Shedding Light on a Bankruptcy Safe Harbor: Defining the Reach of Section 546(e)

Bankruptcy trustees and debtors routinely attempt to increase the amount of money available to creditors in a bankruptcy case by “clawing back” funds transferred by the debtor to another party. Several sections of the bankruptcy code, i.e., 11 U.S.C. §§ 547, 548(a)(1), and 544, grant the debtor or trustee the powers necessary to effectuate the claw back of transfers. Section 546(e), a so-called “safe-harbor” provision, limits most of these claw back powers by barring the avoidance of, for example, “transfer[s] . . . that [are] . . . settlement payments . . . made by or to (or for the benefit of) a . . . financial institution” or that are made “. . . in connection with a securities contract.” The section 546(e) safe harbor was enacted to promote stability in financial markets and to prevent financial contagions by protecting securities transactions from being unsettled by a later bankruptcy. See Hearings on H.R. 31 and H.R. 32 Before the Subcomm. on Civil and Constitutional Rights of the Comm. on the Judiciary, 94th Cong., pt. 4, at 2406, 2412 (1976). In recent years, and even recent months, several courts have interpreted the scope of section 546(e), including in the context of avoiding redemptions from investors in Ponzi schemes.

In Enron Creditors Recovery Corp. v. ALFA, S.A.B. de C.V., 651 F.3d 329 (2d Cir. 2011), for example, the debtor-in-possession sought to recover funds paid to investors to redeem Enron commercial paper prior to its maturity. The debtor-in-possession argued for a narrow construction of section 546(e), contending, among other things, that the redemption payments at issue were not settlement payments because “they did not involve a financial intermediary that took title to the transacted securities and thus did not implicate the risks that prompted Congress to enact the safe harbor.” Id. at 335. The Second Circuit rejected the narrow definition of “settlement payments” advocated by the debtor-in-possession and held that section 546(e) precluded the transfers from being avoided. Id.

In a slightly different context, the Bankruptcy Appellate Panel for the Ninth Circuit, in Hoskins v. Citigroup, Inc. (In re Viola), 469 B.R. 1 (9th Cir. B.A.P. 2012), also took a broad view of this statutory safe harbor, holding that section 546(e) barred a trustee from recovering transfers received by a bank in connection with a Ponzi scheme, even though the bank was alleged to have facilitated the Ponzi scheme by “ignor[ing] multiple red flags and permit[ing] glaring regulatory violations.” Id. at 6, 9-10. The panel noted the appeal of “[the trustee’s] argument that ‘Section 546(e) should not be used as a free pass to avoid liability in a scheme to defraud[,]’” but held that, where an exception for actual fraud already existed, it could not elect to expand the “clear statutory limits” of section 546(e). Id. at 10.

Similarly, in In re Lancelot Investors Fund, L.P., No. 08-B-28225, slip op. (Bankr. N.D. Ill. Mar. 1, 2012), the chapter 7 trustee sought to avoid redemptions taken prior to bankruptcy by investors in a Ponzi scheme. The trustee argued that “the [safe harbor established by Section 546(e)] do[es] not shield payments and transfers tainted by fraud . . . .” Lancelot Investors, slip op. at 13. The court rejected this argument and concluded that, although Congress intended to protect only “legitimate transactions, not massive Ponzi schemes[,]” Congress had achieved that purpose by refusing to extend safe harbor protection to transfers representing actual fraud. Id. at 18. The court further held that “Congress did not . . . requir[e] defendants who seek the safe harbor of Section 546(e) to prove that avoidance of their transfers would cause market instability” and rejected the trustee’s claim that the safe harbors were inapplicable because redemption payments were not made “‘in connection with’ the underlying contracts” or “on a public exchange.” Id. at 20-23.

Like Lancelot, the Southern District of New York in Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011), determined that section 546(e) barred the claw back of Ponzi scheme redemptions because the transfers that the trustee challenged were “made by or to (or for the benefit of) a . . . stockbroker, in connection with a securities contract . . . .” Katz, 462 B.R. at 451-52 (quoting 11 U.S.C. 546(e)). In Picard v. Greiff, 476 B.R. 715 (S.D.N.Y. 2012), the court affirmed Katz, holding that Bernard Madoff’s securities firm qualified as a stockbroker as a result of its legitimate activities (e.g., market-making) or, alternatively, because its customers had every reason to believe that the firm was engaged in securities transactions and were thus entitled to the protections afforded to stockbrokers’ customers, including section 546(e). Greiff, 476 B.R. at 719-20. The court further found that the Madoff firm’s transfers “clearly” involved securities contracts. Id. & n.6. In In re Madoff Securities LLC, Civ. No. 12 MC 0115 (JSR) (S.D.N.Y. Apr. 15, 2013), the trustee contended that section 546(e) was inapplicable where a transferee lacked “good faith.” While the court affirmed its Katz and Greiff holdings and rejected the trustee’s “good faith” contention, the court limited section 546(e) by holding that where a complaint sufficiently alleges facts establishing that the transferee had actual knowledge, “not [just] mere suspicions,” of the underlying fraud, a transferee cannot prevail on a motion to dismiss on section 546(e) grounds. Madoff Securities, slip op. at 3, 7-8.

Finally, in Grede v. FCStone, LLC, No. 09 C 136, slip op. (Bankr. N.D. Ill. Jan. 4, 2013), the court was asked to determine whether section 546(e) barred avoidance of transfers made to a class of customers where (1) only one class of customers received any distribution of funds and (2) certain of the funds received by this class had previously been allocated to another class of customers who received nothing. The bankruptcy court concluded that section 546(e) did not bar the trustee from avoiding these transfers because (1) applying the safe harbors would “create the very type of systemic market risks that Congress sought to prevent with its passage [and (2)] failing to apply the safe harbor . . . w[ould] not result in the unwinding of completed securities and commodities transactions that Congress sought to protect.” Id. The court also found that applying section 546(e) to uphold the inequitable distribution of customer funds was at odds with the intent underlying enactment of the section 546(e) safe harbor. Id.

With the exception of Grede, each of these courts, when analyzing the reach of section 546(e), refused to sharply limit the breadth of the statutory language. The broad interpretative approach employed in these cases suggests that courts are willing to apply section 546(e) to significantly limit trustees’ or debtors’ powers to claw back redemptions even where an investor unknowingly received transfers from a Ponzi scheme.

Notwithstanding the apparent judicial willingness to apply section 546(e) broadly, courts have not embraced the broad application of section 546(e) where its application would potentially lead to inequity. The holdings in Grede, where applying section 546(e) would have allowed some investors to receive a healthy distribution while other, similarly situated investors bore the burden of losses, and Madoff Securities, where the safe harbor was held inapplicable to investors with actual knowledge of a fraud, reflect a reluctance to extend the reach of section 546(e) to bar claims against investors who would otherwise enjoy obvious—and unfair—windfalls. There is disagreement in this context, to be sure: while the courts in Grede and Madoff Securities grafted an unwritten limit onto the reach of section 546(e), the Viola court flatly rejected limiting section 546(e) where a limit was not in the statutory text. Taken together, these recent decisions indicate that although courts are willing to flexibly apply section 546(e), this flexibility is unlikely to extend to cases where use of the safe harbor will reward or facilitate fraud or inequity.