Section 546(e) of the Bankruptcy Code offers a strong defense for holders of bonds, notes and other securities to preference and fraudulent transfer actions brought in bankruptcy proceedings. Essentially, any payment made to settle or complete a securities transaction, including repurchases and redemptions of bonds, notes and debentures, is protected from avoidance under the Bankruptcy Code. For many years, however, this powerful defense was rarely used. When the defense was raised, it was usually in the context of protecting payments made in leveraged buy-outs. Bankruptcy courts were often hostile to the defense and narrowly interpreted the application of the defense to limit its use. Over the last several years, however, the use of the section 546 safe harbors has come to the forefront, as debtors and liquidating trustees have attempted to avoid commercial paper transactions and note redemptions, leveraged buyouts, and transfers made to customers from large brokerage and securities firms that have fallen into bankruptcy. The recent surge in the use of section 546 as a defense against these avoidance actions has allowed for appellate review and interpretation of the use of the defense. These courts have greatly expanded the use and application of the safe harbor defense and have found that the plain language of the statute protects a much wider range of securities transactions and securities contracts than bankruptcy courts had previously found. Most recently, the Second Circuit Court of Appeals in In re Quebecor Worldwide (USA), Inc., affirming bankruptcy court and district court decisions, found that section 546(e) protected the holders of notes and their indenture trustee from being required to give back millions of dollars in payments they had received from Quebecor Worldwide to repurchase their notes in the weeks leading up to its bankruptcy filing. This ruling, along with several other recent rulings, give trustees and bond holders a road map to protect payments received in connection with redemptions, repurchases and other restructurings of bonds, notes, debentures and other securities, from avoidance as a preference and from fraudulent transfer claims in the issuers’ bankruptcies.
What does Section 546(e) Say?
Section 546(e) of the Bankruptcy Code Provides:
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 …, or settlement payment… 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) [any of those parties], in connection with a securities contract… commodity contract, … or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
11 U.S.C. § 546(e). Note that the section 546(e) safe harbors do not apply to the recovery of fraudulent transfers under section 548(a)(1)(A) of the Bankruptcy Code that are found to be actually fraudulent, i.e., made with actual intent to hinder, delay or defraud creditors. However, it does protect against the recovery of any preference claim and against any other type of fraudulent transfer claim, including constructive fraudulent transfer claims and any fraudulent transfer claim brought under state law, even if such state law or other non-bankruptcy law fraudulent transfer claim is an actual fraudulent transfer claim.
Moreover, the term “settlement payment” has a very broad definition under the Bankruptcy Code.
Specifically, a “settlement payment” is defined in Section 741 of the Bankruptcy Code 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.
Also, the term “securities contract” is given a broad and general definition under the Bankruptcy Code. Specifically, Section 741 of the Bankruptcy Code defines “securities contract” to mean “a contract for the purchase, sale, or loan of a security, ... including any repurchase ... transaction on any such security.” It should also be noted that the definition of the term “security” includes, among other things, notes, bonds, debentures and collateral trust certificates. 11 U.S.C. §101(49).
Legislative History and Judicial Interpretation of the Safe Harbor
Congress enacted section 546(e)’s safe harbor in 1982 as a means of “minimiz[ing] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” Enron Creditors Recovery Corp. v. Alfa S.A.B. de C.V. 652 F.3d 329, 334 (2d Cir. 2011). (quoting H.R. Rep. 97–420, at 2 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583). If a firm is required to repay amounts received in settled securities transactions, it might have insufficient capital or liquidity to meet its current securities trading obligations, which would place other market participants and the securities markets themselves at risk. Enron, 652 F.3d at 334. The safe harbor limits this risk by prohibiting the avoidance of “settlement payments” made by, to, or on behalf of a number of participants in the financial markets. Id. By restricting a bankruptcy trustee’s power to recover payments that are otherwise avoidable under the Bankruptcy Code, the safe harbor stands “at the intersection of two important national legislative policies on a collision course—the policies of bankruptcy and securities law.” In re Resorts Int’l, Inc., 181 F.3d 505, 515 (3rd Cir.1999).
