Courts Split in Interpretation of §546(e) Avoidance Action Defense
by: John F. Carlton
Whiteford, Taylor & Preston L.L.P.; Baltimore
Disputes over proper statutory construction of the Code have often pitted strict statutory constructionists against those that hold a more practical, holistic view of bankruptcy law. A split in authority over the proper interpretation of §546(e) of the Code is another example of such a statutory construction dispute. Section 546(e) provides a defense to certain fraudulent conveyance actions that seek to avoid pre-petition transfers in connection with securities transactions. There has been a wide range of opinions in the case law discussing the scope of the transactions to which §546(e) applies. The courts are split as to whether this defense is limited only to transactions involving publicly-traded securities or applies to transactions involving privately held securities as well.
Section 546(e) establishes an absolute defense to certain fraudulent conveyance actions, providing in relevant part that “the trustee may not avoid a transfer that is a margin payment…or a settlement payment, as defined in §§101 or 741 of this title, made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency….”[1] This defense applies to payments in securities transactions that are made through a financial institution, which would otherwise be avoidable as constructive fraudulent conveyances under §548(a)(1)(B) or §548(b) of the Bankruptcy Code or as constructive and intentional fraudulent conveyances under state law pursuant to §544 of the Bankruptcy Code. The defense is not available for intentional fraudulent conveyances under §548(a)(1)(A).[2]
The current split over the application of the §546(e) defense focuses on the interpretation of the term “settlement payment.” Bankruptcy Code §741(8) defines “settlement payment” for the purposes of §546(e) as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.”[3] The fundamental distinction that has split the courts regarding the scope of the §546(e) defense is whether the definition of “settlement payment” is limited to only those transactions involving publicly traded securities that employ the securities industry clearance and settlement systems or, instead, applies to all purchases of securities.
The §546(e) defense to fraudulent conveyance actions has arisen in the context of leveraged buyouts (LBOs) because LBOs often involve securities transactions. Payments or transfers from a corporation related to transfers of its own stock, such as is present in some LBOs, are frequently susceptible to challenge later as avoidable fraudulent conveyances under either §548 or state fraudulent conveyance law as made applicable to a bankruptcy case under §544. Section 546(e) provides a possible defense to actions to avoid fraudulent conveyances related to LBOs. But even beyond the context of LBOs, §546(e) may be implicated in simple stock redemptions.
The basic two-prong test for avoidability of constructive fraudulent conveyances under §548(a)(1)(B) is (1) whether the transfer of the debtor’s assets was in exchange for less than reasonably equivalent value and (2) whether the debtor was insolvent at the time of the transfer or rendered insolvent by the transfer.[4] With regard to a distribution by a corporation to a shareholder on account of an equity interest, this two-prong test really collapses into one: the solvency test. This is because a corporation rarely, if ever, receives reasonably equivalent value in return for the purchase of its own stock or a dividend.[5] As a result, courts have long recognized that payments under stock redemption agreements are avoidable as fraudulent conveyances if the debtor is insolvent at the time of the transfer or rendered insolvent by the payments.[6] The broad application of §546(e) to all securities transactions (whether public or private) by some courts may create a planning opportunity to insulate such transfers from avoidance in a subsequent bankruptcy.
Other courts, however, have rejected such broad interpretations of §546(e) specifically to prevent the application of the defense to transactions that do not involve the public securities markets. Two recent decisions from the Delaware and New York bankruptcy courts highlight and discuss the current split in authority with respect to the scope of the §546(e) defense in avoidance actions. The Bankruptcy Court for the District of Delaware’s decision of December 2006, in Official Committee of Unsecured Creditors of The IT Group Inc. v. Acres of Diamonds L.P. (In re The IT Group Inc.),[7] supports the notion that a payment from a debtor through a financial institution for the purchase of any stock, even if otherwise avoidable under §544 or §548, is rendered nonavoidable by §546(e) without regard to whether the stock is publicly or privately held. In March 2007, the Bankruptcy Court for the Eastern District of New York in Official Committee of Unsecured Creditors of Norstan Apparel Shops Inc. v. Lattman (In re Norstan Apparel Shops Inc.),[8] concluded that the securities transferred in such transactions must be publicly traded in order for the transfers to qualify for the §546(e) defense.
