The U.S. Court of Appeals for the Second Circuit recently ruled that constructive fraudulent conveyance claims arising under state law are preempted by the U.S. Bankruptcy Code, 11 U.S.C. § 101 et seq. (Code), where the transfers were made by or to financial intermediaries effectuating settlement payments in securities transactions or made in connection with a securities contract, irrespective of whether the plaintiff is a debtor in possession, bankruptcy trustee or other creditors’ representative.

The provision at issue, Code § 546(e), states that a trustee may not avoid payments made in connection with securities transactions, with the exception of claims for intentional fraudulent conveyance.[1] In the case of In re: Tribune Company Fraudulent Conveyance Litigation, Docket Nos. 13-3992, 13-3875, 13-4178 and 13-4196 (2d Cir. Mar. 29, 2016), a group of unsecured creditors formed a litigation trust to bring state law-based constructive fraudulent conveyance claims, pursuant to Tribune’s confirmed plan of reorganization, seeking to avoid over $8 billion in payments made to Tribune Company shareholders as part of that company’s 2007 leveraged buyout. The U.S. District Court for the Southern District of New York denied the former shareholder defendants’ motion to dismiss insofar as it relied on the Code § 546(e) safe harbor for securities transactions, holding that the statute, by its plain language, applies only to trustees and not creditors acting on their own behalf. However, the district court granted the motion to dismiss on an unrelated standing issue.

The Second Circuit overruled the district court’s decision upon a de novo review.[2] After initially reversing on the standing issue, the court held that despite language in Code § 546(e) barring constructive fraudulent conveyance claims by the trustee, the statute’s preemptive effect implicitly extends to creditors as well. The court noted that federal law is preeminent in the bankruptcy context, and further that the legislative history of Code § 546(e) and its complete text demonstrate a clear objective to promote stability in securities markets. As such, state law claims such as those asserted by or on behalf of the creditors in Tribune would be an obstacle to the legislative purpose of Code § 546(e), and should be precluded. The court also noted that there would be no intrusion into traditional areas of state concern.

The Tribune appeal presented the Second Circuit with a matter of first impression at the appellate level, as only two district court decisions had previously ruled on this issue: the lower court in Tribune, 499 B.R. 310 (S.D.N.Y. 2013), and In re: Lyondell Chemical Company, 500 B.R. 348 (Bankr. S.D.N.Y. 2014) (which extensively cited the former decision). The use of state law constructive fraudulent conveyance claims to unwind securities transactions is a relatively novel litigation strategy devised by creditors hoping to find a loophole in the Code that allows a trustee to bring intentional fraudulent conveyance claims but prevents him or her from bringing any other type of claim to avoid securities transactions. The Second Circuit’s expansive reading of the safe harbor provision, however, decisively barred the creditors’ claims in Tribune.[3]

It is important to note that the Tribune decision applies only to the Code § 546(e) safe harbor, and does not affect all other types of clawback actions.[4] A trustee or debtor in possession may still bring claims of intentional fraudulent conveyance (which indeed are still pending in Tribune and Lyondell), and even state law-based claims may still be brought if securities transactions are not at issue. Regardless, the decision will have a substantial limiting impact on pending and future fraudulent conveyance actions, particularly in view of the more stringent pleading standards applicable to claims of intentional fraudulent conveyance.

Fraudulent conveyance claims may have a significant impact on parties to bankruptcy proceedings, entities pursuing business combinations regarding securities contracts and investors of all stripes who may later see their securities sale proceeds become the subject of a litigation claim, regardless of their level of involvement in the transaction. As creditors continue to explore the outer bounds and limits of fraudulent conveyance law, the strategies of litigants and the reactions of regulators and courts will continue to be closely monitored and reviewed.