In In re Elrod Holdings Corp.,1 the Bankruptcy Court for the District of Delaware recently considered whether section 546(e) of the Bankruptcy Code operates to protect prepetition transfers made in exchange for stock of a privately-held company, or is limited to transactions involving publicly traded securities. The Court found that payments for private securities are “settlement payments” within the meaning of the Bankruptcy Code, thus satisfying the criteria set forth in section 546(e) that limits a trustee’s avoidance power under section 548(a)(1)(B). The Court’s holding is consistent with its prior decisions and the Third Circuit’s position, but different from certain other jurisdictions’ holdings as discussed below.
Jack K. Elrod Company, Inc. (“JKE”) was a family-owned and operated company in the business of spectator seating arrangements, providing services such as design, fabrication, installation, maintenance and safety inspection. On April 15, 2005, the owners of JKE (the “Owners”) reached an agreement (the “Stock Purchase Agreement”) with Champlain Capital Partners, L.P. (“Champlain”) to sell their entire interest in JKE to Champlain. Pursuant to the Stock Purchase Agreement, Champlain formed Elrod Acquisitions Corp. (“Acquisitions”) as a wholly owned subsidiary of Elrod Holdings Corp. (“Holdings”) to acquire JKE. Three transfers were made on April 15, 2005 between Acquisitions and the Owners pursuant to the Stock Purchase Agreement: (i) approximately $18.2 million in cash was transferred by wire from Acquisitions to the Owners (the “2005 Wire Transfer”), (ii) $5.8 million of secured notes were delivered by Acquisitions to the Owners, and (iii) one-hundred percent of the JKE stock was transferred from the Owners to Acquisitions. Subsequently on August 19, 2006, JKE, the now wholly owned subsidiary of Holdings, made a $3.5 million cash wire transfer to the Owners in partial satisfaction of the $5.8 million secured notes (the “2006 Wire Transfer” and, collectively with the 2005 Wire Transfer, the “Wire Transfers”).
JKE and Holdings (collectively, the “Debtors”) filed for bankruptcy under chapter 7 of the Bankruptcy Code on October 16, 2006, resulting in the appointment of a chapter 7 trustee (the “Trustee”) for the Debtors’ estates. The Trustee filed an adversary proceeding against the Owners, alleging that the Wire Transfers were fraudulent transfers under section 548 of the Bankruptcy Code, and seeking the avoidance of the Wire Transfers under section 550 of the Bankruptcy Code. The Owners (and a company owned and operated by the Owners, which was a subsequent transferee of a portion of the Wire Transfers) filed a motion (the “Motion”) for partial summary judgment on the Trustee’s fraudulent transfer claims, on the ground that the Wire Transfers constitute “settlement payments” made by or to “financial institutions,” and section 546(e) of the Bankruptcy Code specifically prohibits the avoidance of such transfers.
The Trustee argued that the plain language and the legislative history of section 546(e) limit its application to payments made in exchange for publicly traded securities. Because JKE was a privately-owned company, the Trustee argued, the section 546(e) safe harbor for settlement payments was not applicable to these transfers. In rejecting the Trustee’s argument, the Court relied on the Third Circuit decision in In re Resorts Int’l Inc.2 and held that the term “settlement payment” is to be construed broadly to include almost all securities transactions.
The Trustee first argued that the plain language of section 546(e) supported his position that the 546(e) safe harbor provision should be limited to transfers made in exchange for publicly traded securities. Section 546(e) provides, in relevant part, that “the trustee may not avoid a transfer that is a . . . settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a . . . financial institution, . . . made before the commencement of the case.”3 Section 741(8) defines “settlement payment” as a preliminary, partial, interim, or final settlement payment, or a settlement payment on account, or “any other similar payment commonly used in the securities trade.”
In interpreting the definition of “settlement payment,” the Trustee argued that the generally accepted definition of “securities trade” only refers to the business of buying and selling publicly traded securities, because the term “trade” requires a “market” for such buying and selling. The Court found it a “leap in logic” to interpret the term “securities trade” to apply only to publicly traded securities, because there exists a robust market for non-publicly traded securities as well. In addition, the Court stated that the fact that the Owners had been able privately to market and sell their JKE stock further evidenced the existence of a market for nonpublicly traded securities.
