A recent decision by the U.S. Court of Appeals for the Second Circuit, In re Tribune Company Fraudulent Conveyance Litigation,1 represents a significant victory for shareholders who may get cashed out in connection with a leveraged transaction that precedes a company bankruptcy.

As background, in connection with a leveraged buyout (LBO), the shareholders of a public company are often required to sell their shares in return for a cash payment. In the event that the company ultimately goes bankrupt, the shareholders could be subject to constructive fraudulent conveyance claims by the bankrupt company’s trustee, who will seek to “claw back” the money that the shareholders received. Recognizing that these sorts of claims could lead to significant disruption in the securities markets, Congress passed Section 546(e) of the Bankruptcy Code.2 That section precludes trustees from bringing federal constructive fraudulent conveyance claims based upon shareholders’ receipt of cash in return for their shares.

In the hopes of clawing back money received by shareholders in connection with LBOs and similar transactions, creditors recently began trying to structure their claims to avoid Section 546(e). Specifically, creditors began: (1) structuring bankruptcy plans so that constructive fraudulent conveyance claims benefiting creditors are not pursued by the trustee, but by creditors themselves; and (2) bringing their constructive fraudulent conveyance claims under state, rather than federal, law. In litigation involving the Tribune Company and Lyondell Chemical Company, for example, creditors sought under state law to recover money that the companies’ public shareholders had received in connection with leveraged transactions that preceded the companies’ bankruptcy filings.

In the Tribune case, the Second Circuit put an end to creditors’ attempts to circumvent Section 546(e). Specifically, the Court held that allowing creditors to pursue state law constructive fraudulent conveyance claims would frustrate Congress’ goal when enacting Section 546(e) of protecting the securities markets and that, as a result, the creditors’ claims are preempted by federal law. The Tribune decision is a significant victory for the former Tribune shareholders – including the numerous mutual fund clients that we represent in that matter – and, in general, for shareholders who may get cashed out in connection with a leveraged transaction that precedes a company bankruptcy.

Background of the Tribune Litigation3

The Tribune Company was at one time one of the largest media and entertainment companies in the country. Among other things, it owned newspapers and TV stations that reached about 80% of the U.S. market, as well as the Chicago Cubs baseball team. Tribune was a public company with thousands of shareholders.

In April 2007, Sam Zell, a Chicago-based billionaire, announced plans to buy out Tribune’s shareholders for US$34 per share in connection with an LBO. To finance the LBO, Tribune borrowed US$11 billion, US$8 billion of which went to the shareholders. The LBO closed in December 2007. After the LBO closed, Tribune’s performance deteriorated. It filed for bankruptcy in December 2008.

Litigation is Filed

In November 2010, the debtor’s Official Committee of Unsecured Creditors brought an intentional fraudulent conveyance action against Tribune’s shareholders and other parties alleged to have benefited from the LBO.4 The Official Committee alleged that Tribune entered into the LBO with an “actual intent to hinder, delay, or defraud” Tribune creditors.5

In early 2011, two groups of creditors – certain Tribune retirees and certain Tribune noteholders (collectively, Creditors) – sought, and received, permission from the Bankruptcy Court to prosecute the state law fraudulent conveyance claims that the Official Committee was not pursuing. The Bankruptcy Court also held that the automatic stay imposed by the Bankruptcy Code would be lifted so that the Creditors could file their complaints. For its part, the Official Committee encouraged the Creditors to bring their state law claims.

In June 2011, the Creditors filed lawsuits asserting state law constructive fraudulent conveyance claims throughout the country. Unlike the intentional fraudulent conveyance claims asserted by the Official Committee, the Creditors’ constructive fraudulent conveyance claims were based on the theory that the shareholders obtained the proceeds of the LBO for less than reasonably equivalent value and that Tribune was rendered insolvent by the LBO.6

The Official Committee’s and the Creditors’ lawsuits were consolidated and transferred to the Southern District of New York.7 After consolidation, the Southern District of New York appointed an Executive Committee of Defense Counsel to serve as the liaison between the thousands of defendants and the Court and plaintiffs. Michael Doluisio of Dechert served as an Executive Committee member for mutual fund defendants.

