Second Circuit Adopts "Transfer-by-Transfer" Approach to Bankruptcy Code's Safe Harbor for Securities Contracts Payments

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Jones Day

The scope of the Bankruptcy Code's "safe harbor" shielding certain securities, commodity, or forward-contract payments from avoidance as fraudulent transfers has long been a magnet for controversy, particularly after the U.S. Supreme Court suggested (but did not hold) in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), that a debtor may itself qualify as a "financial institution" covered by the safe harbor by retaining a bank or trust company as an agent to handle payments, redemptions, and cancellations made in connection with a leveraged buyout transaction ("LBO").

Bankruptcy and appellate courts in the Second Circuit have made meaningful contributions to the ongoing debate. The U.S. Court of Appeals for the Second Circuit recently weighed in on this issue in In re Nine W. LBO Sec. Litig., 87 F.4th 130 (2d Cir. 2023), reh'g denied, Nos. 20-3257-cv (L) et al. (2d Cir. Jan. 3, 2024). A divided Second Circuit panel reversed in part a district court's 2020 ruling dismissing fraudulent transfer and unjust enrichment claims brought by a chapter 11 plan litigation trustee and an indenture trustee to recover payments made by apparel and footwear company Nine West Holdings, Inc. as part of a 2014 LBO. See In re Nine W. LBO Sec. Litig., 482 F.Supp. 3d 187 (S.D.N.Y. Aug. 27, 2020), aff'd in part, rev'd in part and remanded, 2023 WL 8180356 (2d Cir. Nov. 27, 2023) ("Nine West").

According to the Second Circuit majority, each component transaction in an LBO should be analyzed individually to determine if it falls within the scope of the safe harbor. Because the debtor, through its bank agent, qualified as a "financial institution" in relation to payments made to public shareholders as part of the LBO, the majority held that those payments were safe harbored. By contrast, the majority held that payments made directly to the debtor's officers, directors, and other shareholders were not safe harbored because no financial institution was involved. The substantial dissenting opinion suggests that a "contract-by-contract" analysis would be more appropriate and that all of the transfers should therefore have been shielded from avoidance.

The Section 546(e) Safe Harbor

Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, which include the power to avoid certain preferential and fraudulent transfers. Section 546(e) provides that the trustee may not avoid, among other things, a pre-bankruptcy transfer that is a settlement payment "made by or to (or for the benefit of) a … financial institution [or a] financial participant …, or that is a transfer made by or to (or for the benefit of)" any such entity in connection with a securities contract, "except under section 548(a)(1)(A) of the [Bankruptcy Code]." Thus, the section 546(e) "safe harbor" bars avoidance claims challenging a qualifying transfer unless the transfer was made with actual intent to hinder, delay, or defraud creditors under section 548(a)(1)(A), as distinguished from being constructively fraudulent under section 548(A)(1)(B) because the debtor was insolvent at the time of the transfer (or became insolvent as a consequence) and received less than reasonably equivalent value in exchange.

Section 101(22) of the Bankruptcy Code defines the term "financial institution" to include, in relevant part:

[A] Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity and, when any such Federal reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer (whether or not a "customer", as defined in section 741) in connection with a securities contract (as defined in section 741) such customer…. 

11 U.S.C. § 101(22). "Customer" and "securities contract" are defined broadly in sections 741(2) and 741(7) of the Bankruptcy Code, respectively. Section 741(8) 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." A similar definition of "settlement payment" is set forth in section 101(51A).

The purpose of section 546(e) is to 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. No. 97-420, at 1 (1982). The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id.

Prior to the Supreme Court's ruling in Merit, there was a split among the circuit courts concerning whether the section 546(e) safe harbor barred state law constructive fraud claims to avoid transactions in which the financial institution involved was merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. For its part, the Second Circuit had applied a more expansive interpretation of the section 546(e) safe harbor in In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013), ruling that the safe harbor did apply under such circumstances. In resolving the circuit split in Merit, however, the Supreme Court sided with a narrower interpretation of section 546(e). 

In Merit, a unanimous Supreme Court held that section 546(e) does not protect transfers made through a "financial institution" to a third party, regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, the Supreme Court held that the relevant inquiry is whether the transferor or the transferee in the overarching transaction sought to be avoided (rather than any intermediate transfer) is, itself, a financial institution. Because the parties did not contend that either the debtor, as purchaser, or the selling shareholder in the challenged LBO transaction was a financial institution (even though the conduit banks through which the payments were made met that definition), the Court ruled that the payments fell outside of the safe harbor.