The Trustee also argued that the legislative history of section 546(e) conveyed the lawmakers’ intent to apply the safe harbor only to transfers made in exchange for publicly traded securities. Specifically, the Trustee asserted that section 546(e) was enacted to avoid disruptions in the securities market, specifically in the settlement and clearance system and, therefore, does not apply to payments for privately traded securities where the settlement and clearance system is not implicated. The Court relied on the Third Circuit’s holding in Resorts Int’l, in which a corporation acquired through a leveraged buyout (“LBO”) sued to recover payment made for the LBO, arguing in part that the payment was avoidable as a fraudulent conveyance under section 548(a)(1)(B) of the Bankruptcy Code.
The Third Circuit first noted in Resorts Int’l that it had previously addressed the meaning of “settlement payment” under section 546(f), which is similar to section 546(e) except that it specifically applies in “repo” settings.4 In that prior case, the Third Circuit recognized that section 546 of the Bankruptcy Code lies at the intersection of two crucial national policies in bankruptcy and securities law, respectively of maximizing a debtor’s estate and of ensuring an uninterrupted securities trade. The Third Circuit still concluded that its extremely broad interpretation of the definition of “settlement payment” is consistent with Congress’s legislative intent and held that “a payment for shares during an LBO is obviously a common securities transaction” and, therefore, “also a settlement payment for the purposes of section 546(e).”5 The Court in Elrods followed the Third Circuit’s reasoning from Resorts Int’l and held that “the term ‘settlement payment’ is a broad one that includes almost all securities transactions,” that no clearing agency needs to be implicated to render a transfer a “settlement payment” and that section 546(e), therefore, “protects . . . transfers made to complete securities transactions regardless of whether the securities are publicly or nonpublicly traded.”6
Split in Circuits
The application of section 546(e) and the interpretation of the term “settlement payment” as defined in section 741(8) have not been consistent across courts in different jurisdictions. In 2007, although both the Delaware Bankruptcy Court and the District Court for the Western District of Michigan held that section 546(e) affords a safe harbor for LBO-related transfers involving securities that were not publicly traded,7 the Bankruptcy Court for the Eastern District of New York and the Bankruptcy Court for the Southern District of Florida held that LBO transfers that involved securities that were not publicly traded or conducted in a public securities market were not settlement payments within the meaning of the Bankruptcy Code and, therefore, were not protected from avoidance by section 546(e).8
The Bankruptcy Court for the Eastern District of New York articulated the rationale for the narrow approach to section 546(e) in its decision in In re Norstan Apparel Shops, Inc.9 That court first noted that Congress enacted section 546(e) to prevent the “ripple effect” created by an event of insolvency of one commodity or security firm from spreading to the wider commodities and securities markets. The court reasoned:
[i]f the term ‘settlement payment’ in § 546(e) is construed to encompass any payment made for securities, whether or not involving a public securities market, then any leverage[ d] buyout, if structured as a direct purchase of stock from the shareholders . . . would fall within § 546(e)’s safe harbor and thereby be immunized from avoidance under § 544 or § 548(a)(1)(B).10
The court concluded that this would be “an absurd result” “at odds with the expressed legislative intent” and “flies in the face of the extensive body of jurisprudence under which leveraged buyouts challenged under § 544 or § 548 have been analyzed for fairness and adequacy of consideration.”11 Therefore, the court held that the transfer made in exchange for the non-publicly traded securities in the LBO was not a “settlement payment” within the meaning of the Bankruptcy Code and that “‘[s]ecurities trade’ must be understood to mean transactions in the public markets.”12
The Elrod Court did not address the alternative approach taken by the Eastern District of New York in Norstan Apparel Shops. Instead, the Elrods Court relied solely on the holding of Resorts Int’l, noting that the Third Circuit decision is binding on the Court.
Section 546(e) of the Bankruptcy Code provides a powerful safe harbor for recipients of “settlement payments” in LBOs and other securities transactions. The decision in In re Elrod applies this protection to transactions involving securities that are not publicly traded. In doing so, the Court followed the rationale of the Third Circuit’s Resorts Int’l decision, and disregarded decisions from other jurisdictions that limit section 546(e) to publicly-traded securities. Parties engaged in LBOs may want to structure their transactions so as to fall within the scope of section 546(e), in case the company subsequently files for bankruptcy. Until the applicability of this provision to securities that are not publicly traded is resolved, however, the ability to use this provision to insulate shareholders who received funds in an LBO will depend on where the company files.