A recent New York bankruptcy case holds that the Bankruptcy Code's limitations on using avoidance actions to undo securities transactions did not apply where the underlying transactions did not implicate the public securities market. A debtor or bankruptcy trustee has the power and obligation to recover transfers made by the debtor, prior to the commencement of the bankruptcy case, that were either actually or constructively fraudulent. There are, however, certain enumerated limitations to this power. One such limitation was analyzed in the leveraged buyout context by Judge Robert Drain, presiding in the United States Bankruptcy Court for the Southern District of New York. Bankruptcy Code section 546(e) provides a "safe harbor" for certain transfers relating to the purchase and sale of securities. These securities-related transfers are insulated from avoidance as constructive (but not actual) fraudulent transfers under the Bankruptcy Code or state law, or as preferential transfers under the Bankruptcy Code. The law typically protects "margin payments" and "settlement payments" made in connection with a securities contract, including those made by, or to or for the benefit of, stockbrokers, financial institutions, financial participants, commodity brokers, forward contract merchants, or securities clearing agencies.

In the case of In re MacMenamin's Grill, Ltd., Judge Drain limited the "safe-harbor" provision to instances of potential impact to the public securities market, concluding that section 546(e) was not intended to apply to a private leveraged buyout transaction that had no risk of affecting the stability of the financial markets.


MacMenamin's Grill Ltd. (the "Debtor") was a bar and grill located in New Rochelle, New York, owned by three individuals (the "Shareholders"). Each Shareholder owned 31% of the issued and outstanding common stock. The Shareholders engaged in a leveraged buyout transaction, pursuant to which the Debtor procured a $1.15 million loan from Commerce Bank (including its successor in interest TD Bank) (the "Lender") to fund the purchase of the Shareholders' stock. Upon closing, the funds were transferred to the Shareholders' respective bank accounts, with the Debtor granting the Lender a security interest in substantially all of its assets.

MacMenamin's subsequently filed for bankruptcy. The appointed trustee commenced an avoidance action arguing that the leveraged buyout saddled the bar and grill with all of the debt, while the Shareholders reaped the benefit of the proceeds. The lawsuit against the Lender and the Shareholders sought to recover the transfers of cash to the Shareholders and to nullify the security interest given to the Lender. Judge Drain analyzed whether the section 546(e) "safe harbor" would shield a leveraged buyout transaction from a trustee's avoidance powers where public markets were not implicated or affected.

The parties agreed that the Lender and the Shareholders' banks were "financial institutions," that the stock in the Debtor constituted "securities" and that a payment to purchase stock, including stock that is not publicly traded, may be viewed as a "settlement payment." The parties also agreed the Debtor did not receive fair consideration or reasonably equivalent value (i) for the payments to the Shareholders; (ii) for the incurrence of the loan; (iii) the grant of the security interest to the Lender; and (iv) that the Debtor was insolvent or rendered insolvent upon incurring the obligations under the loan. Essentially, the defendants stipulated that the subject transfers and obligations resulted in constructively fraudulent conveyances. The defendants' position, however, was that the transfer of funds under the leveraged buyout was exempted as it constituted either a "settlement payment" made by and to a "financial institution" or that each payment was a transfer by a financial institution in connection with a "securities contract."


Judge Drain held that the section 546(e) "safe harbor" did not apply. The court found that neither the Lender nor the Shareholders provided any evidence that the avoidance of the transaction at issue involved any entity in its capacity as a participant in any securities market, or that the avoidance of the transactions at issue pose any danger to the securities market. The Congressional intent and policy behind section 546(e) is to minimize the displacement caused in the securities market in the event of a major bankruptcy, and to prevent the ripple effect created by institutional insolvency. As the court explained, that policy is not furthered in any meaningful sense by bringing a leveraged buyout under the section 546(e) exemption simply because funds fortuitously passed through financial institutions on their way into the hands of the defendants. Although Judge Drain reasoned that section 546(e) was inapplicable to the transfers involving both the Lender and the Shareholders, he determined another ground for denying the Lender protection under the provision: the plain language of section 546(e) exempts only transfers made, and not obligations incurred.


Judge Drain recognized that courts have been inconsistent in their interpretation and application of the section 546(e) "safe harbor." Some courts interpret section 546(e) perhaps more narrowly than Judge Drain, finding that securities transactions involving a "mere intermediary" financial institution or stockbroker without a beneficial interest in the transferred asset were not intended to be guarded by the "safe harbor." Other courts take a broad approach, finding that the provision insulates payments by or to a financial institution or stockbroker for privately traded securities in leveraged buyouts, including to insiders, as well as to publicly traded companies. Ultimately, structuring a merger transaction or a leveraged buyout and expecting the benefit of section 546(e) protection is not a certainty in some jurisdictions, and the law is still developing.

Investors, shareholders, directors, officers and lenders should be aware of potential bankruptcy implications -- and "safe harbors" -- surrounding the purchase and sale of securities. While bankruptcy avoidance statutes can avoid fraudulent or preferential transfers, analysis of the transaction prior to closing can help insure that the exchange complies with all necessary regulations. The structuring of most merger, acquisition or buyout transactions requires the advice and assistance of restructuring counsel to assess the potential risks to all parties to the transaction that may arise if the target entity becomes insolvent post closing.