfers “made by” a named entity in section 546(e) ought also to refer to a transfer of property only by the debtor. Additionally, because sections 544, 547, and 548 of the Bankruptcy Code refer to avoidance of transfers to or for the benefit of entities subject to fraudulent-transfer liability, section 546(e)’s safe harbor must refer only to transfers made to a named entity that is a creditor.

Although section 546(e) is to be understood broadly, the Seventh Circuit stated that does not mean that there are no limits. While Valley View’s settlement with Bedford resembled a leveraged buyout, and in that way touched on the securities market, neither Valley View nor Merit were “parties in the securities industry.” They were simply corporations that wanted to exchange money for privately held stock. The Seventh Circuit refused to interpret the safe harbor so expansively that it would cover any transaction involving securities that uses a financial institution or other named entity as a conduit for funds.

Conclusion The Seventh Circuit’s interpretation of the safe harbor aligns with the Eleventh Circuit, but stands in contrast to decisions from the Second, Third, Sixth, Eighth and Tenth Circuits, which have applied the section 546(e) safe harbor when a financial institution is nothing more than a conduit. The contrasting approaches in appellate decisions leave the bankruptcy courts struggling to adopt consistent positions on the scope of safe harbor protections. Unless and until the Supreme Court is ready, willing and able to calm the storm and provide the certitude that Congress intended for the safe harbor to provide, parties to transactions like those addressed in Lyondell and FTI may find themselves exposed to clawback risk despite the language of the safe harbors, depending on where a bankruptcy case is filed.