In a footnote, the Court acknowledged that the Bankruptcy Code defines "financial institution" broadly to include not only entities traditionally viewed as financial institutions, but also the "customers" of those entities, when financial institutions act as agents or custodians in connection with a securities contract. The selling shareholder in Merit was a customer of one of the conduit banks, yet never raised the argument that it therefore also qualified as a financial institution for purposes of section 546(e). For this reason, the Court did not address the possible impact of the selling shareholder's status on the scope of the safe harbor.

In 2019, the Second Circuit made headlines when it ruled that payments made as part of the 2007 LBO of Tribune Co. were protected from avoidance under section 546(e) because, among other things, the debtor itself qualified as a "financial institution" by retaining a bank or trust company as an agent to process the payments made in exchange for shares tendered in the transaction. See In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), cert. denied, 209 L. Ed. 2d 568 (U.S. Apr. 19, 2021) ("Tribune"). 

According to the Second Circuit, the entity the debtor retained to act as depositary in connection with the LBO, Computershare Trust Company, N.A. ("Computershare"), was a "financial institution" for purposes of section 546(e) because it was a trust company and a bank. Therefore, the court reasoned, the debtor was likewise a financial institution because, under the ordinary meaning of the term as defined by section 101(22), the debtor was Computershare's "customer" with respect to the LBO payments, and Computershare was the debtors' agent according to the common-law definition of "agency."

In 2020 and 2021, bankruptcy and district courts in the Second Circuit picked up where the Second Circuit left off in Tribune, ruling that pre-bankruptcy recapitalization or LBO transactions were safe-harbored from avoidance as fraudulent transfers because they were effected through a bank or other qualifying "financial institution." 

The first court to follow Tribune was the district court in Nine West, which (as described in more detail below) dismissed more than $1 billion in fraudulent transfer and unjust enrichment claims brought by a chapter 11 plan litigation trustee and an indenture trustee against the debtor's shareholders, officers, and directors to recover payments made as part of a 2014 LBO. Citing Tribune, the district court ruled that the payments were protected by the section 546(e) safe harbor because they were made by a bank acting as the debtor's agent. 

Shortly thereafter, the U.S. Bankruptcy Court for the Southern District of New York dismissed a chapter 11 plan litigation trustee's complaint seeking to avoid and recover alleged constructive fraudulent transfers. Analyzing the issue under Merit, the court ruled that, even though only one of the transfers involved in the "overarching transaction" was effected through a "financial institution," where the "component steps" formed an "integrated transaction," section 546(e) shielded those component steps from avoidance as a constructive fraudulent transfer. See SunEdison Litigation Trust v. Seller Note, LLC (In re SunEdison, Inc.), 620 B.R. 505 (Bankr. S.D.N.Y. 2020). 

In 2021, a different N.Y. district court judge ruled in Holliday, Liquidating Trustee of the BosGen Liq. Trust v. Credit Suisse Secs. (USA) LLC, 2021 WL 4150523 (S.D.N.Y. Sept. 13, 2021) ("Boston Generating"), appeal filed, No. 21-2543 (2d Cir. Oct. 8, 2021), appeal stayed, No. 21-2543 (2d Cir. Oct. 3, 2022), that payments made to the members of limited liability company debtors as part of a pre-bankruptcy recapitalization transaction were protected from avoidance under section 546(e) because for that section's purposes, the debtors were "financial institutions," as customers of banks that acted as their depositories and agents in connection with the transaction. Applying Merit, the court looked to New York fraudulent conveyance law—"the substantive avoiding power"—to determine that the overarching transfer could not be challenged in "piecemeal fashion" by analyzing a component transfer "in a vacuum." Id. at *3 ("[A]n allegedly fraudulent conveyance must be evaluated in context; '[w]here a transfer is only a step in a general plan, the plan must be viewed as a whole with all its composite implications.'") (quoting Orr v. Kinderhill Corp., 991 F.2d 31, 35 (2d Cir. 1993) (alterations in original)). The court held that, "[s]uch an approach … would permit a trustee to circumvent the safe harbor by carving up an integrated securities transaction consisting of multiple component parts." Id. This, the court continued, "would unnecessarily restrict the safe harbor and 'seriously undermine ... markets in which certainty, speed, finality, and stability are necessary to attract capital.'" Id. (citing Tribune, 946 F.3d at 900) (alterations in original)). 

