Safe Harbor Provisions

Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code.  The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer.[1] The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.

Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor.  The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers.  Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities.  It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”[2]

The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford  Downs, a racino industry competitor.  The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.

The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection:  a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit.[3]  On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers.[4]  The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor.[5]  Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.

Bankruptcy practitioners and scholars are watching this case with great interest.  The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose.[6]  Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents.  These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place.[7]  They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.[8]

The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems.  The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending.  The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners,[9] and the Tribune unsecured creditors submitted a brief in support of Respondent.[10]

Visit HHR’s Bankruptcy Report for future updates on this case.

*Jiun-Wen Bob Teoh assisted with the preparation of this post.

[1]       FTI Consulting Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

[2]       11 U.S.C. § 546(e).

[3]       Brief for Petitioner at 2, Merit Management Group v. FTI Consulting, No. 16-784 (July 13, 2017).

[4]       Brief for Respondent at 2, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 11, 2017).

[5]       Id.

[6]       Brief of National Association of Bankruptcy Trustees as Amici Curiae Supporting  Respondent, at 3, 13-18, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[7]       Brief of Bankruptcy Law Professors Ralph Brubaker, et al. as Amici Curiae Supporting Respondent, at 4, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[8]       Id. at 1-2.

[9]       Brief of Various Former Tribune and Lyondell Shareholders as Amici Curiae Supporting Petitioners, Merit Management Group v. FTI Consulting, No. 16-784 (July 20, 2017).

[10]     Brief of Tribune Company Retirees and Noteholders as Amici Curiae Supporting Respondent, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

On November 5, 2014, the Second Circuit (Judges Winter, Droney, and Hellerstein) held oral arguments in In re Tribune Litigation (Case No. 13-3992) and Whyte v. Barclays Bank PLC (Case No. 13-2653).  As we outlined here, both cases consider the reach of the safe harbor provisions found in section 546 of the Bankruptcy Code that protect certain financial transactions from constructive fraudulent avoidance claims.  The District Court dismissed the plaintiffs’ state law constructive fraudulent conveyance claims in both cases, but reached different decisions on the key question of whether the Bankruptcy Code’s safe harbor provisions impliedly preempt state law causes of action brought by creditors.  Judge Rakoff held that implied preemption applied in Barclays while Judge Sullivan held that the express language of the safe harbors did not preempt state law claims brought by creditors in Tribune.  The defendants in both cases garnered support from numerous amici, including the U.S. Securities and Exchange Commission, U.S. Commodity Futures Trading Commission, the Chicago Mercantile Exchange Inc., the Security Industry and Financial Markets Association, and the International Swaps and Derivatives Association.

At argument, counsel for the creditors’ representative of SemGroup and Tribune both argued that it is clear from the plain language and legislative history of the safe harbor statute that Congress did not intend to preempt state law.  In support of this argument, the creditors’ counsel pointed to, among other things, (i) the express limitation in the statute to claims brought by the trustee (rather than creditors), (ii) language in a separate section of the Bankruptcy Code expressly preempting state law causes of action for avoidance of charitable contributions, (iii) the numerous amendments to the safe harbor provisions without the addition of an express preemption clause, and (iv) a 1976 congressional committee report that shows that the committee did not incorporate the U.S. Commodities Futures Trading Commission’s request for an express preemption provision.  In response, counsel for the defendants in both cases argued that (i) allowing the state law fraudulent transfer claims to proceed would conflict with Congress’ stated purpose in enacting the safe harbor – to ensure stability of the financial markets, (ii) that the creditor representatives should not be permitted to end run federal law by applying state law; (iii) that the scenarios at issue – non-trustee “creditor representatives” pursuing claims under state law that are barred by section 546 – would occur in every case if not barred here.

The court reserved judgment, but early interpretation of oral argument suggests that the majority of the court was persuaded that the safe harbors impliedly preempted the state law causes of action, with one judge noting that the creditors’ state law claims were “the very evil” that Congress intended to avoid when it passed the safe harbor provisions.