In IT Group, the bankruptcy court applied the §546(e) defense as the basis for granting summary judgment in favor of a fraudulent conveyance defendant. In that case, the debtor purchased an additional equity interest in its direct subsidiary for $575,000 from Acres of Diamonds L.P. (Acres). The securities involved were not publicly traded and were not transferred with the use of a clearing agency. The debtor used Citibank, a financial institution, to make the $575,000 payment to Acres. The bankruptcy court, in considering plaintiff’s position that the §546(e) defense was not applicable because the transfers at issue did not involve the public securities markets, acknowledged and discussed the split among the courts regarding the scope of the §546(e) defense. In the end, the IT Group court found that it was bound by Third Circuit’s broad definition of “settlement payment” espoused in Lowenschuss v. Resorts Int’l Inc. (In re Resorts Int’l Inc.). [9] In Resorts, the Third Circuit stated that any transfer of cash or securities made pre-petition by a bankruptcy debtor, through a financial institution,[10] as payment in a securities transaction is a nonavoidable settlement payment under §546(e).[11] Consequently, the IT Group court concluded that under the holding of Resorts, §546(e) provided a complete defense for the defendant, despite the fact that the case did not involve “publicly traded stock or a clearing agency.”[12]
The Tenth Circuit likewise broadly defines “settlement payment” for the purposes of §546(e). In Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.), the Tenth Circuit held that LBOs were not excluded from §546(e) merely because they are not “routine” securities transactions.[13] The Kaiser Steel court noted that §546(e) has no language that would exclude the full scope of securities transactions from being subject to the defense. In an earlier decision in the same bankruptcy case, the Tenth Circuit noted that any conclusion that limited the scope of §546(e) to only routine public securities transactions would be “an act of judicial legislation.”[14]
As explained in IT Group, these courts have employed a literal interpretation of the term “settlement payment” defined in §741(8) and employed in §546(e). “Settlement” is a term of art in the securities industry and means, simply, the completion of a securities transaction.[15] A transfer of “stock or cash to pay for stock” is not avoidable so long as the payment for that stock (i.e., a settlement payment) was made to or by a financial institution.[16] These courts specifically reject any notion that a settlement payment must involve the public securities and settlement system before the §546(e) defense is availing,[17] indicating that nowhere in §741(8) is a settlement payment expressly limited to the payment for public securities employing the settlement system.[18]
In Norstan Apparel, the Bankruptcy Court for the Eastern District of New York was considering the application of §546(e) in an LBO situation. In this fraudulent conveyance action, the defendants’ privately-held equity interests in the debtor were purchased pre-petition for $55 million, with the debtor’s previously unencumbered assets pledged to secure loans made to finance the purchase.[19] The defendants argued that the payments they received were settlement payments and therefore not avoidable pursuant to §546(e). The court rejected the §546(e) defense, finding that the payments at issue were not settlement payments because they did “not involve publicly traded securities or otherwise implicate the public securities markets. . . .”[20]
In reaching its holding, the Norstan Apparel court rejected the rationale employed in IT Group and its progeny. Norstan Apparel, in interpreting the same §748(8) definition of “settlement payment,” concluded that only payments made employing the public securities markets amounted to settlement payments.[21] The decision in Norstan Apparel joined with other courts that have held that the term “settlement payment,” and thus the §546(e) defense, is limited to transactions involving public securities.[22]
Norstan Apparel’s rationale focused on the modifying phrase at the end of the §741(8) definition of settlement payment: “…or any such payment commonly used in the securities trade.” [23] This modifying language, under Norstan Apparel, is what dictates that the §546(e) defense must be restricted to payments made within the public securities trade.[24] To support this conclusion, cases limiting the application of §546(e) to public securities transactions have pointed to the legislative history as indicating that the purpose of §546(e) was to protect the public securities markets.[25] House Report 97-420 recognized that the securities markets “operate through a complex system of accounts and guarantees.”[26] Because of the structure of and volatility within the securities industry, §546(e) provides protections to “prevent the insolvency of one commodity or security firm from spreading to other firms” and to protect against such a “ripple effect” from “threatening the collapse of the affected market.”[27] Thus, the legislative history shows that purpose of the §546(e) defense was to promote the stability of the public securities markets.[28]
Prior to Norstan Apparel, a number of courts also focused on §546(e)’s purpose of protecting public securities markets as a means of determining the limits of the scope of the application of the defense.[29] A common conclusion in these cases is that the §546(e) defense does not apply to securities that are not publicly traded because the stability of the public markets, involving the clearance and settlement process, is not at issue. For example, in Zahn v. Yucaipa Capital Fund, the District Court for the District of Rhode Island found that a transfer of nonpublic stock can never qualify for the §546(e) defense because such transfer has no “connection whatsoever to the clearance and settlement system” and allowing for the avoidance of such a transaction “would have no impact at all on that system.”[30]
Courts reaching these contrasting interpretations of the scope of §546(e) have often used identical approaches to statutory interpretation such as that set forth by the Supreme Court in United States v. Ron Pair.[31] In Ron Pair, the Supreme Court stated that the analysis must begin with a review of the plain language of the statute.[32] When the language is clear, no further inquiry is necessary unless applying the plain language leads to an absurd result.[33] The Third Circuit’s decision in Resorts, for example, specifically found that no absurdity resulted from applying the §546(e) defense in a case where the settlement payment at issue was a payment to shareholders under an LBO that did not employ the clearance and settlement systems.[34] The court in Norstan Apparel, relying on identical principles of statutory construction, refused to apply the §546(e) defense to a transaction not involving the public securities market because such a broad application would lead to “absurd” results.[35]
While absurdity may be in the eye of the beholder, there is no question that a broader application of §546(e) would create a defense for certain otherwise avoidable transfers not intended to be protected by Congress in enacting these provisions. In those jurisdictions where the term “settlement payment” is applied broadly, any transaction involving the transfer by a debtor for the purchase of its own stock can be shielded from avoidance as a constructive fraudulent conveyance by merely having the payment made through a financial institution. Indeed, as recognized in Norstan Apparel, under such an interpretation, “any leveraged buyout, if structured as a direct purchase of stock from the shareholders … would fall within the meaning of §546(e) … and thereby be immunized from avoidance….”[36] More than an opportunity to protect LBOs from subsequent fraudulent conveyance actions, a broad definition of §546(e) also provides a unique opportunity for owners of closely-held corporations to insulate their receipt of corporate distributions from later avoidance. For example, a sole shareholder of a corporation could cause redemption of a portion of her stock, draining an insolvent company of its liquid assets, and yet enjoy nearly complete protection from an action to avoid the transfer as a constructive fraudulent conveyance.[37]
At least until there is a resolution of the split in authority on the application of the §546(e) defense, attorneys working on securities transactions should be mindful of the possible protections that are available to insulate such transactions from subsequent avoidance.