Nine West

In 2014, private equity firm Sycamore Partners Management, L.P. ("Sycamore") acquired The Jones Group, Inc. ("Jones"), a fashion retail company, through an LBO pursuant to a 2013 merger agreement. The transaction involved the merger of Jones into a new Sycamore subsidiary that was ultimately renamed Nine West Holdings, Inc. (the "debtor"). At the close of the merger, Sycamore sold three of the debtor's brands, which allegedly constituted some of Jones's most valuable assets, to newly formed Sycamore affiliates. 

Transfers made to Jones shareholders, directors, and officers as part of the LBO included: (i) $1.1 billion paid to public shareholders (the "shareholder transfers") by canceling and converting each share of common stock into the right to receive $15 in cash; (ii) $78 million paid to directors and officers (the "payroll transfers") by canceling and converting each of their restricted stock and stock equivalent units into the right to receive $15 in cash plus unpaid dividends; and (iii) $71 million in "change in control" payments to certain directors and officers.

The shareholder transfers were made by a paying agent "pursuant to a paying agent agreement in customary form" that, among other things, empowered the paying agent to "act as [the debtor's] special agent for the purpose of distributing the Merger Consideration." The payroll transfers and the change in control payments were processed through the debtor's payroll and by other means (i.e., the paying agent was not involved in these transactions).

The debtor filed for chapter 11 protection in the Southern District of New York four years after the LBO was completed. In February 2019, the bankruptcy court confirmed a chapter 11 plan for the debtor that was made possible by Sycamore's contribution of $120 million for the benefit of unsecured creditors, in exchange for a release of any liability related to the LBO. The plan assigned unreleased potential causes of action arising from the LBO to a litigation trustee and empowered the indenture trustee for certain of the debtor's noteholders to prosecute state law fraudulent transfer claims.

The litigation trustee sued the public shareholders (the "shareholder defendants") and the directors and officers (the "D&O defendants") in various federal district courts seeking to avoid the LBO payments as intentional and constructive fraudulent transfers under state law and section 544 of the Bankruptcy Code (all federal avoidance claims were time barred). He also asserted claims against certain D&O defendants for unjust enrichment, disgorgement, and restitution. The indenture trustee separately sued all of the defendants to avoid and recover the payments under state law. All of the litigation was later consolidated in the U.S. District Court for the Southern District of New York.

Invoking the section 546(e) safe harbor as an affirmative defense, the defendants moved to dismiss the litigation (other than the unjust enrichment claims with respect to the change in control payments).

The district court ruled in favor of the defendants on the motion to dismiss.

District Judge Jed S. Rakoff agreed with the shareholder defendants that the $1.1 billion the debtor paid them in connection with the LBO was a "qualifying transaction" for purposes of section 546(e) because the payments were "settlement payments," as defined by section 741(8) of the Bankruptcy Code, and they were "made in connection with a securities contract," as the term "securities contract" is defined in section 741(7).

Judge Rakoff rejected the trustees' efforts to distinguish Tribune on the basis that Tribune involved payments to public shareholders for the redemption of stock, whereas the debtor's LBO involved the cancellation and conversion of common stock into the right to receive cash. The court noted that the LBO transaction in Tribune was a two-step process. While there was a tender offer involving the redemption of common stock, it was followed by a merger involving the cancellation and conversion of the remaining shares to the right to receive cash. Moreover, the court explained that the plain language of section 741(7) covers not only contracts for the repurchase of securities, but also includes as a "catch-all" any other "similar" contract or agreement. Judge Rakoff concluded that "[t]here is no substantive or essential difference between an LBO that is effectuated through share redemption and one effectuated through share cancellation." Nine West, 482 F.Supp. 3d at 198.

Alternatively, Judge Rakoff held that the payments made to the shareholder defendants were "settlement payments"—i.e., transfers of cash made to complete the merger—consistent with the Second Circuit's "capacious interpretation of § 741(8)." Id. at 199.