While the stated legislative intent of the statute is to minimize displacement in the commodities and securities market caused by a major bankruptcy, the statute does not mention or specify any such limitation. Most Circuit Courts have accordingly interpreted the statute expansively, holding that the statute should be interpreted as it is written, and not limited by the statements in the legislative history. See e.g., Resorts Int’l, 181 F.3d 505; Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 986 (8th Cir.2009); In re Plassein Int’l. Corp., 590 F.3d 252, 258 (3d Cir. 2009). The statute says nothing about displacement or distress in the securities industry, nor does it say that the financial intermediary needs to have possession of or a beneficial interest in the transferred securities.
Also, while most courts acknowledge that the definition of “settlement payment” is rather circular, the majority of circuit courts that have looked at the definition have adopted an “extremely broad” definition of the term, instructing courts to interpret it, “in the context of the securities industry, as the transfer of cash or securities made to complete a securities transaction.” See e.g., Enron, 652 F.3d at 334; QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545, 549 (6th Cir.2009); Contemporary Indus. Corp., 564 F.3d at 985); Plassein Int’l., 590 F.2d at 258; Resorts Int’l, 181 F.3d 505.
With this broad interpretation of settlement payment in tow, Courts have found that a wide variety of transfers constituted settlement payments, thus exempting the transfers from avoidance under section 546(e) of the Bankruptcy Code. In Plassein International Corp. and Resorts International, the Third Circuit found that transfers made to shareholders in leveraged buyouts were settlement payments of the securities purchased, which exempted the transfers from avoidance. In re Plassein Int’l. Corp., 590 F.3d 252, In re Resorts Int’l., 181 F.3d 505. In those cases, the courts found that it didn’t matter that the transfers didn’t go through the normal settlement system for publically traded securities. The transfers still constituted the payment of cash made to complete a securities transaction. Other Courts of Appeals have followed the Third Circuit opinion in Resorts. See, e.g., QSI Holdings, Inc., 571 F.3d at 551; Contemporary Indus. Corp., 564 F.3d at 985–86.
Courts have found that the safe harbor likewise applies to redemption payments made from fraudulent investment schemes to investors. For example, in the Madoff cases, it didn’t matter that Bernie Madoff was not actually trading his client’s securities; Madoff was in fact a stockbroker and the transfers had been made to settle what the investors believed to be a securities transaction. Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities, LLC, 476 B.R. 715, 719-720 (S.D.N.Y. 2012). Madoff had entered into securities contracts with his customers and investors and thus transfers made to customers and investors were settlement payments protected by section 546(e) and were also transfers made in connection with securities contracts. Id.
While courts found that redemption and transfers of stock were clearly securities transactions protected by section 546(e), they have also found that the safe harbor protects redemptions of debt securities.
The Safe Harbor and the Redemption of Bonds, Notes and Commercial Paper
While many of the early cases interpreting section 546(e) dealt with equity securities, the term “security” as defined in the Bankruptcy Code is much broader and encompasses many types of traditional debt instruments, including bonds, notes, debentures and collateral trust certificates. 11 U.S.C. §101(49). It was only a matter of time before courts would apply the broad protections of section 546(e) to these types of debt instruments.
In the Enron case, the Second Circuit found that the early redemption of commercial paper was a settlement payment and thus was exempt from avoidance under section 546(e). Enron, 652 F.3d 329. The majority found that “settlement,” in the context of the securities industry, “refers to the completion of a securities transaction” but found no support in the Bankruptcy Code for “a requirement that title to the securities changes hands.” The Court also found that a financial intermediary does not need to take title to the securities for the safe harbor to apply. Rather, the financial intermediaries can be mere conduits. (It should be noted that the 11th Circuit has held in In re Mumford that the financial intermediary does need to have a beneficial interest in the securities). Moreover, the Court found that, section 546(e) applies on its face, and without limitation, to settlement payments made “by or to (or for the benefit of)” various participants in the financial markets.
