On January 24, 2013, we reported that the United States District Court for the Northern District of Illinois (the “District Court”) declined to apply a literal interpretation of the Bankruptcy Code safe harbor provision protecting “settlement payments” and transfers “in connection with a securities contract” from avoidance and, instead, relied upon equitable considerations to determine that cash distributions from an investment advisor or a future commission merchant to its customers from the proceeds of a sale of securities to a third-party buyer may be avoided in bankruptcy. On March 19, 2014, the United Stated Court of Appeals for the Seventh Circuit (the “Appellate Court”) reversed the District Court’s decision, opting to apply the Bankruptcy Code safe harbor provision literally and expansively to protect such cash distributions from avoidance.
The debtor was an investment management company that served as a discretionary investment advisor with respect to assets deposited with it by its customers. Customers deposited cash with the debtor and, in exchange, received a pro rata beneficial interest in securities held by the debtor. Immediately prior to filing for bankruptcy, the debtor sold securities beneficially owned by its customers to a third-party buyer and distributed a portion of the sale proceeds to select customers.
The liquidating trustee filed adversary proceedings against former customers of the debtor seeking, among other things, to avoid and recover the pre-petition cash distribution as an unlawful preference under section 547(b) of the Bankruptcy Code. Based upon equitable considerations, the District Court held that the pre-petition cash distribution from the debtor to its customers of proceeds from the sale of securities between the debtor and a third-party buyer are not protected from avoidance by the Bankruptcy Code safe harbor provisions. In the District Court’s view, the safe harbor was designed to protect the sale of securities from the debtor to the third-party buyer; it was not designed to protect the distribution of the sale proceeds to the debtor’s customers. The District Court believed that shielding the debtor’s cash distribution to select customers would create the very systemic risk that the safe harbor was deigned to alleviate because the apportionment of losses among customers in the event of an investment advisor bankruptcy would be impossible to predict.
APPELLATE COURT’S ANALYSIS
In broad terms, section 546(e) of the Bankruptcy Code provides that a trustee cannot avoid a transfer that is a margin payment or settlement payment made by or to a commodity broker or a transfer made by or to a commodity broker in connection with a securities contract. This section is meant to insulate legitimate securities and commodities transactions from avoidance because of the potential destabilizing effects that unwinding such transactions could have on the broader market. In the instant case, there was no dispute that the defendant customers were “commodity brokers.” The only disputed issues were whether the cash distribution was a “settlement payment” or was made “in connection with a securities contract.” The Appellate Court answered both questions in the affirmative. As a result, the safe harbor protections of section 546(e) apply, and the pre-petition cash distribution to customers cannot be avoided as a preferential transfer.
The Appellate Court found that the cash distribution qualified as a “settlement payment” under section 546(e) because the debtor’s customers were entitled to pro rata shares of the value of the securities in their investment portfolios and, regardless of how the debtor chose to fund customer redemptions, whether by selling securities from the portfolio or paying customers with cash on hand, the redemptions were intended to settle, at least partially, the customers’ securities accounts with the debtor. Similarly, the Appellate Court found that the cash distribution qualified as a transfer made “in connection with a securities contract” because the distribution was made in connection with the customers’ investment agreement, which constituted a contract for the purchase or sale of securities regardless of the fact that customers were entitled to cash rather than the securities themselves.
Although acknowledging the District Court’s equitable goal of a fair distribution to all customers, the Appellate Court determined that the District Court’s reasoning runs directly contrary to the broad language of section 546(e) of the Bankruptcy Code. The Appellate Court explained that, by enacting section 546(e), Congress chose finality over equity for most pre-petition transfers in the securities industry. The safe harbor reflects Congress’s policy judgment that allowing some otherwise avoidable pre-petition transfers in the securities industry to stand is preferable to the uncertainty caused by putting every settlement payment made in the 90 days prior to bankruptcy at risk of being unwound by a bankruptcy court.
The case may be found here.