A recent decision by the Bankruptcy Court for the District of Delaware in PAH Litigation Trust v. Water Street Healthcare Partners L.P. (In re Physiotherapy Holdings, Inc.), Case No. 13-12965 (KG) (Bankr. D. Del. June 20, 2016), may limit the types of transactions that are subject to the “safe harbor” protections of section 546(e) of the Bankruptcy Code. On June 20, 2016, Judge Kevin Gross issued an opinion holding that state law fraudulent transfer claims may be actionable even where such claims might be barred by the safe harbor if brought under federal law.

Section 546(e) of the Bankruptcy Code provides a “safe harbor” for certain transfers involving the purchase and sale of securities and protects those transfers from avoidance in bankruptcy proceedings as preferences or constructively fraudulent conveyances. Specifically, section 546(e) insulates transfers that are “settlement payments” used in the securities trade, as well as other transfers made to or from certain parties, including financial institutions, financial participants and stockbrokers, in connection with a securities contract. Section 741(8) of the Bankruptcy Code defines “settlement payment” somewhat circularly, as a “preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment or any other similar payment commonly used in the securities trade.”

As we have noted in previous editions of Absolute Priority, courts have increasingly applied the section 546(e) safe harbor to shield virtually all transactions that concern a purported transfer of securities, both public and private, from avoidance. The Second Circuit reinforced the broad scope of the safe harbor in Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Company Fraudulent Conveyance Litigation), 818 F.3d 98 (2d Cir. Mar. 24, 2016), holding that the safe harbor preempted state fraudulent transfer laws. When state and federal laws conflict, federal law displaces, or preempts, state law, pursuant to the Supremacy Clause of the United States Constitution. Applying the preemption doctrine, the Second Circuit found that permitting state law fraudulent transfer claims would undermine numerous policies codified in federal securities laws, discourage investors from maintaining diversified portfolios, and harm the efficient maintenance of secondary markets for common stocks.

In PAH Litigation Trust v. Water Street Healthcare Partners L.P., the debtor, Physiotherapy Holdings was a leading provider of outpatient physical therapy services that operated 650 clinics in 33 different states. Six years before filing for bankruptcy, Physiotherapy’s common stock was acquired by two private equity funds. By 2009, Physiotherapy’s financial condition had deteriorated and its equity interests were sold to Court Square, which issued $210 million in senior secured notes that Physiotherapy agreed to assume.

Two years after confirmation of Physiotherapy’s prepackaged plan of reorganization, Physiotherapy’s litigation trustee brought an adversary complaint alleging that in order to finance the prepetition sale of Physiotherapy to Court Square, Physiotherapy’s former controlling shareholders orchestrated a scheme to make it appear that Physiotherapy was worth approximately twice its value.

The complaint alleged that the offering memorandum for the senior secured notes fraudulently overstated Physiotherapy’s revenue stream and its overall firm value, leading Court Square to acquire an insolvent company and the noteholders to receive debt instruments worth far less than their face value. The trustee, on behalf of certain noteholders who helped finance the Court Square transaction, sought to recover payments made to Physiotherapy’s former controlling shareholders in exchange for their equity in Physiotherapy under both state and federal fraudulent transfer laws.

The shareholder defendants filed a motion to dismiss the complaint, arguing that the payments were immune from avoidance under the safe harbor as settlement payments to a financial institution in connection with a securities contract. The trustee responded, in part, by arguing that the safe harbor does not apply to creditors asserting fraudulent transfer claims under state law.

Judge Gross agreed with the trustee’s argument that the safe harbor does not preempt claims asserted by a litigation trust under state fraudulent transfer law. In arriving at this conclusion, Judge Gross disagreed with Tribune’s holding that permitting state law fraudulent transfer claims would undermine federal securities laws. Instead, relying upon other bankruptcy court decisions, Judge Gross concluded that the safe harbor does not preempt state law fraudulent transfer claims where only private stock is involved because there is no risk of destabilizing financial markets by increasing systemic risk.

Physiotherapy has significant implications for the viability of the safe harbor exception in the context of privately held companies and chips away at the broad protections of the safe harbor. At the same time, Physiotherapy’s holding was limited to circumstances where (1) the transaction sought to be avoided did not pose a threat of “ripple effects” in the relevant securities markets; (2) the transferees received payment for non-public securities; and (3) the transferees were corporate insiders that allegedly acted in bad faith. In circumstances where those factors are not present, such as a transaction where public securities are involved, the safe harbor may still preempt state law fraudulent transfer claims. However, it is unclear whether Physiotherapy represents meaningful precedent for future cases because Judge Gross’s conclusions appear to have been largely driven by the facts of the case. The shareholder defendants filed a motion for leave to appeal on July 15, 2016, and it is possible that an appellate court will overturn Physiotherapy and follow the Second Circuit’s decision in Tribune.