Next, guided by Tribune, Judge Rakoff determined that the debtor's shareholder transfers involved a "qualifying participant" because the debtor qualified as a "financial institution" under section 546(e) as a "customer" of an agent bank that was also a financial institution. In addition, Judge Rakoff noted that at least 82 of the shareholder defendants independently qualified as "financial institutions" because they were registered investment companies, and one qualified as a commercial bank.

Judge Rakoff also concluded that the payroll payments made to the D&O defendants were protected as both settlement payments and transfers made in connection with a securities contract, even though the payments, unlike the shareholder payments, were not processed by the debtor's agent bank. He reasoned that, because the debtor was a financial institution as a customer of the agent bank, section 546(e) safe-harbored all transfers made in connection with the LBO. In so ruling, Judge Rakoff rejected the trustees' "transfer-by-transfer" approach, which would distinguish between payments that were processed by the agent bank and those that were not in construing the definition of "financial institution" under section 101(22)(A) of the Bankruptcy Code, protecting only those payments with respect to which a financial institution played an agency role. 

Instead, the court opted for the more comprehensive "contract-by-contract" approach, which views the transaction as a whole. This approach, the court reasoned, is more consistent with the text of section 101(22)(A), which provides that a customer of a bank qualifies as a financial institution when the bank is acting as agent in connection with a "securities contract" as opposed to when a bank is acting as agent in connection with a "transfer." Id. at 206. The court further concluded that the "contract-by-contract" approach better comports with Merit's holding that "the relevant transfer for purposes of the § 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid," and "not any component part of that transfer." Id. (internal quotation marks omitted).

Finally, the district court held that section 546(e) preempts the litigation trustee's unjust enrichment claims against the D&O defendants because such claims, however denominated, sought recovery of the same payments that were protected from avoidance under the safe harbor. However, the court did not dismiss the unjust enrichment claims with respect to the change-in-control payments because the D&O defendants did not seek dismissal.

The litigation trustee and the indenture trustee appealed the ruling to the Second Circuit.

The Second Circuit's Ruling

A divided three-judge panel of the Second Circuit affirmed the ruling in part, reversed it in part, and remanded the case below.

The Second Circuit majority agreed with Judge Rakoff's decision insofar as he held that the shareholder payments were protected from avoidance under the section 546(e) safe harbor because the funds were deposited with the debtor's paying agent, which distributed checks or wire transfers to the shareholders in exchange for their shares in accordance with the relevant paying agent agreement. 

In so ruling, the Second Circuit majority first examined the meaning of the term "financial institution" in section 101(22)(A) of the Bankruptcy Code. The trustees argued that a "financial institution" includes only bank customers in transactions where the bank acted as the customer's agent, whereas the shareholder and D&O defendants contended that the term applies to any transaction related to a securities contract, provided the bank acted as the customer's agent at some point in connection with that contract (i.e., at some point during the overarching transaction).

The Second Circuit majority concluded that:

for these purposes, "financial institution" includes bank customers only in transactions where the bank is acting as their agent and that [the paying agent] acted as Nine West's agent in the [shareholder transfers] but not in the [payroll transfers]. We conclude, further, that under the transfer-by-transfer interpretation of § 101(22)(A), [the debtor] was a "financial institution" with respect to the [shareholder transfers] and those payments are therefore safe harbored under § 546(e). The [payroll transfers], however, are not so shielded.

Nine West, 87 F.4th at 143.

The Second Circuit majority faulted the district court for employing a "contract-by-contract" interpretation of section 101(22)(A) in determining that, in accordance with Tribune, because the paying agent acted as the debtor's agent in connection with the shareholder transfers made pursuant to the 2013 merger agreement and the 2014 LBO, all transfers made in connection with the LBO were shielded from avoidance by the safe harbor. According to the majority, the court's holding in Tribune "does not support such a reading of § 101(22)(A)." Id. at 145.

Instead, based on the language of section 101(22)(A), the statutory structure of the Bankruptcy Code, and the purpose of the safe-harbor provision, the Second Circuit majority concluded that section 101(22)(A) must be analyzed on a "transfer-by-transfer" basis to determine if section 546(e) applies. 

The majority explained:

[T]he Bankruptcy Code defines a 'financial institution' to include a 'customer' of a bank or other such entity 'when' the bank or other such entity 'is acting as agent' for the customer 'in connection with a securities contract,' 11 U.S.C. § 101(22)(A) (emphasis added). It does not provide that a customer is covered when a bank has ever acted as a customer's agent in connection with a securities contract. In other words, the text creates a link between a bank 'acting as agent' and its customer with respect to a transaction. To satisfy that link, the plain language of § 101(22)(A) indicates that courts must look to each transfer and determine 'when' a bank 'is acting as agent' for its customer for a transfer, assuming, of course, the transfer is made in connection with a securities contract.

