Restructuring

Contributed by Lee Jason Goldberg
In Part II of this three-part entry, we mentioned that the District Court for the Southern District of New York in AP Services LLP v. Silva made two key holdings regarding application of the safe harbor in section 546(e) of the Bankruptcy Code. First, the Silva court held that a “financial intermediary” was not required, only a “financial institution.” Second, the court refused to require a factual determination as to whether upsetting a concluded LBO would have an adverse effect on the financial markets.
We examined the first holding in Part II, and in this part of the entry, we discuss how the Western District of New York bankruptcy court in Cyganowski v. Lapides (In re Batavia Nursing Home, LLC, et al.) and the Northern District of New York bankruptcy court in Woodard v. PSEG Energy Technologies Asset Mgmt. Co., LLC, et al. (In re Tougher Industries, Inc., et al.) relied on the second Silva holding to analyze the much smaller LBOs – $1.179 million and $3.6 million, respectively – at issue in the cases before them.
Is the Dollar Amount of a Transaction Analogous to the Commonness of a Transaction?
Even assuming that a financial intermediary is not required for application of the section 546(e) safe harbor, the question remains as to whether a party must show that undoing a transaction would pose a risk to the financial markets. Some courts have considered this question by looking at, among other things, the dollar amount of the transaction at issue, as avoidance plaintiffs have continued to argue that the safe harbor should not be applied to small transactions.
In upholding the application of the safe harbor to a $106 million transaction, the court in Silva rejected any requirement that a party show that undoing a transaction would have a negative effect on the financial markets, relying on, inter alia, the Third Circuit (Brandt v. B.A. Capital Co. LP (In re Plassein Int’l Corp.)), the Sixth Circuit (QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.)), and the Eighth Circuit (Contemporary Indus. Corp. v. Frost) (where the court suggested that undoing a transaction with “so much money at stake” – $26.5 million – could impact the financial markets, as “at least a portion of [the payments] were probably reinvested”).
The Batavia court acknowledged that the $1.179 million at issue seemed to be “far more remote from the ‘financial markets’” than the $106 million involved in Silva but noted that the Silva court, as to that “much higher amount,” rejected any argument that “would require a factual determination in each case as to whether upsetting a concluded LBO would have an adverse effect on the financial markets, thus casting all or at least many such transactions into uncertainty. In view of the Second Circuit’s reasoning in [Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.)], that course is not properly open to this Court.” As discussed below, however, the Second Circuit’s reasoning entailed refusing to require a factual determination as to a transaction’s “commonness” for application of the section 546(e) safe harbor.
The Tougher court similarly agreed with Silva and rejected the trustee’s argument that the section 546(e) safe harbor should not be applied because, given the relatively small amount of money involved in the transaction, avoidance of the transfers would not have a substantial impact on the financial markets. The court found that the plain language of section 546(e) does not provide a threshold amount below which the safe harbor is not available and noted that the trustee’s position would add a requirement that a “factual determination” be made as to whether the dollar amount of a transaction would have an impact on the financial markets.
The court in Tougher noted that the Second Circuit rejected a “similar argument” in Enron. As one of its three proposed limitations on the definition of “settlement payment” in section 741(8) of the Bankruptcy Code, Enron argued that the final phrase of the definition – “commonly used in the securities trade” – excluded all payments (including the redemption payments at issue in Enron) that are not common in the securities industry from the safe harbor for settlement payments in section 546(e). The Second Circuit rejected this argument, finding that it would make application of the safe harbor in every case depend on a factual determination regarding the “commonness” of a given transaction. Further, as the Tougher court remarked, the Second Circuit indicated that such a reading of the statute “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.”
Holding that the Second Circuit’s rationale as to “commonness” was “equally applicable here” (with “here” referring to the dollar amount of the transaction), the court in Tougher, like the courts in Silva and Batavia, thereby effectively equated a transaction’s size to its “commonness” without acknowledging that it was doing so. Yet, none of those courts included the Enron court’s illustration of the challenges presented by a “factual determination as to commonness,” i.e., whether such determination would “depend on the economic rationality of the transaction, its frequency in the marketplace, signs of an intent to favor certain creditors . . . such as the alleged coercion by Enron’s commercial paper noteholders . . . or some other factor.” Importantly, it was only after offering such an illustration that the Second Circuit sounded its cautionary note about resulting “commercial uncertainty and unpredictability.” The courts in Silva, Batavia, and Tougher, however, failed to explain why the rationale militating against requiring a factual determination as to the commonness of a transaction is equally applicable to requiring a factual determination based on dollar amount.
