Section 546(e) of the bankruptcy code bars state law constructive fraudulent conveyance claims asserted by creditors seeking to augment recoveries from a bankruptcy estate
Earlier today, the Second Circuit Court of Appeals issued a decision in In re Tribune Company Fraudulent Transfer Litigation, No. 13-3992-cv, holding that the Bankruptcy Code’s safe harbor of Section 546(e) (the Safe Harbor) prohibits clawback claims brought by creditors under state fraudulent transfer laws to the same extent that it prohibits such claims when brought by a debtor.
Tribune is the latest pronouncement by the Second Circuit about the Safe Harbor’s scope. Previously, in In re Enron Creditors Recovery Corp.1 and In re Quebecor World (USA) Inc.,2the Second Circuit applied the broad language of the Safe Harbor to bar preference and constructive fraudulent conveyance claims brought by debtors, irrespective of whether the challenged transactions were those that were contemplated by Congress in passing the Safe Harbor. In Tribune, the Second Circuit took the next step, holding that the Safe Harbor preempted state law avoidance claims brought by creditors when the same claims would otherwise have been barred by the Safe Harbor if brought directly by the debtor.3
The Second Circuit also rejected the notion – articulated by a number of lower courts – that transfers received by selling shareholders in a leveraged buyout (LBO) are outside the scope of the Safe Harbor’s protection.
The Tribune litigation arises out of the Chapter 11 filing by Tribune Company, which followed shortly on the heels of the LBO of the newspaper and media giant. After the debtor failed to assert state law fraudulent conveyance claims in a timely manner, two groups of Tribune’s unsecured creditors sought to pursue these claims directly against shareholders that redeemed stock in the LBO.
Section 546(e)’s Safe Harbor provides that except in cases of actual fraud, a debtor or trustee may not avoid transfers made by, to or for the benefit of certain participants in the financial markets when such transfers are (i) margin or settlement payments, or (ii) made “in connection with a securities contract.” In Tribune, there was no dispute that the constructive fraudulent conveyance claims brought by creditors would be barred by the Safe Harbor if brought directly by the debtor (or the creditors committee), as a result of the Second Circuit’s previous holdings in Enron and Quebecor.
Nonetheless, plaintiffs argued that the Safe Harbor did not bar their state law claims. Specifically, the plaintiffs’ core argument was that the right to bring state law fraudulent conveyance claims – which belong to creditors in the absence of a bankruptcy proceeding, but which are vested in the debtor upon the filing of bankruptcy – return to creditors if such claims are abandoned by the debtor. The plaintiffs further posited that their ability to bring state law fraudulent conveyance claims was not encumbered by the Safe Harbor, because the language of the Safe Harbor only prohibits avoidance claims brought by debtors, and does not apply to bar the same claims if brought directly by creditors.4
The plaintiffs also argued that the Safe Harbor should, in any event, not apply to this case because the Safe Harbor was designed to protect the stability of the financial system by immunizing financial institutions that act as intermediaries in a financial transaction from clawback risk, not to protect investors who were the ultimate beneficiary of certain financial transactions. Defendants – a group of financial institutions, mutual funds and hedge funds that received payment in exchange for their shares of Tribune in the LBO – disagreed.
The Second Circuit’s Decision
The Second Circuit sided decisively with defendants on both points, affirming the dismissal of plaintiffs’ claims as preempted by Section 546(e) of the Bankruptcy Code.5
With respect to the plaintiff’s primary argument, the Second Circuit concluded that the plaintiffs’ theories were in “outright conflict” with the Safe Harbor’s goals, and therefore found that plaintiffs’ state law fraudulent conveyance claims were preempted by the Safe Harbor. The Second Circuit noted that “[t]here is little apparent reason to limit [debtors] to intentional fraud claims [which are exempt from the Safe Harbor] while not extinguishing constructive fraud claims but rather leaving them to be brought later by individual creditors.” Permitting creditors to bring state law constructive fraudulent conveyance claims, the Second Circuit reasoned, would result in the very same harm that Congress sought to prevent by prohibiting debtors from bringing such claims. Regardless of whether the clawback claims were brought by a debtor under the Bankruptcy Code or by creditors under state law, the Second Circuit continued, “unwinding settled securities transactions,” years after the fact, would undermine the stability of the securities markets “in which certainty, speed, finality, and stability are necessary.” Summing up, the Second Circuit concluded that “[o]n its very face, the idea of preventing a trustee from unwinding the specified transactions while allowing creditors to do so, but only later, is a policy in a fruitless search of a logical rationale.”
The Second Circuit also rejected plaintiffs’ argument that redemptions of shares in the context of an LBO did not pose a threat to the stability of the financial markets and should therefore not benefit from the Safe Harbor’s protections. Rather, the Second Circuit concluded that the language of the Safe Harbor “does not distinguish between kinds of transfers, e.g. settlements of ordinary day-to-day trading, LBOs, or mergers” and that “[s]o long as the transfer sought to be avoided is within the language of” the Safe Harbor, it is immune from avoidance (except in the case of actual fraud). In so doing, the Second Circuit expressly accepted that the Safe Harbor was designed to protect two policy goals: (i) the stability of financial intermediaries and also (ii) the stability of the nation’s securities and financial markets by ensuring that settled transactions would not be at risk of being unwound years later.
The Second Circuit’s decision in Tribune is important for several reasons. First, the Tribune decision signals the Second Circuit’s continued commitment to the broad application of the Safe Harbor first announced in Enron and Quebecor. There, the Second Circuit held that the broad language of the Safe Harbor effectively prohibited debtors (except in the case of actual fraud) from seeking to undo transfers received by participants in the financial markets in connection with certain financial transactions. In Tribune, the Second Circuit went further, holding that the broad reach of the Safe Harbor cannot be avoided by delegating the debtor’s ability to bring constructive fraudulent conveyance claims. Whether such claims are brought by debtors, creditors’ committees, litigation trusts, or individual creditors, they are unlikely to succeed if the challenged transaction is within the scope of the Safe Harbor. Second, and equally importantly, the decision effectively rejects the efforts of certain lower courts to read an “LBO-exception” into the Safe Harbor, by unambiguously concluding that whether as part of an LBO or otherwise, transfers received by selling shareholders in exchange for their equity investments are immune from clawback, except in cases involving actual fraud.6