Delaware District Judge Leonard P. Stark has seemingly split with the Second Circuit and held that the safe harbor in Section 546(e) of the Bankruptcy Code does not bar fraudulent transfer claims brought on behalf of creditors under state law, ratifying a June 2016 opinion from Delaware Bankruptcy Judge Kevin Gross.
The safe harbor provided by Section 546(e) bars actions by the trustee but does not, by its terms, bar actions by other plaintiffs. The Second Circuit in Note Holders v. Large Private Beneficial Owners (In re Tribune Co.), 818, F.3d 98 (2d Cir. 2016) reversed the U.S. District Court for the Southern District of New York and held that state law constructive fraudulent transfer laws were preempted by Section 546(e). The Second Circuit reasoned that “[o]nce a party enters bankruptcy, the Bankruptcy Code constitutes a wholesale preemption of state laws regarding creditor’s rights.” The Second Circuit rejected the appellants’ argument that if the trustee fails to bring a constructive fraudulent transfer claim, the claim reverts back to the individual creditors.
Stating that the authority in Tribune was not binding on him, Judge Kevin Gross for the U.S. Bankruptcy Court for the District of Delaware held that the safe harbor only bars trustees from suing, not creditors from asserting their own claims. In PAH Litig. Tr. v. Water St. Healthcare Partners LP (In re Physiotherapy Holdings Inc.), 2016 WL 3611831 (Bankr. D. Del. June 20, 2016), the debtor was a provider of healthcare services at 650 locations in 33 different states. After a 2007 merger, the debtor’s finances deteriorated significantly, and by 2009, the debtor’s controlling shareholders decided to sell the company. As a result of a change in the debtor’s revenue recognition methods, shares of the company were grossly overvalued at the time it was sold pursuant to a leverage buyout in 2009. Eventually the debtor defaulted and filed Chapter 11.
After the petition was filed, the state law fraudulent transfer claims against the controlling shareholders were transferred to a litigation trust, which ultimately filed a fraudulent transfer action against the former shareholders to avoid the transfers received in the LBO. Judge Gross found that Section 546(e) did not eliminate a creditor’s right to bring a state constructive fraudulent transfer claim in all cases. Specifically, the court determined that a finding of implied preemption was inappropriate when three factors were present: (1) the transaction sought to be avoided poses no threat of “ripple effects” in the relevant securities markets; (2) the transferees received payment for non-public securities; and (3) the transferees were corporate insiders that allegedly acted in bad faith.
Judge Stark ultimately agreed with Judge Gross’s reasoning in Physiotherapy, stating in the process that Judge Gross had founded his opinion on “well-established Third Circuit and Supreme Court law.” In denying an interlocutory and direct appeal, Judge Stark remarked that the “bankruptcy court’s reading of the safe harbor is supported by the plain language of the statute, and its careful analysis followed controlling Third Circuit and Supreme Court precedent.” By almost outright saying that the Second Circuit was wrong about federal preemption of state fraudulent transfer law, Judge Stark teed up what might become a contentious circuit split headed straight for the U.S. Supreme Court.