Indeed, a hypothetical dollar threshold for application of the safe harbor, e.g., $5 million, shows that the analogy between commonness of a transaction and dollar amount of a transaction is imperfect. Notwithstanding the arbitrary nature of setting a specific dollar amount for application of the safe harbor, the simplicity of a dollar threshold contrasts with the array of potential factors cited by the Enron court that may bear on the commonness of a transaction, and, therefore, a dollar threshold may present a more certain and predictable means of determining whether the safe harbor applies.
Must Undoing a Transaction Pose a Risk to the Financial Markets for the Safe Harbor to Apply?
The purpose of pointing out the imperfect analogy between commonness and dollar amount drawn by the courts in Silva, Batavia, and Tougher is that those courts used the Enron rationale to reject plaintiffs’ arguments that undoing the transactions at issue would not have a negative effect on the financial markets. Plaintiffs’ continued use of this argument, which relies on the extra-textual purpose of the statute expressed by the Second Circuit and other courts (generally, that of protecting the financial markets from risks to their stability) – despite the fact that in Enron and Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.) the Second Circuit professed to reach its conclusions regarding section 546(e) based on the statute’s plain language – attests to the need for the Second Circuit to clarify whether undoing a transaction must pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor.
The court’s decision in Batavia also evidences the need for such clarity. The court reasoned that “were any bankruptcy court to decide to conduct an evidentiary hearing into whether a small LBO might be so small as to fail to ‘disrupt the financial markets’ (which was, of course, the stated focus of Congress in enacting the ‘safe harbor,’ [sic]) then every LBO in an amount beneath some indeterminate dollar amount that everyone would agree would ‘disrupt the financial markets’ per se would be suspect” (i.e., not susceptible to protection of the safe harbor).
In attempting to align safe harbor protection of small LBOs with the statutory purpose, the Batavia court observed that the very act of conducting an evidentiary hearing into whether “undoing an LBO might possibly disrupt the financial markets” could cause the disruption that the safe harbor statute sought to avoid. Although the Batavia court’s observation appears to dovetail with the Enron court’s concerns about “certainty and predictability,” the Batavia court was not referring to the markets that would be disrupted by the ultimate recovery of LBO funds in an avoidance action. Instead, the Batavia court was referring to the market for bonds (or other securities) funding “smaller” LBOs that would be disrupted; however, such funding sources are not the recipients of “transfers” subject to avoidance action clawbacks, so section 546(e) does not apply to them.
Thus, the Batavia rationale does not answer the question implied by the court in Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.) prior to Enron that some argue remains outstanding subsequent to Enron – whether protecting a small transaction from avoidance is so demonstrably at odds with the Congressional purpose of section 546(e) that a dollar threshold for application of the safe harbor must be inferred. The imperfect analogy between commonness and dollar amount drawn by the courts in Silva, Batavia, and Tougher does not answer this question, either. The Second Circuit, therefore, arguably has left unanswered the question of whether a lower court may, as in MacMenamin’s, refuse to apply the section 546(e) safe harbor if a party claiming its protection cannot show that avoiding the transaction would pose a risk to the financial markets.
Until the Second Circuit expressly overrules MacMenamin’s, there remains room for plaintiffs to argue that, like in that case, a transaction is not protected by the safe harbor because “Congress intended section 546(e) to address risks that the [defendants] have failed to show conclusively are implicated by the avoidance of the transaction at issue here.” Indeed, the Second Circuit may have left this door open itself. In Part II of this entry, we indicated that the Second Circuit reached its conclusion in Enron by looking to statute’s plain language and declined to address Enron’s arguments regarding legislative history, “which, in any event, would not lead to a different result.” In support of this comment, the Second Circuit cited the canon of statutory construction that “[i]t is well-established that when the statute’s language is plain, the sole function of the courts – at least where the disposition required by the text is not absurd – is to enforce it according to its terms.”
In Part II, we asked, what if a party’s arguments regarding legislative history did lead to a different result? In other words, would the Second Circuit extend the protection of the section 546(e) safe harbor to the small transactions at issue in Batavia and Tougher, or would it find such a result to be absurd or contrary to the Congressional purpose of the statute? Appeals of the decisions in Batavia and Tougher may have provided an opportunity for the Second Circuit to clarify the scope of section 546(e), but, before the district courts rendered their decisions in those cases, the trustees agreed to dismiss their respective appeals.
What Is Next for the Section 546(e) Safe Harbor?
Even a decision from the Second Circuit purporting to clarify the scope of the section 546(e) safe harbor as it is currently drafted may not forestall litigation over the statute, given the conflict between its seemingly broadly worded language and its apparently narrower purpose. Accordingly, it may be in the hands of Congress to refashion a safe harbor that more precisely protects the financial markets from risks to their stability. Without Congressional action, it is likely that parties will continue battling over the contours of the section 546(e) safe harbor in its current form.