Restructuring

Contributed by Brian Wells
In its recent decision, In re Quebecor World (USA) Inc., the District Court for the Southern District of New York found that payments made to redeem outstanding notes by a company on the verge of bankruptcy qualified as “settlement payments” under the 546(e) safe harbor and thus could not be clawed back in an avoidance action.  The court upheld Judge Peck’s application of the Second Circuit’s Enron decision and confirmed that section 546(e) broadly encompasses cash transfers made to “complete a securities transaction” (creating an equally broad exception to preference and fraudulent transfer restrictions).
At issue in Quebecor was a $371 million redemption payment made to a class of subordinated noteholders during the ninety-day preference window.  The notes included a covenant restricting Quebecor’s debt-to-capitalization ratio to, at most, fifty-five percent, and were redeemable upon payment of outstanding principal and interest, along with an additional “make-whole” premium.  Breach of the covenant was imminent, a result Quebecor could not afford because of cross-default clauses in its other agreements; however, strapped for cash, it also wanted to avoid redeeming all of the outstanding notes at a premium.  Its solution was to make a limited tender offer for a controlling share of the notes, in exchange for an agreement by consenting noteholders to loosen the required debt-to-capitalization ratio to sixty-five percent.  In response, the noteholders unanimously rejected this offer, entering a separate agreement amongst themselves and preventing the transfer of notes to any party that was not then a noteholder.  This tactic effectively blocked any attempt by Quebecor to renegotiate the restrictive covenant, and as a result it had no choice but to redeem all of the outstanding notes.  Shortly thereafter Quebecor’s US subsidiary, which had guaranteed the notes, petitioned for chapter 11.
The redemption payment was almost certainly a preferential transfer under Bankruptcy Code section 547(b), i.e., a payment made by an insolvent debtor on account of an antecedent debt within the ninety days preceding bankruptcy.
Though such payments would ordinarily be clawed back under the trustee’s avoidance power, the noteholders argued that the redemption payment fell within the safe harbor of 546(e), which shields “settlement payments” from avoidance.  Judge Peck heard expert testimony on the meaning of “settlement payment” in the securities industry (and whether the term would apply to the redemption payment); however, before he came to a decision the Second Circuit issued an opinion on section 546(e) in the Enron case.  The Enron court held that under the plain language of the Bankruptcy Code a “settlement payment” was “a transfer of cash to a financial institution to complete a securities transaction.”  As a result of the decision, Judge Peck declared his hands tied and ruled that the contested transfers were “settlement payments.”
The decision was appealed to the District Court for the Southern District of New York, where the appellants argued that the bankruptcy court had misinterpreted the Second Circuit’s Enron decision and improperly expanded the decision to cover redemption payments.  The District Court, like the Bankruptcy Court, reviewed the Enron decision and found that the Second Circuit’s opinion was controlling.  It found that the simple test was whether the redemption payments were “a transfer of cash to a financial institution to complete a securities transaction.”  Walking through the facts, the court noted that 1) pursuant to the redemption Quebecor had transferred over $376 million, 2) the cash was transferred to the noteholders’ trustee, a financial institution, and 3) because the redeemed notes qualified as securities under the Bankruptcy Code, the payment completed a securities transaction.  The safe harbor was thus satisfied and the payments could not be avoided.
As a result of this decision, creditors of a company on the verge of bankruptcy now have greater certainty that a redemption of debt instruments will be safe from challenge as a preference or fraudulent transfer if the issuer later files for bankruptcy—at least issuers who file in bankruptcy courts within the Second Circuit.  The decision has broader implications as well, suggesting that notes, bonds, debentures, and other any obligation recognized by the Bankruptcy Code as a “security” can be repaid during the preference window without the threat of avoidance (as long as the funds are initially paid to a financial institution, as was the case in Quebecor).
Perhaps with these consequences in mind, the District Court expressed some misgivings with the outcome.  The District Court approvingly quoted sources critical of the Enron decision, including Judge Peck’s opinion, and noted that if it were “writing on a blank slate, it might conclude that [the appellant’s arguments] called for a narrower definition of ‘settlement payment’ that excluded the payments here.”  However, bound by Enron’s extremely broad definition of “settlement payment,” Judge Furman noted that any change in the rule would have to come from the Second Circuit—or the Supreme Court.