Likewise, in the Quebecor Worldwide case, both the Southern District of New York and the Second Circuit Court of Appeals found that the pre-petition redemption of notes by a subsidiary of Quebecor qualified for protection under section 546(e). In re Quebecor Worldwide (USA), Inc., 719 F.3d 94 (2d Cir. 2013). In the Quebecor case, Quebecor World Capital Corp., a subsidiary of Quebecor World, Inc., raised $371 for the Quebecor family of companies by issuing private placement notes. Quebecor World, Inc., and Quebecor World (USA), Inc., guaranteed the notes. When Quebecor started having financial difficulty in 2007, it risked breaching a financial covenant in the notes, thereby risking a default under Quebecor’s $1 billion revolving credit facility. To avoid defaulting under the credit facility, Quebecor agreed to redeem the notes from their holders. To avoid tax implications in Canada, Quebecor structured the transaction such that Quebecor World (USA) would purchase the notes for cash from the holders, and then Quebecor World Credit Corp. would redeem the notes from Quebecor World (USA) in exchange for forgiveness of the debt Quebecor World (USA) owed to Quebecor World Credit Corp. To effectuate the transfer, Quebecor World (USA) transferred approximately $376 million to the trustee for the holders of the notes, CIBC Mellon Trust Co. CIBC Mellon distributed the funds to the holders of the notes, who then surrendered the notes to Quebecor. Quebecor World (USA) filed for bankruptcy in the Southern District of New York on January 21, 2008, less than ninety days after repurchasing the Notes.
The committee of unsecured creditors for Quebecor World (USA) then initiated a suit against the former holders of the notes, seeking to avoid and recover the $376 million transfer from Quebecor World (USA), through CIBC Mellon, to the former holders of the notes, as a preference. The bankruptcy court granted the former noteholders summary judgment, finding that under the Second Circuit’s holding in Enron, the transfer of cash from Quebecor World (USA) to the holders of the notes was a settlement payment and that whether the transfer was in exchange for a purchase or was a redemption of the notes, the transaction was a securities contract. The District Court for the Southern District of New York affirmed, finding that the transfer was in fact a settlement payment, but that a transfer to “redeem” securities could not qualify as a “transfer made ... in connection with a securities contract” because the Code defines a “securities contract” as one “for the purchase, sale, or loan of a security.” Nevertheless, the district court affirmed the bankruptcy court’s alternative holding on the basis that the transaction was in fact a “purchase,” not a “redemption.” The Second Circuit affirmed, finding that it need not decide whether the payments fall within the “settlement payments” safe harbor because the payments clearly fall within the safe harbor for “transfers made ... in connection with a securities contract.”
In the district court opinion in Quebecor Worldwide, District Judge Furman was sympathetic to the argument that the definition of settlement payment was so broad that it could apply to protect payments made on ordinary loans evidenced by private notes. Quebecor, 480 B.R. at 477. As one commentator noted, “[T]he net effect of Enron may be [to] allow the parties to insulate most debt held by financial institutions from the reach of the preference laws—a result seemingly far afield from that intended by Congress.” Id. However, Judge Furman stated he was compelled to follow the Enron decision, under which, the note payments in Quebecor would clearly be protected by section 546(e) as a settlement payment, i.e., a payment made to complete a securities transaction. Id. at 475.
The Second Circuit panel affirmed Judge Furman, finding that the transaction clearly qualified as a “transfer made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract.” Quebecor World, 719 F. 3d at 98. Quebecor World (USA) transferred funds to the noteholders’ trustee, CIBC Mellon, in the amount and manner prescribed by the note purchase agreement. The parties agreed that CIBC Mellon is a financial institution. The Second Circuit concluded that “[t]he [Note Purchase Agreements]were clearly ‘securities contracts’ because they provided for both the original purchase and the ‘repurchase’ of the Notes.” Id. at 99. “Accordingly, this was a transfer made to a financial institution in connection with a securities contract that is exempt from avoidance.” Id. The Second Circuit also held that the financial intermediary involved in the transaction [i.e., 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”] need not have a beneficial interest in the transfer. Id. Agreeing with the Third, Sixth and Eighth Circuits, and rejecting the Eleventh Circuit, the Second Circuit held that “a transfer may qualify for the section 546(e) safe harbor even if the financial intermediary is merely a conduit.” Id.
