In a unanimous decision arising out of the Tribune Media Company bankruptcy cases, a panel of the Second Circuit held that the safe harbor under section 546(e) of the Bankruptcy Code, which precludes avoidance of certain transfers by a debtor to specified financial intermediaries in connection with a securities contract (unless there was intentional fraud), barred state law constructive fraudulent transfer claims asserted by individual creditors of Tribune even though the language of the statute refers only to claims of a “trustee,” i.e., the debtor in possession or an authorized estate representative. The court found that, even though section 546(e) of the Bankruptcy Code does not expressly refer to individual creditors, the prosecution of state law claims by individual creditors that would be barred if prosecuted by the trustee in a bankruptcy proceeding were preempted and barred by federal bankruptcy law.
The dispute arose out of the leveraged buyout (LBO) of Tribune in 2007. In consummating the LBO, Tribune borrowed over $11 billion secured by its assets to refinance Tribune’s debt and cash out Tribune’s shareholders. Soon after the LBO, Tribune filed for bankruptcy in the District of Delaware. The bankruptcy court authorized the official committee of unsecured creditors to pursue an intentional fraudulent transfer action to recover the payments to shareholders in connection with the LBO (intentional fraud claims are not barred by section 546(e)). In June 2011, after the confirmation of Tribune’s chapter 11 plan, various unsecured creditors filed state law constructive fraudulent transfer claims in numerous state and federal courts. These actions were later consolidated before the District Court for the Southern District Court of New York.
After consolidation, the Tribune shareholders moved to dismiss the claims on two grounds: (i) the individual creditors lacked standing and were prohibited from prosecuting their claims by the automatic stay and (ii) the state law constructive fraudulent transfer claims were preempted by federal bankruptcy law and barred by section 546(e). The district court held that the claims were barred by the automatic stay but rejected the shareholders’ argument under section 546(e), finding that on its face the statute only applied to the claims of a bankruptcy trustee and Congress did not extend the safe harbor to state law, fraudulent transfer claims brought by creditors.
On appeal, the Second Circuit reversed but still dismissed the individual creditors’ state law constructive fraudulent transfer claims. The court held that the creditors were not enjoined by the automatic stay from prosecuting the claims, but their state law claims were preempted by federal bankruptcy law and barred by section 546(e). The court relied on the doctrine of implied preemption and fundamental principles of bankruptcy law to support its decision. Under the implied preemption doctrine, “state laws are preempted to the extent . . . state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.” Decision at *17. “Once a party enters bankruptcy, the Bankruptcy Code constitutes a wholesale preemption of state laws regarding creditors’ rights.” Decision at *19. Upon the filing of a bankruptcy case, those state law claims vest with the bankruptcy trustee and are subject to the limitations on such claims imposed by Congress, such as section 546(e).
The Tribune creditors argued that there was no interference with federal bankruptcy law if the state law claims were allowed to proceed. Specifically, the creditors argued that if a bankruptcy trustee does not commence a fraudulent transfer action within the statute of limitations period, those claims revert back to individual creditors. The creditors should then be entitled to pursue their own state law causes of action without restrictions that would have been imposed by the Bankruptcy Code had the claims been prosecuted by the bankruptcy trustee. Otherwise stated, the individual creditors’ state law claims were put on hold until the bankruptcy trustee decided whether to prosecute the action. After the trustee failed to prosecute, the claims reverted back to the individual creditors unhindered by limitations on the prosecution of such claims by the bankruptcy trustee imposed by the Bankruptcy Code. Thus, they argued, there was no conflict between federal bankruptcy law and state law in allowing the individual creditors to later prosecute individual claims under state law.
The court rejected this theory. The court held that there was no statutory basis to support the reversion of state law fraudulent transfer claims of individual creditors if the bankruptcy trustee did not prosecute them. Decision at *27-28. The court found the creditors’ theory to be contrary to the underlying purposes of vesting the right to bring state law based avoidance claims in the bankruptcy trustee pursuant to section 544 of the Bankruptcy Code and the vesting of all property of the debtor’s estate with the bankruptcy trustee generally – namely, to simplify proceedings, reduce the costs of marshalling the debtor’s assets and assure an equitable distribution to creditors. Id. at *29. The court held that allowing individual creditors to prosecute claims that would be barred if prosecuted by the bankruptcy trustee would encourage piecemeal litigation and is contrary to the equality of distribution principles of bankruptcy law. Id. at *30-33.
The decision reinforces the primary objectives of the Bankruptcy Code. The Bankruptcy Code is intended to bring about a final resolution of disputes between a debtor and all of its stakeholders in one forum and proceeding with the objective of treating creditors equally and fairly. The avoidance powers under the Bankruptcy Code provide the bankruptcy trustee a mechanism to treat creditors fairly and enable a ratable distribution of the debtor’s assets. But Congress imposed limitations on those powers through the safe harbor provisions. If individual creditors could bring the very same claims that were restricted in the hands of the bankruptcy trustee to enhance their individual recoveries, then the objectives of achieving an equitable and final resolution of all disputes and claims among a debtor and its creditors would be totally destroyed. In addition, Congress’ determination to protect certain transfers from avoidance in favor of the protection of the financial markets would be undermined.
Sunny Singh is an Associate at Weil Gotshal & Manges, LLP in New York.