The U.S. Court of Appeals for the Second Circuit recently held that prematurity redemptions of commercial paper made by Enron Corp. shortly before it filed for bankruptcy were protected from avoidance by 11 U.S.C. § 546(e)’s safe harbor for securities transaction settlement payments. In re Enron Creditors Recovery Corp. v. Alfa., No. 09-5122-bk (2d Cir. June 28, 2011). In so doing, the Second Circuit resolved a clash between the Bankruptcy Code’s interest in avoiding preferential debt repayment and the securities industry’s interest in preserving transaction finality. The Second Circuit’s decision, which addressed a question of first impression in the circuit courts, liberally construes Section 546(e)’s safe harbor to preserve the finality of transactions involving tradable commercial paper and may provide a basis to further extend this safe harbor to encompass other debt securities.

Enron’s Prematurity

Redemptions of Commercial Paper

Rumors of Enron’s imminent collapse began to circulate in late 2001 after the resignation of its CEO, the announcement of approximately $600 million in third-quarter losses and the correction of four years of financial statements. In what appears to have been a last ditch attempt to quell market speculation about the company’s viability, and in response to what Enron later claimed was coercion by creditors, Enron embarked on a massive program to redeem its commercial paper. Between October 25, 2001 and November 6, 2001, Enron drew down its credit lines to retire more than $1.1 billion of its unsecured commercial paper prior to the paper’s maturity. Enron redeemed the paper at the accrued par value, which was calculated as the purchase price plus accrued interest, an amount that was well above the price at which the paper had been trading. The redemptions were executed through broker-dealers and the commercial paper was extinguished from the bookkeeping entries of Enron’s clearing agent, the Depository Trust Company, without Enron taking title to it. Enron subsequently filed for Chapter 11 bankruptcy on December 2, 2001.

The Bankruptcy and District Court Proceedings

Approximately two years later, Enron (Enron Corp. and the reorganized Enron Creditors Recovery Corp. are collectively referred to herein as “Enron”) initiated adversary proceedings against hundreds of financial institutions from which it had redeemed commercial paper. Enron sought to avoid and recover the redemption payments pursuant to 11 U.S.C. § 547(b) on the grounds that they were (1) made on account of an antecedent debt within 90 days prior to bankruptcy and (2) constructively fraudulent transfers under 11 U.S.C. § 548(a)(1)(B), because the redemption price exceeded the commercial paper’s fair market value.

The defendant financial institutions moved to dismiss Enron’s complaint on the basis that the redemptions were settlement payments protected from avoidance by 11 U.S.C. § 546(e)’s safe harbor. Section 546(e) provides that “the trustee may not avoid a transfer that is a . . . settlement payment, as defined in section . . . 741 of this title.” Section 741(8), in turn, 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.”

The Bankruptcy Court denied the defendants’ motion to dismiss and held that the Section 546(e) safe harbor did not apply to Enron’s redemptions for two reasons. First, it interpreted the phrase “commonly used in the securities trade” in Section 741(8)’s definition of a settlement payment to modify all the terms in the preceding definition, and thus to limit settlement payments to payments that are commonly used in the securities industry. Accordingly, it concluded that evidence was necessary to determine whether Enron’s redemption payments were “commonly used” or were extraordinary and resulted from coercion by the noteholders. In re Enron Corp., 325 B.R. 67, 685-86 and n.7 (Bankr. S.D.N.Y. 2005). Second, the Bankruptcy Court concluded that whether Enron’s redemptions constituted settlement payments depended on whether the redemption payments were made to retire debt or to purchase commercial paper, which was a question of fact.

Most of the defendant financial institutions settled with Enron after the Bankruptcy Court denied their motion to dismiss. Three institutions, however, Alfa, S.A.B. de C.V. (“Alfa”), ING Balanced Portfolio, Inc. and ING VP Bond Portfolio, Inc. (the two ING entities, “ING”), did not. After discovery, Alfa and ING moved for summary judgment based on Section 546(e)’s safe harbor. The Bankruptcy Court denied their motions in a decision that held that the safe harbor for settlement payments did not apply to payments made to retire debt, as opposed to payments made to purchase or sell securities. The Bankruptcy Court also emphasized the unusual nature of the payments. In re Enron Creditors Recovery Corp., 407 B.R. 17, 45 (Bankr. S.D.N.Y. 2009).

