In what appears to be a matter of first impression, Bankruptcy Judge Robert D. Drain, United States Bankruptcy Court for the Southern District of New York, has held that a statutory safe harbor against constructive fraudulent conveyance actions under the Bankruptcy Code involving securities transfers does not apply to the private sale of securities, even when there are no allegations of illegal conduct or fraud involved in the underlying transaction. See Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.) , Case No. 08-23660 (RDD), Adv. Pro. No. 09-8266 (RDD) (Bankr. S.D.N.Y. Apr. 21, 2011). MacMenamin’s Grill represents an important decision from the influential Southern District of New York that conflicts with precedent in the Third Circuit, which includes the equally influential District of Delaware — a split in authority that could prove critical to bankruptcy practitioners in the future.

Factual and Procedural History

The facts underlying Judge Drain’s decision are relatively simple. MacMenamin’s Grill (the Debtor) filed for chapter 11 relief under the Bankruptcy Code on November 18, 2008. A chapter 11 trustee (the Trustee) was appointed on March 12, 2009. Squire, Sanders & Dempsey (US) LLP represents the Trustee.

The Debtor had three non-insider shareholders (the Shareholders), each of whom owned approximately 31 percent of the Debtor’s stock. In July 2007, the Shareholders sold their stock to the Debtor for approximately US$1.15 million in what Judge Drain described as "a classic LBO, although writ small." The stock purchase was financed through a loan (the Loan) that was secured by a lien (the Lien) on substantially all of the Debtor’s assets and guaranteed by the Small Business Administration (SBA). The stock transaction was consummated on August 31, 2007 through wire transfers (the Transfers) by TD Bank, N.A. (the Lender) of approximately pro-rata portions of the loan proceeds, net of fees, directly to the Shareholders’ bank accounts.

On or about July 15, 2009, the Trustee commenced an adversary proceeding against the Shareholders and the Lender seeking to avoid and recover the Transfers, the Loan and the Lien as constructive fraudulent transfers pursuant to sections 544(b) and 548(a)(1)(B) of the Bankruptcy Code and sections 273, 275 and 278 of the New York Debtor and Creditor Law. The Trustee did not assert that any actual fraud had occurred in the transaction.

The Shareholders and the Lender each moved for summary judgment, arguing that the entire transaction in question fell within the safe harbor for securities transactions provided under section 546(e) of the Bankruptcy Code. Judge Drain decided to bifurcate the proceeding, first addressing the issue of the "safe harbor" under section 546(e) and then addressing solvency and reasonably equivalent value if necessary. Thus, for purposes of determining the application of section 546(e), the parties stipulated that the Debtor was insolvent and had not received fair consideration or reasonably equivalent value for the Transfers, the Loan or the Lien.

Bankruptcy Court’s Analysis and Application of 11 U.S.C. Section 546(e)

Judge Drain began with a brief discussion of the relevant statutory provisions. Section 546(e) of the Bankruptcy Code provides that:

Notwithstanding sections 544, 545, 547, 548 (a)(1)(B), and 548 (b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548 (a)(1)(A) of this title.

Section 741(8) of the Bankruptcy Code defines a "settlement payment" 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.

Section 101(22) of the Bankruptcy Code defines a "financial institution" as, among other things, "an entity that is a commercial or savings bank [or a] federally-insured credit union." Section 741(7) of the Bankruptcy Code defines a "securities contract" as, among other things, "a contract for the purchase . . . of a security," 11 U.S.C. section 741(7)(A)(i), and section 101(49)(A)(ii) of the Bankruptcy Code defines a "security" to include "stock," without reference to whether such stock is publicly traded. However, the Trustee appeared to acknowledge that any payment to purchase stock, including through a private sale, could be viewed as a "settlement payment" and that an agreement to purchase stock may be viewed as a "securities contract."

The parties generally did not dispute that the Lender and the Shareholders’ banks constituted "financial institutions" or that the stock purchased constituted "securities." The parties also agreed that the definition of "settlement payment" under the Bankruptcy Code was "frustratingly self-referential."

The Shareholders argued that the Transfers — the payment of the loan proceeds from the Lender into the Shareholders’ bank accounts in return for the sale of the Shareholders’ stock — fell within the plain meaning of the section 546(e) safe harbor in two ways, both (i) as a settlement payment made to a financial institution and (ii) as a transfer between financial institutions in connection with a securities contract.

Judge Drain began by observing that many courts have disagreed with the view that section 546(e) necessarily exempts private stock transactions from avoidance as a constructive fraudulent transfer, including two from within the Second Circuit. See Jackson v. Mishkin (In re Adler, Coleman Clearing Corp.), 263 B.R. 406, 478-80 (S.D.N.Y. 2001) and Official Comm. of Unsecured Creditors v. Lattman (In re Norstan Apparel Shops, Inc.), 367 B.R. 68, 76-77 (Bankr. E.D.N.Y. 2007). According to Judge Drain, these courts generally agreed that extending the 546(e) safe harbor to private securities transactions had nothing to do with the legislative intent underlying the safe harbor, which is "reducing systemic risk to the financial markets." In other words, the section 546(e) safe harbor was intended to prevent the domino effect that could occur as a result of a major bankruptcy and the avoidance of securities transactions due to the interconnectedness of those within the securities industry.

