In a decision with potentially broad implications, the U.S. Court of Appeals for the Sixth Circuit recently determined that payments made to former shareholders of a privately held company in a leveraged buyout transaction are protected as "settlement payments" pursuant to section 546(e) of the Bankruptcy Code.

In QSI Holdings, Inc. v. Alford (In re: QSI Holdings, Inc.), Adv. No. 08-1176, 2009 WL 1905237 (6th Cir. July 6, 2009), the court found that the payments to shareholders could not be recovered in a subsequent bankruptcy proceeding because they constituted "settlement payments" under the plain language of section 546(e), and that this provision was not limited to transactions involving publicly traded securities, but also extended to privately held securities transactions.

The case arose from the leveraged buyout of Quality Stores, Inc. ("QSI"), a privately held company, through a merger with Central Tractor Farm and Country, Inc. Under the transaction, QSI's 170 shareholders were paid in either cash or stock in the surviving entity, with the total value exchanged exceeding $200 million. The transactions were accomplished through HSBC Bank USA acting as exchange agent to collect the stock from individual shareholders, and distribute cash payments or new stock to them in return.

Some of QSI's stock had been held in an Employee Stock Ownership Trust ("ESOT"). For these shares, the settlement process also involved the ESOT trustee, LaSalle Bank.

Post-Merger Bankruptcy

Two years after the merger, the surviving entity, which had changed its name to Quality Stores, Inc., fell on hard times. Creditors filed an involuntary bankruptcy against it in late 2001, and QSI ended up in a chapter 11 proceeding. In its capacity as debtor in possession, QSI thereafter filed a fraudulent conveyance action against the former shareholders alleging that the stock tendered for cash payments represented less than reasonably equivalent value in return, and that the LBO transaction left the company with unreasonably small capital and caused it to incur debts greater than its ability to pay.

In response, the former shareholders filed a motion for summary judgment on the basis that the cash they received constituted "settlement payments" made by a financial institution, and were therefore exempt from avoidance.

The bankruptcy court agreed, concluding that these payments fell within the section 546(e) exemption. On appeal, the district court affirmed the bankruptcy court's decision.

The debtor further appealed to the Sixth Circuit, contending that this exemption is limited to transactions involving publicly traded securities. It argued that Congress did not intend for the exemption to extend to transactions involving a leveraged buyout of privately held stock, because this type of payment is not "commonly used in the securities trade," as defined in section 741(8) of the Bankruptcy Code.

The debtor contended that the court should follow more the restrictive views of certain other courts construing the scope of this exemption.

'Settlement Payment'

The Sixth Circuit rejected these arguments and joined a number of other courts that recognize that the definition of "settlement payment" is extremely broad, although somewhat circular. The court focused on the final phrase in the section 741(8) definition: the payment must be one "commonly used in the securities trade." Id. at 549. It rejected the debtor's suggestion that the lower courts had failed to consider whether the buyout of QSI contained the hallmarks of a payment made in the securities trade.

The court's brief review of the legislative history revealed that the purpose of section 741(8) was to ensure expanded protection that would include "margin and settlement payments to and from brokers, clearing organizations, and financial institutions. Again, Congress's purpose was to 'minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.'" Id. at 549-50, quoting from Kaiser Steel Corp. v. Charles Schwab & Co., Inc., 913 F.2d 846, 849 (9th Cir. 1990).

Although the Kaiser Steel court had ruled upon a buyout of publicly-traded securities, the court nonetheless concluded that "the transfer of consideration in an LBO is consistent with the way 'settlement' is defined in the securities industry." Id. at 550.

The Sixth Circuit determined that the logic of the Kaiser Steel decision extends to privately held securities. It relied upon the recent decision in Contemporary Indus. Corp. v. Frost, 564 F. 3d 981 (8th Cir. 2009), in which the Eighth Circuit faced the same issue and found there was no indication of any intent to exclude such payments from the definition of "settlement payments" merely because the stock was privately held. The Eighth Circuit interpreted the phrase "commonly used in the securities trade" as "a catchall phrase intended to underscore the breadth of the § 546(e) exemption." Id. at 986.

The Sixth Circuit adopted this conclusion reached by the Eight Circuit. Id. at 550.