Participants in the securities and futures markets rely on the Bankruptcy Code’s safe harbor provisions to protect their transactions and assets when a counter-party enters bankruptcy.  Reliance on the safe harbor provisions, whose objective is to increase the overall stability of the financial markets, was tested by a recent decision of the District Court for the Northern District of Illinois in Grede v. FCStone LLC[1] when the court refused to apply the safe harbor protections of section 546(e) to defeat a preference action by a liquidating trustee against a futures commission merchant that had received a pre-petition transfer from the debtor. Securities and futures market participants surely breathed a sigh of relief on March 19, 2014 when the Court of Appeals for the Seventh Circuit reversed the District Court’s decision[2] and held that the “deliberately broad” text of section 546(e) protected the pre-petition transfers to the futures commission merchant despite the “powerful and equitable” arguments at the heart of the District Court’s decision.  The Seventh Circuit’s decision is consistent with decisions in the Second, Sixth and Tenth Circuits and reemphasized the broad protections that the safe harbor provisions provide to financial market participants in events of counter-party bankruptcy.[3]

Grede focused on a transfer by Sentinel Management Group (“Sentinel”) to FCStone LLC, a former customer of Sentinel, just prior to its collapse in 2007.  The day before it filed for bankruptcy, Sentinel sold a portfolio of customer securities to an equity fund for more than $300 million and deposited the cash proceeds into an omnibus segregated customer cash account.  Mere hours before filing its petition, Sentinel started paying out full and partial redemptions to certain customers, FCStone being one of them.  After the bankruptcy court appointed a trustee for the estate, the trustee commenced adversary proceedings to avoid the transfer to FCStone (as well as transfers to other former customers) as preferential. The District Court withdrew the reference to the bankruptcy court, finding that the proceedings raised significant unresolved non-bankruptcy issues.  It then held that the trustee could avoid the transfer as preferential because it constituted a mere “distributions of proceeds” and because applying the safe harbor could create systematic risk to the financial markets.

On appeal, the Seventh Circuit reversed, holding that safe harbor contained in section 546(e) prevented the avoidance of the transfer as preferential. Specifically, the court found that the transfer was a “settlement payment…in connection with a securities contract,” and that the securities sale to the equity fund, a swap of shares for cash, fell squarely within section 546(e)’s definition of a “settlement payment.”  The Court also noted that even though the customers did not have rights to the specific securities in their investment portfolios, their investment agreements obligated Sentinel to purchase and sell securities for their benefit.  As such, each agreement constituted a “contract for the purchase or sale of a security” thereby satisfying the requirements of section 546(e).  The Seventh Circuit recognized the public policy reasons for the District Court’s ruling, but held that, absent a finding of actual fraud in the pre-petition transfer, the District Court’s decision was in direct conflict with the explicit, broad language of the safe harbor provision.

The Seventh Circuit’s ruling paid particular attention to Congress’s intention in enacting the safe harbor provision to prevent a large bankruptcy from having a domino effect of successive bankruptcies among affected securities or futures businesses.  The court recognized that in the securities and futures industry, where large amounts of money are transacted rapidly to settle trades, the finality of a transaction is of critical importance.  The safe harbor provision reflects Congress’s decision to prioritize finality over equity, allowing some otherwise avoidable pre-petition transfers to stand rather than allowing uncertainty and lack of liquidity to persist for 90 days after every settlement payment.[4]

Although the District Court and the Seventh Circuit both took notice of Sentinel’s wrongful conduct of commingling its customers’ supposedly segregated assets with its own, ultimately, these facts did not serve to defeat Congress’s clear intent in passing the safe harbors.  The Seventh Circuit’s ruling provides assurances to market participants that the protections of the Bankruptcy Code’s safe harbor provisions will be applied regardless of the facts of a particular bankruptcy.


[1]       485B.R. 854 (N.D. Ill. 2013)

[2]       Grede v. FCStone, LLC, Nos. 13-1232, 13-1278 (7th Cir. Mar. 19, 2014)

[3]       See, Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 334 (2d Cir. 2011); QSI Holdings Inc. v. Alford (In re QSI Holdings Inc.), 571 F.3d 545, 547 (6th Cir. 2009); Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.), 952 F.3d 1230, 1235 (10th Cir. 1991).