Alfa and ING were granted leave to pursue an interlocutory appeal to the District Court, which reversed the Bankruptcy Court’s decision on the grounds that (1) the definition of “settlement payment” was not limited to “commonly used” payments and (2) the fact that Enron’s redemption did not involve a purchase, or acquisition of title to the commercial paper, was not dispositive. In re Enron Creditors Recovery Corp., 422 B.R. 423, 424 (S.D.N.Y. 2009). Enron appealed the District Court’s decision to the Second Circuit.

The Second Circuit’s Decision

On appeal, Enron offered three reasons for excluding its prematurity redemptions of commercial paper from Section 546(e)’s safe harbor: (1) the safe harbor applied only to payments that were “commonly used in the securities trade,” (2) the redemption payments were not settlement payments because they did not involve the purchase or sale of commercial paper, and (3) the redemption payments did not implicate the purpose of the statute.

In a 2-1 opinion, the Second Circuit rejected all of Enron’s arguments. The court first analyzed Enron’s proposed limitation of settlement payments to payments “commonly used in the securities trade” in light of the statute’s grammatical structure and concluded that the lack of a comma precluded Enron’s interpretation. The court observed that Section 741(8) somewhat circularly defines “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.” The Court noted that, under the last antecedent rule of construction, a limiting clause or phrase should ordinarily be read to modify only the noun or phrase that it immediately follows. As a result, the phrase “commonly used in the securities trade” should be read to modify only the immediately preceding phrase “any other similar payment,” and not the entire definition of a settlement payment. Enron had invoked another rule of construction in which a modifier set off from a series of antecedents by a comma should be read to apply to each of those antecedents. The court reasoned, however, that the absence of a comma immediately before the clause “commonly used in the securities trade” rendered Enron’s proposed rule inapplicable.

Enron’s argument that the redemption payments were not settlement payments because they involved the retirement of debt and not the purchase of commercial paper was also unavailing. Enron had relied on the Second Circuit’s decision in SEC v. Sterling Precision Corp., 393 F.2d 214 (2d Cir. 1968), which held that a “redemption” did not constitute a “purchase” under the Investment Company Act. But the Second Circuit concluded that whether the redemption constituted a purchase was beside the point, as there was nothing in the Bankruptcy Code requiring that a settlement payment involve either a purchase or a sale. The Second Circuit also rejected Enron’s argument that applying the safe harbor to Enron’s redemption of commercial paper was inconsistent with well-established case law allowing the avoidance of preferential debt payments. The court distinguished these precedents on the grounds that Enron’s redemptions involved widely-issued debt securities and not the ordinary non-tradable loans that had been the subject of prior avoidance case law.

Finally, the court rejected Enron’s argument that its redemptions should be excluded from Section 546(e)’s safe harbor because no financial intermediary had taken a beneficial interest in the securities during the transaction, and thus that avoidance of such transactions would not pose the systemic risk to the securities industry that had motivated Congressional enactment of the safe harbor. The court instead agreed with decisions by three other circuit courts, which had held that undoing transactions would substantially affect the stability of the financial markets even in the absence of a beneficial interest held by a financial intermediary.

The court’s decision was not unanimous. In a thorough dissent that touched on industry usage of the term “securities transaction” and the legislative history of Section 546(e), Judge Koeltl (sitting by designation) argued that a “settlement payment” required the purchase or sale of a security, which had not occurred in Enron’s redemptions.

Conclusion

The Second Circuit’s decision, and the broad effect it gives to Section 546(e)’s safe harbor, is an important and welcome one for the securities industry. Notably, both the SEC and the Securities Industry and Financial Markets Association, a trade group representing the interest of securities firms, banks and asset managers, had filed amicus briefs in support of Alfa and ING’s arguments that the safe harbor applied to redemptions of commercial paper. It remains to be seen, however, whether the Second Circuit’s opinion will be the last word on the issue. The other circuit courts have yet to address the question, and Judge Koeltl’s dissent illustrates the competing argument for limiting the safe harbor to purchases or sales of securities. Ultimately, a final resolution of the tension between a broad construction of Section 546(e)’s safe harbor and the Bankruptcy Code’s interest in avoiding preferential debt repayment may require a decision by the U.S. Supreme Court.