A Western District of New York bankruptcy court has held that the safe harbor provisions of section 546(e) of the Bankruptcy Code apply to leveraged buy-outs of privately held securities. See Cyganowski v. Lapides (In re Batavia Nursing Home, LLC), No. 12-1145 (Bankr. W.D.N.Y. July 29, 2013). This holding conflicts with a prior case from a Southern District of New York bankruptcy court, which held that a leveraged buy-out of privately held stock would not be protected by this safe harbor provision unless there is evidence that unwinding the particular transaction would have an adverse effect on the financial markets. See Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.), 450 B.R. 414 (Bankr. S.D.N.Y. 2011).
In relevant part, section 546(e) of the Bankruptcy Code exempts “settlement payments” made by or to certain parties1 in connection with a “securities contract” from avoidance and recovery except in cases of actual fraud.
Background of Batavia Nursing Home
Defendant Jeffrey Lapides had been a 50-percent owner of Batavia Nursing Home LLC (BNH), Geriatric Realty Corp. (GRC) and four other entities. In June 2008, Lapides, the co-owner and each of these entities entered into a leveraged buy-out transaction whereby Lapides’ ownership interests in six of the entities (including BNH and GRC) were acquired or redeemed by the entities, and Lapides acquired all of the co-owner’s interests in the seventh. Part of the financing for this transaction came from Fifth Third Bank, which paid off an existing loan to BNH and GRC and a portion of Lapides’ consideration.
In July 2010, BNH and GRC defaulted under the terms of their loan facility with Fifth Third Bank and, in September 2011, filed for bankruptcy protection. In November 2012, the bankruptcy trustee filed a complaint seeking to avoid certain payments made to Lapides, including the payments made by Fifth Third Bank in connection with the leveraged buy-out. Lapides moved to dismiss the complaint with respect to the leveraged buy-out payments.
Batavia Nursing Home Decision
The Bankruptcy Code defines “securities contract,” in relevant part, as “a contract for the purchase, sale, or loan of a security.” 11 U.S.C. § 741(7)(A)(i). The term “security” includes stock and any “other claim or interest commonly known as ‘security.’” See id. § 101(49)(A). A “settlement payment” is “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.” Id. § 741(8).
The bankruptcy court granted Lapides’ motion to dismiss with respect to the leveraged buy-out payments because it found that Lapides was “situated precisely” as the defendants in AP Services LLP v. Silva, 483 B.R. 63 (S.D.N.Y. 2012). The court in that case held that section 546(e) protected payments made as part of a leveraged buy-out of privately held securities. See id. at 69. The Batavia Nursing Home court not only reached the same conclusion as the Silva court, it also adopted that court’s rejection of a plaintiff’s argument that section 546(e) should only apply where the avoidance of the transaction at issue would have an adverse effect on the financial markets. Both courts rejected making the protections of section 546(e) subject to an inquiry into whether unraveling the particular leveraged buy-out at issue would upset the financial markets, holding that such an inquiry would bring doubt into all such transactions. As the Batavia Nursing Home court put it, any such inquiry to undo “a particular LBO might possibly ‘disrupt’ the financial markets and cause the disruption that the statute sought to avoid.”
The Silva and Batavia Nursing Home holdings stand in contrast to the Southern District of New York bankruptcy court’s ruling in MacMenamin’s Grill. 450 B.R. at 425-26. Though that court appeared to acknowledge that leveraged buy-outs of privately held securities would be covered by the plain language of section 546(e), it noted that the Bankruptcy Code essentially defines “settlement payment” as “settlement payment.” The court found that this “frustratingly self-referential” definition created an ambiguity requiring it to look to the legislative history for guidance. The legislative history reveals that section 546(e) was enacted to prevent a domino effect in the financial markets whereby the insolvency of one firm could cause the collapse of another, which could in turn cause the collapse of another, and so on. See id. at 419-20. The court therefore chose not to apply the exemption despite section 546(e)’s plain language because “exempting transactions like the sale of the three Shareholders’ stock in their bar and grill from avoidance is so far removed from achieving Congress’ professed intent to protect the financial markets that it would be absurd to apply section 546(e) . . . .” Id. at 423.
As a leading bankruptcy treatise has noted, “there is much disagreement over whether section 546(e) applies to both public and nonpublic securities transactions . . . .” 5 Collier on Bankruptcy ¶ 546.06[b][i], at 546-53 (16th ed. rev’d 2012). As the conflict between the Batavia Nursing Home and MacMenamin’s Grill decisions show, even federal courts within New York state cannot agree. Until Congress or the Supreme Court settles the dispute, it is not safe to assume that leveraged buy-outs of privately held securities will be exempt from avoidance by a bankruptcy court.