Id. According to the Second Circuit majority, "the transfer-by-transfer approach is the more logical and reasonable interpretation," whereas the "contract-by-contract" interpretation "would lead to the absurd result of insulating every transfer made in connection with an LBO, as long as a bank served as agent for at least one transfer." Id. 

The transfer-by-transfer approach, the majority noted, is likewise, supported by the "structure" of the Bankruptcy Code, which grants trustees avoidance powers to "help implement the core principles of bankruptcy." Id. at 146. While these avoidance powers are not "unfettered" (and are expressly limited by the section 546(e) safe harbor), the majority concluded that a broad interpretation of the safe harbor under a contract-by-contract approach would undermine these avoidance powers "that are so crucial to the Bankruptcy Code." Id. 

Finally, the court emphasized that a transfer-by-transfer approach is consistent with the safe harbor's purpose in protecting from avoidance transfers that, if avoided, could trigger systemic risk in the financial markets. Id. By contrast, the majority reasoned, a broader interpretation of the safe harbor "would limit the avoidance power even where it would not threaten the financial system," which was, in the majority's view, "an expansion of the safe harbor provision likely not intended by Congress." Id. 

Next, the Second Circuit majority determined that the district court correctly found that the 2013 merger agreement was a "securities contract" and that the shareholder payments were "settlement payments" within the scope of section 546(e). Id. at 149–50.

Finally, the Second Circuit majority held that the trustees' claims for unjust enrichment arising from the shareholder transfers "conflict with the purpose of § 546(e)," but that the claims arising from the payroll transfers do not because they do not fall within the scope of the safe harbor. It accordingly ruled that the litigation trustee's state law claims for unjust enrichment arising from the payroll transfers were not preempted by section 546(e). Id. at 150.

U.S. Circuit Judge Richard J. Sullivan authored a dissenting opinion in which he agreed with the majority that the safe harbor applied to the shareholder transfers but stated that section 546(e) should also apply to the payroll transfers. Judge Sullivan rejected the majority's transfer-by-transfer approach. "Instead," he wrote, "I believe that the district court's 'contract-by-contract' approach better comports with the plain meaning of section 101(22)(A)'s text and more faithfully gives effect to Congress's purpose in enacting section 546(e)." Id. at 151 (dissenting opinion). Judge Sullivan accordingly would have affirmed the district court's ruling in all respects.


On January 3, 2024, the Second Circuit denied a petition filed by the shareholder defendant-appellees of Nine West's publicly traded predecessor, Jones, seeking a panel rehearing and rehearing en banc of the ruling.

With the Second Circuit's ruling in Nine West, it would appear that the litigation over the debtor's 2014 LBO is far from over. The district court will now have to adjudicate the liquidation trustee's unjust enrichment claims against the D&O defendants as well as the resurrected claims seeking avoidance of the payroll transfers. 

Nine West is an important ruling for a number of reasons. First, it reinforces the Second Circuit's groundbreaking decision in Tribune expanding the scope of the section 546(e) safe harbor to shield from avoidance constructively fraudulent transfers in which a qualifying financial institution acted as the debtor-transferor's agent. Second, the Second Circuit rejected the "contract-by-contract" approach and adopted the "transfer-by-transfer" approach in interpreting section 546(e) to ensure that the scope of the safe harbor does not reach beyond its underlying purpose by insulating every component of a transaction from avoidance even though a financial institution did not act as the debtor-transferor's agent for each component of the transaction. In addition, Judge Sullivan's full-throated support of the contract-by-contact approach and rejection of the transfer-by-transfer approach in his dissent appears to indicate that the debate over the breadth of the 546(e) safe harbor is alive and well. 

On October 3, 2022, the Second Circuit issued an order staying the appeal of the district court's decision in Boston Generating pending the issuance of its ruling in Nine West, directing the parties to address the effect of the ruling on the appeal no later than 14 days after it handed down its decision. The remaining litigants submitted post argument letter briefs on December 11, 2023.

Read the full Business Restructuring Review here.

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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