The United States Bankruptcy Court for the District of Delaware in Elway Company, LLP v. Miller (In re Elrod Holdings Corp.), 2008 WL 4414315 (Bankr. D. Del. Sept. 30, 2008) recently held that transfers in payment of a private stock sale to insiders constituted “settlement payments” under section 546(e) of the Bankruptcy Code and were therefore immune from avoidance as constructively fraudulent transfers by the chapter 7 trustee. Judge Brendan Shannon held that the “settlement payment” safe harbor was not limited to publicly-traded securities and applied to sales of privately held stock that did not implicate the public securities clearance and settlement system.

Family-owned Jack K. Elrod Company, Inc. (“JKE”) operated a spectator seating business. In April 2005, its owners, the Elrods, agreed to sell their entire interest in JKE to Champlain Capital Partners, L.P. (“Champlain”) through a stock sale the parties consummated via three transfers: A newly formed entity, Acquisitions (1) paid the Elrods approximately $18 million in cash (the “2005 Transfer”); (2) issued $5.8 million in secured notes to the Elrods; and (3) received 100% of the Elrods’ stock in JKE. A little over a year later, in August 2006, JKE paid $3.5 million in partial satisfaction of the secured notes (the “2006 Transfer”). Two months later, on October 16, 2006, JKE filed for chapter 7 relief. The chapter 7 trustee sought to avoid the 2005 and 2006 Transfers as constructively or intentionally fraudulent transfers under sections 544 and 548 of the Bankruptcy Code. The Elrods opposed avoidance on the ground that the transfers were “settlement payments” made by “financial institutions” and thus excepted from avoidance by section 546(e) of the Bankruptcy Code. Section 546(e) limits a trustee’s avoidance powers and shelters certain payments made by or to financial institutions in settlement of securities and other transactions from attack as constructively fraudulent transfers.

The Bankruptcy Court agreed with the Elrods. It rejected the trustee’s textual argument that the statute’s reference to payments “commonly used in the securities trade” − which the trustee argued was synonymous with the securities “business” or “market” − thereby only included publicly traded securities within the meaning of “settlement payment.” The court noted the existence of a robust trade or market for non-publicly traded securities, as evidenced by the Elrods’ ability to sell their JKE stock in a private sale, from which it concluded that private sales could also fall within the statutory reference to “securities trade.” The court also rejected the trustee’s argument that section 546(e)’s legislative history intended application of the “settlement payment” safe harbor only to securities trades that implicated the public settlement and clearance system. Bankruptcy Judge Shannon cited the Third Circuit Court of Appeals decision in Lowenschuss v. Resorts Int’l, Inc. (In re Resorts Int’l,. Inc.), 181 F.3d 505 (3d Cir. 1999) in which the Third Circuit held that the term “settlement payment” was broad and includes almost all securities transactions, including payments made during leveraged buyouts. The court therefore concluded that section 546(e) was not limited to public securities, and that sales of privately held stock could benefit from the section 546(e) safe harbor.

The court’s ruling that section 546(e) applies to payments made through financial institutions to complete securities transactions regardless of whether the securities are publicly or non-publicly traded will benefit transfers made in connection with private sales and acquisitions. Please note, though, that the section 546(e) “settlement payment” defense has an exception: An intentional fraudulent conveyance claim brought under section 548(a)(1)(A) of the Bankruptcy Code is outside the protections of the statute; that provision has a one year reach-back period for cases filed before October 17, 2005 and a two year reach back period for cases filed thereafter.