Restructuring

Contributed by Dana Hall
A recent decision by the District Court for the Southern District of New York in AP Services LLP v. Silva further broadens the securities settlement payment safe harbor provision under section 546(e) of the Bankruptcy Code by providing that the safe harbor may apply regardless of whether the unwinding of the transaction in question would have an adverse effect on financial markets.
Section 546(e) of the Bankruptcy Code limits a trustee’s avoidance powers under sections 544, 545, 547, and 548 of the Bankruptcy Code by providing, in pertinent part, as follows:

[A] trustee may not avoid a transfer that is a . . . settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7) . . . .

In 2011, the Second Circuit handed down a decision in Enron which applied the section 546(e) safe harbor to an issuer’s redemption of its commercial paper prior to the maturity date.  In that decision, the Second Circuit interpreted section 546(e) broadly and determined, among other things, that the safe harbor provided under section 546(e) could be equally applied to transactions in which a financial intermediary did not take a beneficial interest in the securities.  The Enron decision was discussed here.  A subsequent decision by the District Court for the Southern District of New York in In re Quebecor World (USA) Inc.,interpreting Enron, was discussed here.  The decision in AP Services relies heavily upon the Enron precedent in its broad interpretation of section 546(e) of the Bankruptcy Code.
In AP Services, the principal shareholders (who also served as the CEO, COO, and chair of the Board) of Chem Rx, a long-term care pharmacy, sold their shares to Paramount Acquisition Corporation, an acquisition vehicle, for the purpose of implementing a leveraged buyout.  Paramount’s stock acquisition was funded via a $177 million loan provided by several lenders.  Following the stock purchase, Paramount merged with Chem Rx and changed its name to Chem Rx Corporation (“CRC”).  Shortly after completing the leveraged buyout, CRC violated its loan covenants, defaulted on its obligations, filed for bankruptcy protection, and was liquidated pursuant to a chapter 11 plan of liquidation.
The litigation trustee appointed pursuant to CRC’s chapter 11 plan sought to avoid the payments to the principal shareholders of Chem Rx for the buyout of their shares on the basis that those transfers constituted fraudulent transfers because they were made with actual intent to defraud CRC’s creditors and, in any event, had been made for less than reasonably equivalent value and had rendered CRC insolvent. The trustee asserted that the principal shareholders of Chem Rx had, in connection with the preparation of documents presented to Paramount’s lenders, misstated Chem Rx’s historical financial performance and offered unreasonable future projections based on false data.  The principal shareholders, in turn, argued that the trustee’s fraudulent transfer action was barred by the securities settlement payment safe-harbor provision provided under section 546(e) of the Bankruptcy Code.  Although the trustee also asserted other breach of fiduciary duty claims against the principal shareholders, this article deals only with the trustee’s avoidance action and application of section 546(e) of the Bankruptcy Code.
Relying on Enron, the AP Services court rejected the trustee’s argument that the 546(e) exemption was not meant to apply to a transaction in which the funds were transferred directly to a shareholder’s bank account.  The District Court found that a payment for securities constitutes a “settlement payment” even where no financial intermediary has taken a beneficial interest in the transferred securities.  Further, the court found that the transactions were protected by the safe harbor provision because the settlement payments were made to the principal shareholders’ banks – “financial institutions” – and, therefore, satisfied the requirements of section 546(e) of the Bankruptcy Code.
The AP Services court also rejected the trustee’s argument that the transaction did not implicate any of the concerns raised by the Second Circuit in Enron, i.e., that unwinding the transaction would “substantially and negatively affect the financial markets.”  Relying on precedent in the Third, Sixth, and Eighth Circuits, the court found that section 546(e) was intended to be applied in the context of a leveraged buyout involving privately held shares because, given the amount of money in question, unwinding such a transaction could potentially affect national markets.  The court also noted that requiring a factual determination to be made in each case with respect to whether unwinding a concluded leveraged buyout would have an adverse impact on financial markets would cloud all such transactions in uncertainty and that, accordingly, such a result was not permissible.  The court’s language seems to open the door to the possibility that the recipient of funds in any securities transaction, regardless of how small, may be permitted to benefit from the protections of section 546(e) of the Bankruptcy Code as long as the funds in question were not handed over in a briefcase (i.e., were transferred to a “financial institution”).
The trustee has appealed from the District Court order to the Second Circuit.  It therefore remains to be seen whether the Second Circuit will embrace the extension of Enron adopted by the District Court in AP Services.  In the meantime, in light of the Enron, Quebecor,and AP Services decisions, it is likely that courts in the Second Circuit will continue to construe section 546(e) of the Bankruptcy Code broadly and apply the safe harbor provision regardless of whether the transaction in question involved the sale of privately held shares or the use of a financial intermediary.