[4]       To reach this conclusion, the Seventh Circuit analyzed the two sets of transfers separately.  The court held that the post-petition transfer could not be avoided under section 549 of the Bankruptcy Code because the bankruptcy court had specifically authorized the disbursement of funds and because the parties relied on that authorization.  The safe harbor provision did not govern the post-petition transfer’s analysis.

Parties to financial contracts often include in those contracts triangular setoff provisions to reduce risk in case of default by allowing one party to offset the debt owed by another party against the obligations to a third party.  Notwithstanding the customary nature of these setoff provisions, the mutuality requirement of Section 553 of the Bankruptcy Code prohibits parties from setting off non-mutual debts once bankruptcy proceedings have commenced.  Until recently, however, whether the “safe harbor” provisions of the Bankruptcy Code exempt swap and repurchase agreements from the mutuality requirement of Section 553 remained unsettled.  In November 2013, the bankruptcy court in the District of Delaware answered this question, holding that the “safe harbor” provisions do not provide an exception to the mutuality requirement for parties seeking to enforce prepetition triangular setoff agreements.  In re Am. Home Mortgage Holdings, Inc., 501 B.R. 44 (Bankr. D. Del. 2013).

Background

While it was an operating entity, American Home Mortgage Investment (“AHM”) entered into two financial contracts: a repurchase agreement with Barclays Bank and a swap agreement with Barclays Capital, an affiliate of Barclays Bank.  The swap agreement contained a broad setoff provision that purported to authorize Barclays Bank to effectuate a “triangular setoff” of its obligations to AHM.  Under the provision, Barclays Capital could set off monies owed to AHM under the swap agreement against funds owed to Barclays Bank under the repurchase agreement.  AHM later filed for bankruptcy, and Barclays attempted to enforce its rights under the agreement by executing the setoff provision.  AHM sued Barclays Bank and Barclays Capital seeking, among other things, a declaratory judgment that the triangular setoff was improper.

The Court’s Analysis

The question before the district court was whether the safe harbor provisions of Sections 559, 560 and 561 create an exception to the general mutuality requirement of Section 553 for prepetition triangular setoff agreements that are part of financial contracts otherwise covered by the safe harbor provisions.  Section 553 of the Bankruptcy Code preserves prepetition contractual setoff rights in bankruptcy but imposes two key restrictions.  First, both the amount owed by the debtor and the debtor’s claim against the creditor must be prepetition.  Second, the debtor’s claim against the creditor and the debt owned the creditor must be mutual.  Mutuality exists when the debts and credits are between the same parties, standing in the same capacity.  Because triangular setoffs involve debts and credits that are not mutual, they are generally impermissible once a debtor has commenced bankruptcy proceedings.

Defendants argued that that the safe harbor provisions of Sections 559-561 trumped the mutuality requirement and exempted setoffs in swap and repurchase agreements.  The court disagreed, however, relying primarily on two decisions from the United States Bankruptcy Court for the Southern District of New York in the Lehman Brothers proceedings.  In the first—Lehman/Swedbank—Judge Peck had held that the safe-harbor provisions did not override the mutuality requirement even with respect to swap agreements.  That case, however, involved an agreement to set off prepetition claims against funds collected postpetition—not a multi-party setoff.  In the second—Lehman/UBS—Judge Peck addressed a more comparable factual scenario and held that the safe-harbor provisions do not exempt financial contracts from the mutuality requirement.

Consistent with these rulings, the Delaware court held that parties could not contract around the mutuality requirement of Section 553 even in the context of financial arrangements that otherwise might receive special treatment under the safe-harbor provisions of Sections 559-561.

