SDNY Finds Direct Payments to Shareholders in a LBO Are Safe Harbored Under Section 546(e) of the Bankruptcy Code

by Cadwalader, Wickersham & Taft LLP

On November 7, 2012, Judge Lewis A. Kaplan for the United States District Court of the Southern District of New York held that payments made in connection with a leveraged buyout to holders of privately held securities were safe harbored under section 546(e) of the Bankruptcy Code notwithstanding the fact that the payments passed directly from the purchaser to the seller without the use of any financial intermediary. AP Services LLP v. Silva, et al., Case No. 11-03005 (S.D.N.Y. Nov. 7, 2012). The decision comports with the trend among the United States Courts of Appeal, including the Second Circuit, to interpret section 546(e) broadly, and provides clarity regarding the section’s application to payments made in connection with a LBO that are wired directly to a shareholder’s bank account.

Section 546(e)

Congress passed section 546(e) of the Bankruptcy Code in 1982 upon determining that exempting certain types of transfers from the avoidance powers under the Bankruptcy Code could help prevent “the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market.” H.R. Rep. 97-420, at 2 (1982), as reprinted in 1982 U.S.C.C.A.N. 583, 583. Section 546(e) provides, in pertinent part:

Notwithstanding [the avoidance powers codified in] sections 544, 545, 547, 548(a)(1)(B) and 548(b) [of the Bankruptcy Code], the trustee may not avoid a transfer that is . . .  a 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 . . . that is made before the commencement of [a bankruptcy] case.

Much of the litigation surrounding section 546(e) has concerned the meaning of  “settlement payment”. Section 741(8) of the Bankruptcy Code tautologically defines “settlement payment” as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, . . . or any other similar payment commonly used in the securities trade.” Circuit courts have clarified this circular definition, interpreting settlement payment to generally mean the transfer of cash or securities made to complete a securities transaction.

In the LBO context, courts have found that payments to shareholders of both privately held and public companies constituted settlement payments for purposes of section 546(e). Many of these decisions involved indirect payments from the purchaser to the shareholders, such that the purchaser transferred funds to a clearing agency or other financial intermediary which then transferred the funds to the shareholders. Case law is less clear, however, when the purchaser pays shareholders directly and the funds do not pass through any financial intermediary. This was the key issue before the District Court in AP Services LLP.

AP Services LLP

In 2007, the Silva family, the principal shareholders of a privately held long-term care pharmacy, Chem Rx, sold their shares to Paramount Acquisition Corporation, an acquisition vehicle created to effectuate a LBO. Pursuant to the LBO, Paramount obtained financing to purchase the Silvas’ stock, merged with Chem Rx to form Chem Rx Corporation (“CRC”), and CRC wired approximately $106 million directly to the Silvas’ bank accounts in exchange for their Chem Rx stock. One year later, CRC defaulted on the loans used to finance the LBO. In 2010, CRC filed for chapter 11 protection in the Southern District of New York. CRC ultimately liquidated and established a litigation trust to pursue avoidance actions and other claims on behalf of the CRC estate.

The litigation trustee subsequently sought to avoid CRC’s payments to the Silvas as actually and constructively fraudulent transfers under section 544(b) of the Bankruptcy Code and New York Debtor & Creditor Law, and asserted claims against the Silvas for breach of fiduciary duty and unjust enrichment in connection with the LBO. The Silvas defended by arguing that all of the trustee’s claims were barred by section 546(e) of the Bankruptcy Code. It bears noting that section 546(e) of the Bankruptcy Code does not insulate from avoidance actually fraudulent transfers in violation of section 548(a)(1)(A) of the Bankruptcy Code. However, because the two-year statute of limitations period under section 548(a)(1)(A) had expired, the litigation trustee could resort only to avoidance under applicable state law pursuant to section 544(b). This was a distinction with a difference. While section 546(e) does not insulate from avoidance actually fraudulent transfers under section 548(a)(1)(A), it does not distinguish between actually and constructively fraudulent transfers made in violation of state law pursuant to section 544(b). Accordingly, the Silvas were able to assert a safe harbor defense under section 546(e) for the claims of actual fraud – a defense that would not have been available had the trustee been able to pursue the claims under section 548(a)(1)(A).