Public and Private Markets

The QSI court acknowledged that other courts have reached a different conclusion on the issue because of their focus on a perceived purpose of section 546(e) to protect publicly traded securities from market volatility resulting from a bankruptcy, citing In re Norstan Apparel Shops, Inc., 367 B.R. 68 (Bankr. E.D.N.Y. 2007).

Norstan arose from the leveraged buyout of all of the company stock, which was owned directly and indirectly by the two principal officers. The proceeds of the loans made to finance the stock purchase flowed directly from the lender to the shareholders, rather than to the company. Id. at 73.

The Sixth Circuit distinguished the Norstan case on the basis that it "involved the two sole shareholders of a closely held Subchapter S corporation, did not implicate public securities markets, and lacked many of the indicia of transactions 'commonly used in the securities trade.'"

By contrast, the QSI situation involved "a transaction with the characteristics of a common leveraged buyout involving the merger of nearly equal companies, ....[t]he value of the securities at issue is substantial and there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities." Therefore, the Sixth Circuit concluded that nothing in the text of section 546(e) precluded its application to settlement payments involving privately held securities. Id. at 550.

Limits to 'Settlement Payments' Exception

The debtor also contended that an element of section 546(e) had not been satisfied because there had been no "transfer ... made by or to a ... financial institution." The debtor argued that the intermediary bank never had dominion or control over the funds but instead had acted merely as a conduit, relying on a decision by the Eleventh Circuit in In re Munford, Inc., 98 F.3d 604, 610 (11th Cir. 1996). According to this argument, the bank could not have received a transfer of the debtor's property if it never had a beneficial interest in either the funds or the shares exchanged for those funds.

The Sixth Circuit rejected this position, following instead decisions from several other circuit courts that have found that the plain language of section 546(e) does not require a "financial institution" to have a "beneficial interest" in the transferred funds, relying on In re Resorts Int'l, Inc., 181 F.3d 505, 516 (3d Cir. 1999), and Contemporary Indus., 564 F.3d 986-87. According to the Sixth Circuit, the role played by HSBC Bank in the QSI buyout was sufficient to satisfy the requirement that the transfer was made to a financial institution. Id. at 551.

The Sixth Circuit's analysis and careful use of language suggests limits to the "settlement payments" exception through the use of an intermediary financial institution in buyout transactions.

In particular, its contrast between the Norstan Apparel decision and the QSI situation provides insight. In the view of the Sixth Circuit, Norstan Apparel merely involved the two sole shareholders of a Subchapter S corporation (who were paid directly by the LBO lender and not through a separate intermediary). The transaction lacked "many of the indicia of transactions commonly used in the securities trade."

QSI's buyout, on the other hand, involved 170 shareholders who received more than $200 million in cash and stock through HSBC Bank USA. In the view of the Sixth Circuit, this transaction "had the characteristics of a common leveraged buyout" and involved "the merger of nearly equal companies." The potential impact of unwinding the settlement payments would be comparable to a transaction involving publicly traded securities.

The wording of the actual QSI holding—that nothing in the text of section 546(e) precludes its application to settlement payments involving privately held securities—also suggests that not all buyout transactions involving an intermediary financial institution may be entitled to this exemption. Transactions that do not share much in common with transactions "commonly used in the securities trade" or that lack the characteristics of a common leveraged buyout may not be able to rely on such protection under section 546(e).

For example, a small buyout transaction where the use of a financial institution as exchange agent appears to have been unnecessary except to gain the protections of section 546(e), could fall into what the district court below referred to as "exceptional circumstances" and not be entitled to the exemption. Another example of exceptional circumstances would clearly be the exception contained in section 546(e) for transactions sought to be avoided under section 548(a)(1)(A), that is, for transactions involving actual fraud.

Going Forward

The QSI decision represents increasing legal support for protection of payments for sales of stock in either a public or a private company appropriately made through a financial institution where no fraud was present. This protection extends to constructive fraudulent conveyance and preference theories.

The use of a financial institution as an exchange agent or other similar intermediary to facilitate the buyout of a corporation's stock where justified by the needs of the transaction, and having the indicia of transactions "commonly used in the securities trade," would appear to insulate the payments from avoidance should the corporation later end up in a bankruptcy proceeding.