However, Judge Drain also noted that several other courts, including those courts of appeal to have considered the question — including the Third Circuit — have held that, based on the statute’s "plain meaning," section 546(e) applies to payments by or to a financial institution or stockbroker for privately traded securities in LBOs, including to insiders. See Brandt v. B.A. Capital Co., LP (In re Plassein Int’l Corp.), 590 F.3d 252, 258-59 (3d Cir. 2010) cert. denied 130 S. Ct. 2389 (2010); In re QSI Holdings v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545, 550-51 (6th Cir. 2009) cert. denied 130 S. Ct. 1141 (2010); and Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 987-88 (8th Cir. 2009) (additional citations omitted).

Judge Drain observed that the language of the safe harbor provision itself is linked to the securities markets, given that it relies on key definitional cross references to sections 741 and 761 of the Bankruptcy Code, which apply exclusively to stockbroker and commodity broker liquidations. This context, and section 741(8)’s reference to the "securities trade," suggested to Judge Drain that Congress intended to limit the safe harbor to the business of engaging in securities transfers in securities markets. Moreover, as recognized by other courts, applying the safe harbor to transactions such as that between the Debtor and the Shareholders "is so far removed from achieving Congress’ professed intent to protect the financial markets that it would be absurd to apply section 546(e) to the [t]rustee’s well established and important avoidance powers under sections 544 and 548(a)(1)(B) and (b) of the Bankruptcy Code."

Judge Drain acknowledged, however, that application of the safe harbor may be implicitly tied to the value of the securities transaction being challenged and the number of shareholders involved. Compare In re Norstan Apparel Shops, Inc., 367 B.R. at 73, 76-77 (holding that transfer of approximately US$71 million to just five shareholders of a closely held company did not fall within the safe harbor) with In re QSI Holdings, Inc., 571 F.3d at 548, 550 (holding that the safe harbor applied in a case involving US$208 million and hundreds of shareholders, which result may have been consistent with Norstan had similar facts been presented).

Judge Drain also noted that several cases from within the Second Circuit have held that the 546(e) safe harbor does not apply to transactions that involved illegal conduct. See Jackson v. Mishkin; Alfa, S.A.B. de C.V. v. Enron Creditors Recovery Corp., 422 B.R. 423, 433-34 (S.D.N.Y. 2009); and Picard v. Merkin (In re Bernard L. Madoff Inv. Sec. LLC), 440 B.R. 243, 267-68 (Bankr. S.D.N.Y. 2010). Here, however, there were no allegations of illegal conduct or, for that matter, actual fraud.

Ultimately, Judge Drain found that applying the section 546(e) safe harbor to the facts before him would give rise to an absurd result contrary to Congress’ intent that the provision apply to transactions occurring within the securities markets or the avoidance of which would pose a danger to the functioning of the securities market. As a result, Judge Drain held that the section 546(e) safe harbor did not apply to either the Shareholders or the Lender.

With regard to the Lender, Judge Drain also found that the safe harbor did not apply to allow avoidance of the Loan or the Lien held by the Lender as a matter of statutory interpretation. Section 546(e) refers exclusively to "transfers" that are exempt from the Trustee’s avoidance powers. However, sections 544(a) and 548(a)(1) of the Bankruptcy Code allow the Trustee to avoid both transfers and "any obligation incurred by the debtor." Judge Drain found the distinction between a transfer and the incurrence of an obligation sufficient to exclude the incurrence of the loan obligation by the Debtor from the section 546(e) safe harbor. Judge Drain also noted that Congress knew how to exempt both transfers and the incurrence of obligations from avoidance under section 548, as evidenced by section 548(c), which excludes both transfers and obligations incurred in good faith. Judge Drain also rejected the Lender’s attempt to rely on regulations promulgated by the SBA that purport to preclude the avoidance of a loan and security interest guaranteed by the SBA, concluding that that regulation applies only to non-bankruptcy avoidance provisions and does not trump federal bankruptcy law.


The importance of the MacMenamin’s Grill decision, if upheld, will likely be determined through subsequent application or distinction in cases involving larger transfer amounts or more shareholders. However, counsel for both shareholders and their financially challenged companies need to be aware of the possibility that the section 546(e) safe harbor may not provide them with refuge if the company is venued in the Southern District of New York. Trustees and creditors, on the other hand, now have another weapon in their arsenal when attempting to unwind or mitigate the consequences of unsuccessful leveraged buyout transactions.

Equally important to practitioners, the MacMenamin’s Grill decision is in direct contradiction with controlling authority in the Third Circuit, which holds that the section 546(e) safe harbor applies, even in the case of private securities acquired from a small number of shareholders of a closely held corporation. See In re Plassein Int'l Corp., 590 F.3d at 259 (applying Lowenschuss v. Resorts Int'l, Inc. (In re Resorts Int'l, Inc.), 181 F.3d 505, 509 (3d Cir. 1999)). This conflict in authority presents another consideration that must be vetted before any bankruptcy filing where venue is proper in either Delaware or New York.