Is Section 546(e) a Roadmap to Eliminate Preferences?
So what are the limits of the section 546 safe harbors? Could sophisticated parties set up their loan transaction as the purchase and sale of notes and debentures and have payments flow through an indenture trustee who is essentially acting as the administrative agent? Under such a arrangement, any restructuring or workout of the loan could be structured as a redemption or repurchase of the notes, thereby insulating the transfers made in connection with the transaction from avoidance under section 546(e). The transfers in that scenario would be settlement payments made to complete a securities transaction.
Some judges and commentators have expressed concern that the interpretation of the safe harbor, and in particular, the definition of “settlement payment,” is so broad that the safe harbor will exempt ordinary loan transactions from avoidance. In his dissenting opinion in Enron, Judge Koeltl argued that the definition of “settlement payment” should be limited to those situations where there is actually a purchase and sale of securities. Enron, 651 F.3d at 346. Deriding the majority holding, Judge Koeltl stated: “In fact, the Court’s definition of a settlement payment would seem to bring virtually every transaction involving a debt instrument within the safe harbor of Section 546(e), thus allowing the settlement payment exception to swallow up the Section 547(b) avoidance provision…. The Court’s reasoning thus applies equally to any payment on account of a debt evidenced by a writing, and does indeed imperil decades of cases that allow the avoidance of debt-related payments.” Id. at 346, 347.
However, the majority in Enron rejected the notion that the definition of settlement payment required a purchase and sale of a debt security in order to qualify for protection under section 546(e). Noting that nothing in the definition of “settlement payment” supports a purchase or sale requirement, the court found “little support for the contention that a securities transaction necessarily involves a purchase or sale,” only that the transaction involve an exchange of money or securities that completes a securities transaction. Id. at 337. The court also rejected the notion that its decision would imperil decades of cases that allow the avoidance of debt related payments. The cases cited by the dissent, the majority explained, “involved non-tradeable bank loans, not widely issued debt securities.” Id. at 337. The majority thus concluded “that the safe harbor protects payments made to redeem tradeable debt securities does not contradict case law permitting avoidance of payments made on ordinary loans. Interpreting the term settlement payment in the context of the securities industry will exclude from the safe harbor payments made on ordinary loans.” Id.
The Second Circuit holding in Quebecor further expanded the section 546(e) safe harbor, finding that the repurchase of notes that were not widely traded, but were held by a small group of private placement investors, also qualified for the safe harbor. Under these holdings, the redemption, purchase or repurchase of notes, debentures and bonds will likely qualify for the safe harbor, excluding transfers made in connection with such transactions from avoidance as preferences or constructively fraudulent transfers. Thus, creditors and trustees seeking to workout defaulted note, debenture or bond transactions should consider structuring those transactions as purchases or redemptions of the securities in an effort to qualify for the safe harbor and to evade the avoidance of any transfers as a preference or fraudulent transfer.
What Should Trustees and Holders of Notes, Bonds and Debentures Do?
When there has been a default under a note, debenture or bond indenture, trustees should be wary of accepting late payments. Payments made on time in accordance with the terms of the indenture will likely not be avoidable as a preference because they are payments made in the ordinary course of business. If there has been a default and a payment has been missed, creditors and trustees should consider structuring the workout and repayment of the defaulted notes as a purchase, repurchase or redemption of the notes. Payments should flow through the trustee so that a financial institution is involved in the transaction. An agreement for the purchase or redemption of the notes should be executed. If those steps are followed, the payment from the debtor would likely be a settlement payment from its bank to the trustee, both financial institutions, and the payment would complete a securities transaction, the purchase or redemption of a security. Under these circumstances, there is a good chance a court would be required to apply the safe harbor of section 546(e) to the transaction and exempt the transfer from avoidance under section 546(e).