The Court began its analysis by noting that the key issue was whether the payments to the Silvas as part of the LBO constituted settlement payments under section 546(e), and observing that several circuit courts have held that payments made for shares during a LBO fit within the definition of a settlement payment. In response, the trustee argued that even when made as part of a LBO, payments for securities are only settlement payments if they pass from the purchaser through a financial  intermediary to the seller. The Court acknowledged that a number of other courts have held that, in order for a payment to constitute a settlement payment for purposes of section 546(e), it must pass through the “settlement payment system”, in which a financial intermediary takes a beneficial interest in the securities. However, the Second Circuit has rejected this requirement, holding in Enron that payments for securities were settlement payments even where “no financial intermediary took a beneficial interest in the exchanged securities during the course of the transaction.” In re Enron Creditors recovery Corp., 422 B.R. 423, 423 (S.D.N.Y. 2009), aff’d 651 F.3d 329 (2d Cir. 2010). The Court also noted that other circuit courts, including the Third, Sixth, and Eighth Circuits, have similarly rejected the requirement and applied section 546(e)’s safe harbor to LBO’s of private companies involving financial intermediaries which served only as conduits.

The trustee countered by arguing that Enron should not be expanded to apply to the Silvas’ payments, as unlike Enron, funds were transferred directly to the Silvas’ banks and did not pass through a financial intermediary. The Court disagreed, finding that the plain language of the statute did not indicate that an intermediary is necessary to trigger the safe harbor. Rather, section 546(e) requires only that the settlement payments be made by or to “a commodity broker, forward contract merchant, stockbroker, [or] financial institution.” And given that the Bankruptcy Code defines “financial institution” as, among other things, “a Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, [or] savings and loan association . . .”, CSC’s transfer of funds directly to the Silvas’ banks constituted a payment to a financial institution. Accordingly, the Court held that the plain language of section 546(e), together with the “general understanding” among the circuit courts that the definition of settlement payment should be construed “extremely broadly”, demonstrate that the payments to the Silvas’ fit within the safe harbor of section 546(e).

Having lost on the law, the trustee turned to policy, arguing that avoiding the transfers to the Silvas would not have any impact on the stability of financial markets – a concern specifically cited by the Second Circuit in Enron. The Court was not persuaded, noting that section 546(e) is not limited to publicly traded securities and has been applied by other courts to LBO’s involving privately held securities. Further, in light of the large sum of money at issue and the likelihood that at least a portion of it was reinvested in the market, the Court expressed its skepticism that unraveling the transaction would have no impact on the market.

The Court also dismissed the trustee’s policy argument on the basis that it would be inconsistent with the Second Circuit’s clear aversion to construing section 546(e) in a way that would make every application of the safe harbor dependent on some additional factual inquiry. In Enron, the Second Circuit declined to consider whether the payments at issue were commonly used in the securities trade, as such an inquiry would result in “commercial uncertainty and unpredictability at odds with the safe harbor’s purpose and in an area of law where certainty and predictability are at a premium.” Enron, 651 F.3d at 336. The Court concluded that indulging the trustee’s request to evaluate the potential market impact of avoidance would lead to the same problem identified by the Second Circuit – market uncertainty – the precise ill section 546(e) was designed to remedy.

Concluding that the payments to the Silvas could not be avoided as fraudulent transfers because they were safe harbored under section 546(e), the Court then addressed the trustee’s claims for unjust enrichment and breach of fiduciary duty. Consistent with other courts’ rulings in the Second Circuit and elsewhere, the court found that the trustee’s state law unjust enrichment claim sought to recover the same payments held unavoidable pursuant to section 546(e), and accordingly, was preempted. With respect to the trustee’s claims for breach of fiduciary duty, however, the Court again relied on precedent and found that because such claims sought only money damages they did not “implicate the danger against which Section 546(e) [was] intended to protect” and therefore were not preempted. However, as no other federal claim remained, the Court determined that it lacked subject matter jurisdiction to hear the breach of fiduciary duty claims, which it dismissed without prejudice.


AP Services LLP adds to the already robust precedent in the Second Circuit calling for a broad application of section 546(e) of the Bankruptcy Code. Recipients of direct transfers made to complete a securities transaction that would otherwise have the potential to be avoided should take comfort that, in the Second Circuit, such transfers do not have to pass through a financial intermediary in order to qualify for the safe harbor protections of  section 546(e) of the Bankruptcy Code. Additionally, the decision serves as a helpful reminder that parties seeking to avoid transfers that have the potential to be safe harbored by section 546(e) should pay careful attention to the two-year statute of limitations imposed by section 548(a)(1)(A) of the Bankruptcy Code governing actually fraudulent transfers, which are not insulated from avoidance by section 546(e).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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