Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.), Adv. Case. No. 09-8266, Bankr. Case No. 08-23660, 2011 WL 1549056 (Bankr. S.D.N.Y. Apr. 21, 2011)
Before filing for bankruptcy, the debtor obtained a secured loan for purposes of a leveraged buyout transaction, where the loan proceeds went directly to the bank accounts of three individual shareholders of the debtor as payment by the debtor for those individuals’ stock. In the bankruptcy case, the chapter 11 trustee sought to (1) avoid the debtor’s transfer of the loan proceeds, incurrence of its loan obligation to the lender, and grant of security interests to the lender, and (2) recover the transfers or the value thereof. While the transfers were avoidable as constructively fraudulent, the shareholders and lender contended that the transfers were protected by the safe harbor provisions of section 546(e) of the Bankruptcy Code, which excepts from avoidance transfers that are settlement payments by or to a financial institution, as well as payments made by or to a financial institution in connection with a securities contract.
After engaging in a thorough analysis of the legislative history and the divergent case law, the court concluded that the transfers did not involve any entity in its capacity as a securities market participant, the avoidance of the transfers did not pose any danger to the functioning of any securities market, and the incurrence of a loan obligation is not a transfer described in 546(e). The Bankruptcy Court, therefore, held that the transfers did not fall within the safe harbor provisions of section 546(e), and thus were subject to avoidance.
Mooney, Hantho, and Clark each owned 31 percent of the issued and outstanding stock of MacMenamin’s Grill, a bar and restaurant. On August 31, 2007, pursuant to a Stock Purchase Agreement, the shareholders sold their shares to MacMenamin’s. To fund the purchase, MacMenamin’s entered into a Loan and Security Agreement with TD Bank, borrowing $1.15 million. As security for the loan, MacMenamin’s gave the lender a security interest in substantially all of its assets. The closing of the loan and security agreement occurred on August 31, 2007, at which time the lender disbursed the loan proceeds directly to each shareholder’s bank account, and the shareholders delivered the stock to MacMenamin’s. The Bankruptcy Court described this as “a classic LBO, although writ small.”
MacMenamin’s filed a chapter 11 bankruptcy petition on November 18, 2008. In the bankruptcy case, the chapter 11 trustee sought to (1) avoid the debtor’s transfer of the loan proceeds, incurrence of its loan obligation to the lender, and grant of security interests to the lender and (2) recover the transfers or the value thereof. All parties agreed that the transfers at issue were avoidable as constructively fraudulent transfers, agreeing that the debtor did not receive fair consideration or reasonably equivalent value for the payments, incurrence of the loan, or grant of the security interest, and the debtor was insolvent at the time of or became insolvent as a result of the transfers. The shareholders and lender argued, however, that section 546(e) protected the transfers from avoidance by the trustee.
Section 546(e) provides: “… the trustee may not avoid a transfer that is a…settlement payment as defined in section…741 of this title, made by or to…a…financial institution…or that is a transfer made by or to…a… financial institution…in connection with a securities contract, as defined in section 741(7)….” A “settlement payment” is defined 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.” “Securities contract” is defined as, among other things, “a contract for the purchase…of a security.” “Security” is defined to include stock, without specifying whether the stock must be publicly traded.
The parties did not seriously dispute that the transfers of the loan proceeds were “settlement payments” made “by and to financial institutions” in connection with a “securities contract.” The shareholders, citing favorable case law, thus argued that those transfers clearly fell within the plain language of section 546(e), both as settlement payments made by and to financial institutions, and as transfers between financial institutions in connection with a securities contract. Citing legislative history and favorable case law, the trustee argued that section 546(e) does not exempt private stock transactions like this one from avoidance as constructive fraudulent transfers, and even more so when such transfers are void ab initio or per se illegal under applicable law.
Relying heavily on the legislative history, the Bankruptcy Court found that applying the plain language of section 546(e) under the facts of this case would produce a result far removed from Congress’ intent in enacting section 546(e) and, thus, concurred with the cases cited by the trustee. Those cases “note that granting a safe harbor to a constructively fraudulent private stock sale has little if anything to do with Congress’ stated purpose in enacting section 546(e): reducing systemic risk to the financial markets.” The court added that Congress enacted this section “to minimize the displacement caused in the commodities and securities markets in the event [of] a major bankruptcy affecting those industries” and to prevent a “ripple effect” that may occur as a result of such a bankruptcy. In other words, by enacting section 546(e), Congress sought to protect the financial industry’s clearance and settlement system, and that interest was not served by applying the safe harbor to a small, private transaction like the instant transaction. Thus, following those cases, the Bankruptcy Court held that, despite the plain language of section 546(e), the safe harbor did not apply to the transfers of the loan proceeds because they did not involve a securities market participant, and their avoidance would not pose any danger to the functioning of a securities market. While the Bankruptcy Court also entertained the trustee’s argument that transfers either void ab initio or per se illegal are also excepted from the safe harbors of section 546(e), the court held that the subject transfers were neither void ab initio nor per se illegal under New York corporate and criminal law.
Similar to the shareholders, the lender argued that section 546(e) protected the incurrence of the loan obligation and grant of security interests from avoidance. The Bankruptcy Court rejected the argument for the same reasons it rejected the shareholders’ argument, and went on to hold that the incurrence of a loan obligation is not a transfer described in section 546(e). The court explained that section 546(e) uses the word “transfer” and not “incurrence of an obligation.” Sections 544(a) and 548(a)(1), however, give the trustee the power to avoid any “transfer” of property by the debtor and any “obligation incurred” by the debtor. Thus, the court concluded that the lender had no basis on which to argue that the incurrence of the loan obligation was even contemplated to be protected from avoidance under the safe harbors provided by section 546(e). Thus, the trustee could, subject to certain other defenses available to the lender, reduce “dollar for dollar” the lender’s claims against the estate.
The Bankruptcy Court, therefore, held that the subject transfers did not fall within the safe harbor provisions of section 546(e) and were subject to avoidance.
Secured lending for purposes of leveraged buyouts has long been an area where lenders must tread cautiously. This case is a reminder of that fact and calls attention to the divergent case law in this area. In many instances, lenders will benefit from the advice of counsel before financing a leveraged buyout (or any transaction that could be construed as a leveraged buyout).