Just How Safe a Harbor Is Bankruptcy For Pre-Bankruptcy Securities-Related Transactions?

Oct 10, 2017 | Blog

The Bankruptcy Code contains a variety of what has been frequently referred to as “safe harbor provisions” that provide significant benefits to certain participants in the financial markets. Among these provisions is section 546(e) of the Bankruptcy Code which limits the power of a debtor or trustee to avoid and recoup for the bankruptcy estate the financial benefits of certain types of transfers made pre-bankruptcy by or to an enumerated group of financial market participants. Those participants are defined to include commodities brokers, stockbrokers, financial participants, forward contract merchants, and securities clearing agencies. The types of transfers that are exempt from avoidance under the safe harbor of section 546(e) are a “margin payment” and a “settlement payment.”

Prior to 2010, courts generally were caused to deal with this safe harbor provision in the context of leveraged buyouts (LBOs). However, since then the courts have been caused to address this provision in more expanded horizons, including for “settlement payments” related to certain types of securities transactions covered by the safe harbor. Beginning in 2009, the Courts of Appeals for the Third, Sixth and Eighth Circuits held that payments made in connection with an LBO to holders of securities of private companies are protected by the safe harbor of section 546(e). During that same year, the District Court for the Southern District of New York joined these courts in expanding the scope of the 546(e) safe harbor in holding that a premature redemption of a debt is a “securities transaction” qualifying for protection as a “settlement payment” under the Bankruptcy Code safe harbor provision. Most of these decisions applied a “plain language approach” to the interpretation of the safe harbor language in section 546(e) resulting in ever-expansive protection to the securities markets.

A half decade later in 2015 the Second Circuit Court of Appeals issued a new and highly anticipated decision addressing section 546(e) that was again interpreted as expanding the scope of the safe harbor protections. In that decision, the Second Circuit determined that in the highly reported bankruptcy case surrounding the demise of the Madoff funds that the trustee, Irving Picard, could not recover certain prepetition withdrawal payments made to customers of Madoff. The Court once again read broadly the language of section 546(e) in holding that it shielded these payments from recovery back into the bankruptcy estate, even though no “securities” were actually purchased or sold by or to Madoff’s customers. Here, issues arose because Madoff never actually conducted any securities or options trades on behalf of its customers. Instead, the company fabricated account statements, that purported to show securities trading activity and the profits therefrom but, were in fact, simply fictitious. The Second Circuit, however, initially relied on the “extraordinary breadth” of the definition of a “securities contract” under the Bankruptcy Code to find that the variety of Madoff customer account documents qualified as a “securities contract” for purposes of consideration for the protections of section 546(e). The Court then turned to determining whether the customer withdrawals from the Madoff funds were made “in connection with” these security contracts. In doing so the Second Circuit stated that section 546(e) only set a “low bar” for this requirement by merely requiring that a transfer be “related to” or “associated with” a securities contract. In the Court’s view this analysis applied even if the underlying agreements were either irrelevant to the payments made or that the payments themselves were unauthorized. Thus, the Second Circuit found that the customer withdrawals in question were made “in connection with” the security contracts (i.e., collective account documents) even though they were fraudulently made from fictitious profits of the Madoff Ponzi scheme. Alternatively, the Court determined that the customer withdrawals were protected from being avoided because they were “settlement payments” as that term has been broadly construed to apply to “the transfer of cash or securities made to complete [a] securities transaction.” Underlying this legal analysis was also a significant policy consideration of the potentially devastating impact on the securities markets if the trustee, in this instance (and thereafter), was allowed to claw back “millions” if not billions of dollars from Madoff’s former customers and thereby result in the type of “displacement” that section 546(e) appears to have been designed to avoid. Notably, also, the Second Circuit’s determinations (as well as those prior from the Seventh Circuit) deviated from prior decisions of other courts, including those in the Ninth and Fifth Circuits that expressed reluctance to extend the safe harbor protections to the context of a Ponzi scheme or other fraudulent or alleged illegitimate activities. Yet, the Supreme Court still denied certiorari in considering any review of the Second Circuit’s Madoff decision, even in light of a split in authority in this instance.

While the Second Circuit, in particular, has continued to take an ever expansive view of the scope of the protections afforded by the safe harbor provision of section 546(e) and of its preemptive rights thereunder, other circuits and courts have not been as willing to push the contours and reach of the safe harbor. Indeed, creditors, and their counsel, must remain conversant in the ever changing world of judicial interpretation of section 546(e) or they may be unduly surprised to learn that one court’s view is hardly that of another.

Case in point, the Supreme Court has recently finally agreed to consider the applicability of the safe harbor of section 546(e) after new differing interpretations of the statute once again created a split among the circuits. In this instance, the case taken up to our highest court is one out of the Seventh Circuit, FTI Consulting, Inc. v. Merit Mgmt. Grp., LP. The Court’s ultimate determination here could very well result in impacting how parties look to structure asset transactions and debt obligations moving forward.

In FTI Consulting the Seventh Circuit was faced with the issue of whether private transactions of securities should be afforded the protections of section 546(e). Notably, many private company transactions flow through financial institutions or participants or involve financial institutions as the third party lenders to LBOs. A majority of circuit courts have adopted a plain-meaning, pass-through theory to similar situations in finding that a broad interpretation of the statute results in protecting such transfers as having been “by or to” a financial institution as captured by the plain language of section 546(e). In FTI Consulting the Seventh Circuit chose to reject the majority view and applied a more narrow interpretation to the scope of section 546(e) and its protections. This Court found that the pass-through of a security through a financial institution as well as the lending provided by a third-party do not trigger, at least in that circuit, the safe harbor provision of section 546(e). This interpretation is in line with that of a divided opinion out of the Eleventh Circuit in Munford v. Valuation Research Corp. which found that a transaction similar to the one before the court in FTI Consulting that involved a financial institution as a mere conduit was not protected by the safe harbor of section 546(e). Yet, courts of the Second, Third, Sixth, Eight and Tenth Circuits have found to the contrary and disagree with the interpretations applied by the Seventh and Eleventh Circuits. Those Circuit courts have been finding that both the language of section 546(e) is unambiguous and that intermediary financial institutions that touch a securities transaction referenced in section 546(e) trigger the safe harbor protections. If the Supreme Court decides to follow this majority view and overturn the Seventh Circuit (a not unexpected potential result given the current makeup of the Court), it would solidify the ever-growing barrier of section 546(e) against a trustee or a debtor from having the wherewithal to even attempt to clawback certain pre-bankruptcy securities-related transactions.

In short, the safety of the safe harbor provision for securities-related transactions remains a very fluid area under bankruptcy law. Should you have any questions regarding these rulings or with respect to other bankruptcy-related issues, please contact Eric Sleeper.