On December 19, 2019, the Second Circuit held that appellants’ state law constructive fraudulent transfer claims were preempted by virtue of the Bankruptcy Code’s safe harbors that exempt transfers made in connection with a contract for the purchase, sale or loan of a security from being clawed back into the bankruptcy estate for distribution to creditors. The Second Circuit had previously reached this same conclusion in a 2016 opinion, but its basis for holding that the transfers were preempted—namely, because entities covered by section 546(e) of the Bankruptcy Code had served as intermediaries in the transaction at issue—was determined to be foreclosed as a result of the Supreme Court’s holding in Merit Management, which held that section 546(e) does not protect transfers in which financial institutions served as mere conduits. The Second Circuit, in an amended opinion, found that Tribune was a financial institution—and therefore covered by the section 546(e) safe harbor—because Tribune was a customer of Computershare Trust Company, and Computershare was Tribune’s agent, in the LBO transaction.

Background

In a March 2016 decision, the Court of Appeals for the Second Circuit held that creditors are preempted from asserting state law constructive fraudulent conveyance claims by virtue of the Bankruptcy Code’s “safe harbors” that, among other things, exempt transfers made in connection with a contract for the purchase, sale or loan of a security (in the case of Tribune, in the context of an LBO), from being clawed back into the bankruptcy estate for distribution to creditors. We discussed the factual background of Tribune in detail in a client alert, Making the Safe Harbors Safe Again. The Court of Appeals had addressed two issues: first, whether the Appellants (which included the litigation trust as well as the unsecured creditors who moved to prosecute their own state law constructive fraudulent conveyance claims) were barred by the automatic stay from bringing state law constructive fraudulent conveyance claims while avoidance claims by the litigation trustee are ongoing; and if not, whether such claims were preempted by the safe harbor of section 546(e) of the Bankruptcy Code.

At the time of the 2016 decision, it was law in the Second Circuit that the payments at issue fell within section 546(e) because entities covered by section 546(e) had served as intermediaries. Appellant had petitioned for certiorari, asking whether the Court of Appeals had correctly held that a fraudulent transfer is exempt under section 546(e) when a financial institution acts as a mere conduit for fraudulently transferred property. While that petition was pending, the Supreme Court held in Merit Management that section 546(e) does not protect transfers in which financial institutions served as mere conduits (for more on that decision, you can revisit our client alert on the topic, Not So Safe: The Supreme Court Clarifies the Scope of the Bankruptcy Code’s Section 546(e) Safe Harbor Provision). Instead, the Supreme Court concluded in Merit that, for purposes of determining whether the safe harbor in 546(e) applies to shield a transfer from an avoidance action, the only relevant transfer is the transfer to the end recipient, and not whether the transfer was executed through one or more financial intermediaries. Thereafter, Appellants filed a motion to recall the mandate, which was recalled in anticipation of further panel review. The Court of Appeals agreed on changes to its prior opinion, which changes are discussed below, and vacated the original opinion.

Amended Opinion

The Court of Appeals framed the threshold question as whether, in the aftermath of Merit, Tribune’s payments to shareholders remain subject to section 546(e). Under Merit, the payments can be subject to section 546(e) only if (i) Tribune, which made the payments, was a covered entity, or (2) the shareholders, who ultimately received the payments, were covered entities. Section 546(e) provides, in part, that the trustee may not avoid a transfer made by a financial institution in connection with a securities contract. The Bankruptcy Code defines “financial institution” to include an entity that is a commercial or savings bank or trust company, and, when any such entity is acting as agent or custodian for a customer, such customer. The Court of Appeals found that Computershare is a “financial institution” for the purposes of section 546(e) because it is a trust company and a bank. Therefore, the Court of Appeals stated that Tribune likewise was a “financial institution” with respect to the LBO transaction if Tribune was Computershare’s customer, and Computershare was acting as Tribune’s agent.

The Court of Appeals found that those customer and agency criteria were met. In its role as Depositary, Computershare performed multiple services for Tribune (e.g., holding Tribune’s deposit of the purchase price for the shares, receiving and retaining the tendered shares on Tribune’s behalf, and paying the tendering shareholders). Given those facts, the Court of Appeals concluded that Tribune was Computershare’s customer with respect to the LBO payments. The Court of Appeals also found that Computershare was Tribune’s agent. Tribune manifested its intent to grant authority to Computershare by depositing the purchase price for the shares with Computershare and entrusting Computershare to pay the tendering shareholders. Computershare, in turn, manifested its assent by accepting the fund and effectuating the transaction. Moreover, Tribune maintained control over key aspects of the undertaking as the transaction proceeded. Therefore, the Court of Appeals found that Computershare was Tribune’s agent, thus rendering Tribune a “financial institution” and therefore a safe-harbored entity under section 546(e) with respect to the LBO payments.

The Court of Appeals then restated its conclusions from its 2016 opinion regarding the automatic stay, and held that Appellants were not barred by the automatic stay from bringing state law constructive fraudulent conveyance claims. First, the Bankruptcy Court had granted Appellants relief from the automatic stay with respect to the filing of such claims on numerous occasions, all with no objection by the Tribune shareholders. Moreover, the confirmed Plan expressly allowed Appellants to pursue any and all claims related to the LBO arising under state fraudulent conveyance law. As a result, if Appellants had actionable state law constructive fraudulent conveyance claims, assertion of such claims was not subject to the automatic stay.

Discussion

In Merit, the Supreme Court noted in a footnote that neither side argued that a party would qualify as a “financial institution” under section 101(22)(A) of the Bankruptcy Code by virtue of its status as a “customer.” As a result, the Supreme Court did not address what impact, if any, the Bankruptcy Code’s definition of “financial institution” would have in the application of the 546(e) safe harbor. The Court of Appeals’ amended opinion did address this argument and found that Tribune, as a customer of Computershare in the LBO transaction, was a financial institution and therefore covered by the section 546(e) safe harbor.

In its 2016 opinion, the Court of Appeals stated that allowing creditors to bring claims that a bankruptcy trustee would be barred from bringing under section 546(e), only after the trustee fails to exercise powers it does not have, would increase the risk of market disruption by lengthening the period of uncertainty for intermediaries and investors with respect to whether pre-bankruptcy transactions could be unwound. Moreover, the entire purpose of section 546(e) is to protect the national and heavily regulated financial markets from disruption by limiting creditors’ rights, an intentional and notable conflict with the Bankruptcy Code’s goal of maximizing the assets available to creditors. This decision protects these policy purposes in concluding that Appellants’ state law constructive fraudulent transfer claims are preempted by the safe harbors of section 546(e) of the Bankruptcy Code.