The District Court’s Decision

The Tribune shareholders moved to dismiss the Creditors’ state law claims on two grounds. First, the shareholders argued that the claims were preempted by Section 546(e), which bars a bankruptcy trustee from asserting constructive fraudulent conveyance claims that seek to unwind “settlement payments,” such as shareholder payments in connection with an LBO.8 Second, the shareholders argued that, because the Official Committee (now acting through a Litigation Trust) was pursuing intentional fraudulent conveyance claims, the Creditors lacked standing to bring their largely duplicative claims.9

Judge Richard J. Sullivan granted the motion to dismiss. Significantly, however, Judge Sullivan based his decision on the Creditors’ lack of standing, and not on preemption. With regard to the issue of preemption, Judge Sullivan rejected the shareholders’ argument, explaining that Section 546(e) only precluded claims asserted by a bankruptcy trustee; it did not apply to claims brought under state law by individual creditors.10 Both sides appealed to the Second Circuit.

The Second Circuit Decision

In a unanimous decision relying on both the plain language of the Bankruptcy Code and the turmoil that the Creditors’ claims would create, the Second Circuit held that: (1) the Creditors had standing to bring their claims, but (2) the claims were preempted by Section 546(e). Specifically, the Court held that the Creditors’ claims were preempted under principles of conflict preemption because Congress’ goal of protecting the securities markets from disruption would be thwarted if the Creditors’ claims could proceed.11

Standing

In holding that the Creditors had standing to bring their claims, the Second Circuit relied heavily on the particular facts of the Tribune bankruptcy case. For instance, the Court noted that the Bankruptcy Court had expressly allowed the Creditors to bring their claims. The Second Circuit’s reliance on the particular facts of the case suggests that this portion of its decision will not have a wide-ranging impact.

Preemption

On the other hand, the Second Circuit’s holding with respect to Section 546(e) should have a huge impact going forward, as it should preclude creditors from bringing state law constructive fraudulent conveyance claims against shareholders following an LBO or similar transaction.

First, the Court explained that, unlike in areas traditionally governed solely by state law, there was no need to presume that Congress did not intend for Section 546(e) to preempt constructive fraudulent conveyance claims.12 The Court explained that “the regulation of creditors’ rights has ‘a history of significant federal presence’” and that “once a party enters bankruptcy, the Bankruptcy Code constitutes a wholesale preemption of state laws regarding creditors’ rights.”13 Thus, preemption here did not involve any “measurable concern about federal intrusion into traditional state domains.”14

Next, the Court explained that the Creditors’ core theory (i.e., Section 546(e)’s use of the word “trustee” meant that it did not apply to creditors’ claims) raised “ambiguities, anomalies, or conflicts with the purposes of the Code.”15 For example, the Court explained that the Creditors’ theory, which would allow for individual creditors to file claims throughout the country, directly contravened the intent of Section 544 of the Bankruptcy Code to “simplify proceedings, reduce the costs of marshalling the debtor’s assets, and assure an equitable distribution among the creditors.”16 The Court also explained that the Creditors’ theory would make it nearly impossible for a trustee in bankruptcy to settle claims with shareholders, because the shareholders would not be able to protect themselves via the settlement from claims by individual creditors.

Finally, and most significantly, the Court explained that “every congressional purpose reflected in Section 546(e) ... is in conflict with [the Creditors’] legal theory.”17 The Court explained that Section 546(e) was intended to protect settled securities transactions from disruption and that this protection is “essential to securities markets.”18 The Court specifically recognized the harm that the Creditors’ claims would cause mutual funds and other investors, writing:

A lack of protection against the unwinding of securities transactions would create substantial deterrents, limited only by the copious imaginations of able lawyers, to investing in the securities market.... For example, all investors in public companies would face new and substantial risks, if [the Creditors’] theory is adopted.... The risks are not confined to the consummation of securities transactions. Pension plans, mutual funds, and similar institutional investors would find securities markets far more risky if exposed to substantial liabilities derived from investments in securities sold long ago.

Therefore, because Congress’ purpose in enacting Section 546(e) would be thwarted if the Creditors’ claims proceeded, the claims were preempted.

Impact

The Second Circuit’s Tribune decision is a significant victory for the former Tribune shareholders. The decision should put an end to the efforts of creditors’ representatives to claw back payments to former shareholders in LBOs and similar transactions through state law constructive fraudulent conveyance claims. The Court’s observations about the havoc that these sorts of claims would wreak on the United States’ financial markets is persuasive and likely to be followed by other courts faced with similar claims.