Restructuring

Contributed by Kyle J. Ortiz
With his hands tied by the recent Enron decision, Judge Peck recently granted summary judgment in favor of a group of noteholders that had been sued in a preference action brought by the Unsecured Creditors’ Committee in Quebecor’s chapter 11 case.  In re Quebecor World (USA) Inc., No. 08-10152, 2011 WL 3157292 (Bankr. S.D.N.Y. July 27, 2011).  As we recently discussed in this blog, the Second Circuit held in Enron that certain payments made by Enron to investors for early redemption of its commercial paper constituted “settlement payments” that were protected from avoidance by the safe harbor provisions of section 546(e) of the Bankruptcy Code.  The Second Circuit reached this result even though the payments did not precisely follow practices “commonly used in the securities trade.”

Prior to the Enron ruling, Judge Peck had been evaluating conflicting testimony in Quebecor regarding the usage of the term “settlement payment” within the private placement sector of the securities industry “to decide whether the prepetition transfer of value to the defendants should be characterized as redemption of the private placement notes rather than a repurchase.”  Following Enron, however, Judge Peck stated that the “distinction to the extent it once had significance, no longer matters, and the analytical task for the court has been simplified by precedent making clear that the transfers at issue in this litigation fit the statutory definition of settlement payments and may not be avoided.”
Background and Pre-Enron Trajectory of Quebecor
In 2000, a Quebecor entity issued notes in a private placement.  Quebecor had the right to repay all or part of the notes at any time for any reason, and any note paid or prepaid was required to be surrendered to Quebecor for cancellation.  By 2007, Quebecor was in dire financial straits, in danger of defaulting under a financial covenant in the notes, and desperate to make a deal with the noteholders to avoid a cross-default under a separate $1 billion bank revolver.  In August, 2007, Quebecor made a partial tender offer to repurchase 50.1% of the notes in exchange for the noteholders’ consent to amend the financial covenant.  The noteholders, however, refused the offer.
Without any other options and facing a default, Quebecor issued a notice of redemption designating October 29, 2007 as the date it would redeem all outstanding notes.  On that date, Quebecor wired money to the trustee for the notes, which in turn distributed the funds to each noteholder.  The noteholders subsequently surrendered the physical notes by mailing them to Quebecor’s headquarters.
Although Quebecor had avoided a cross-default, its financial situation continued to deteriorate, and it filed for CCAA protection in Canada on January 20, 2008, and chapter 11 in the United States a day later.  Shortly thereafter, the creditors’ committee commenced its action to avoid and recover Quebecor’s payments made to the noteholders in connection with early redemption of the notes.
The creditors’ committee alleged that the payments were preferential transfers subject to avoidance under section 547(b) of the Bankruptcy Code. The noteholders, in defense, claimed that the transfers were “settlement payments” carved out as an exception to section 547(b) by operation of the safe harbor provision of section 546(e) of the Bankruptcy Code.  If the transfers to redeem the notes qualified as settlement payments, the noteholders would be able to preserve their payment in full while other unsecured creditors received percentage distributions.
Judge Peck noted that such lopsided treatment of similarly situated creditors is exactly what the Bankruptcy Code seeks to prevent:  “Purely from an equitable perspective, the disparity in relative recoveries between the Noteholders and Quebecor’s other creditors almost cries out for a remedy unless the payments fall within an appropriately more favored category of transfers that logically fits the definition of settlement payments under the Code.”
The creditors’ committee argued that the Quebecor transaction did not fit the definition because, among other defects, the transaction involved a unilateral payment by Quebecor to the noteholders in exchange for the noteholders’ later return and cancellation of the notes.  The creditors’ committee argued that this lack of simultaneity was indicative of the fact that there was no settlement risk relating to a contemporaneous exchange of cash for securities, and thus the transaction was not consistent with common procedures for settlement payments in the securities trade.
In discussing the merits of these arguments, Judge Peck pointed out that Judge Drain had recently been asked to determine whether certain transactions should be extended the protections of “settlement payments” in In re MacMenamin’s Grill, Ltd. Judge Drain looked to legislative history and found that Congress intended section 546(e) to shield from avoidance transfers that involve an “entity in its capacity as a participant in any securities market” or that “pose any danger to the functioning of any securities market.”  Judge Drain held that the transfers in MacMenamin (three small payments of a few hundred thousand dollars as part of a leveraged buyout of a bar and grill) did not pose any danger to the securities market and held that section 546(e) did not protect the transactions from avoidance.
Second Circuit Decides Enron
While Judge Peck was making his way through the extensive testimony and briefing of the parties to determine whether the repurchases were “settlement transactions,” the Second Circuit handed down Enron.
Unlike Judge Drain in MacMenamin, the Second Circuit did not look to the legislative history of section 546(e) because it found the plain language of the statute unambiguous.  The Second Circuit concluded that the failure of the redemption payments to follow standard industry procedures did not render them ineligible as “settlement payments” because “the grammatical structure” of section 741(8) “strongly suggests that the phrase ‘commonly used in the securities trade’ modifies only the term immediately preceding it.”  In essence, Enron seemingly held that any payment in settlement of a security qualifies as a settlement payment.  Whether subsequent courts would try to find some way to limit Enron’s holding remained to be seen.
Judge Peck’s Interpretation and Application of Enron
Judge Peck found, in the context of the Quebecor transaction, that the creditors’ committee could not escape the application of section 546(e)’s settlement payment exception, stating that “[t]he practical effect of [Enron] is to make it more difficult for a plaintiff such as the Committee to maintain a viable cause of action for avoidance in relation to prepetition transfers made to complete a transaction involving a security. Because the definition of the term ‘security’ in section 101(49) of the Code covers such a long list of debt and equity instruments, the impact of the decision on avoidance actions may be quite far reaching.”
Judge Peck held that Enron left no doubt that the payments in Quebecor were settlement payments because they involve the transfer of cash to complete a securities transaction.  “The test has become quite simple and all-encompassing and does not lend itself easily to the formulation of nuanced exceptions.”
What Do Enron and Quebcor Mean Going Forward?
Although Judge Peck followed precedent and dismissed the action in Quebecor, he expressed concern about what Enron means going forward.  “One of the challenges in applying the Enron holding on a case-by-case basis is that the definition may extend protection to transfers that Congress never intended to immunize and may lead to unintended consequences.”  Peck noted that the Second Circuit’s definition of settlement transaction is so broad that it will be difficult to determine where to draw the line between what should be exempt and what should not.   A transaction that has no connection to the securities market (e.g., MacMenamin ) may now be protected from avoidance despite posing no systemic risk.
The practical consequences of such a broad definition are far reaching.  As Judge Peck noted, the noteholders “gang[ed] up on a vulnerable borrower to obtain clearly preferential treatment in the months leading up to a bankruptcy.”  As Quebecor shows, after Enron, other creditors have far more limited means to remedy inequities in recoveries between securityholders and other creditors.