Practical Implications

The AHM decision represents the latest in a series of decisions narrowing the availability of triangular setoffs in bankruptcy.  As a result, parties to swap and repurchase agreements that contain triangular setoff provisions should not expect triangular setoff provisions to be enforceable under all circumstances.  Parties seeking to redeem purported triangular setoff rights should seek relief from the automatic stay before setting off any obligations.  In addition, parties in the drafting stages should take care in crafting triangular setoff provisions and seek alternative ways to reduce risk should bankruptcy occur.

When a legal right depends on the capacity in which a party purports to act, it won’t be long before the lawyers are talking about “hats.”  In two bankruptcy cases now pending before the Second Circuit, the hat in question is that of the trustee under section 546 of the Bankruptcy Code and the right in question is the right to seek avoidance of a fraudulent transfer within the “safe harbor” provisions of section 546.  The purpose of the safe harbors is to provide stability and certainty in markets for financial instruments like securities and swap agreements by confining the bankruptcy avoidance risk to cases of actual fraud.  Thus, section 546 bars the “trustee” from bringing an avoidance action based on constructive fraud (which does not require a fraudulent state of mind), whether asserted under the Bankruptcy Code or state creditor protection laws.  Section 546 is silent as to actions brought by persons other than the “trustee,” leaving open the question whether creditors may still invoke state law rights to seek avoidance without a showing of actual fraud.

In Whyte, accepting creditors under a plan were required to assign their claims to the trustee, who then asserted state law constructive fraud claims in her capacity as assignee of creditor rights, asserting that the actual fraud limitation of section 546 became irrelevant when she switched hats.  Judge Rakoff held that the section 546 safe harbors were not negated by this “clever argument,” and that the state claims were impliedly preempted – otherwise the section 546 safe harbors would be rendered a “nullity.”  Whyte v. Barclays Bank PLC, 494 B.R. 196, 199-200 (S.D.N.Y. 2013).  By contrast, in Tribune, Judge Sullivan found that the trustee hat carries with it the exclusive right to challenge a transaction unless this right is abandoned by the bankrupt estate.  In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310, 320-21 (S.D.N.Y. 2013).  At the same time, while noting that the filing of a bankruptcy petition can create “powerful magic,” Judge Sullivan did not find preemption of state law creditor claims, because section 546 refers only to the disability of the trustee, leaving creditor claims unaffected.  Id.  Judge Sullivan also distinguished Whyte as holding merely that a party “could not simply take off its trustee hat, put on its creditor hat, and file an avoidance claim.”  Id. at 319.

Both cases have been appealed, and the Second Circuit will be confronted with complex arguments involving trustee and creditor standing, preemption, and the automatic stay.

SemGroup

The transaction at issue in Whyte is a swap agreement wherein a swap participant paid $143 million for the commodities derivatives portfolio of SemGroup, an energy transport and storage company.  About a month later, SemGroup filed a petition under Chapter 11.  Pursuant to SemGroup’s plan of reorganization, which provided that certain creditors assigned “any and all” of their claims to a SemGroup Litigation Trust, the litigation trustee, as assignee of SemGroup’s creditors, filed suit to avoid the swap on the ground that the transaction was a constructive fraudulent conveyance under New York’s Debtor-Creditor Law.

The swap participant moved to dismiss under section 546(g), which provides that “the trustee may not avoid a transfer” to “a swap participant or financial participant, under or in connection with any swap agreements.”  On June 11, 2013, Judge Rakoff dismissed the SemGroup trustee’s complaint, holding that the transaction was a safe harbored transfer made in connection with a swap agreement.  Whyte, 494 B.R. at 201.  The court found that allowing the trustee to pursue the claim “wearing her non-bankruptcy hat,” would render section 546(g) a nullity and “make a mockery of Congress’s purpose of minimizing volatility in the swap markets.”  Id.  This “absurd result” was avoided under “well-established principles of federal preemption”: section 546(g) “impliedly preempts the Trustee’s attempt to resuscitate fraudulent avoidance claims as the assignee of certain creditors.”  Id. at 199, 200-01.

Tribune

Tribune addressed avoidance claims based on a massive leveraged buyout of the publicly held common stock of the soon-to-be-bankrupt Tribune Company.  As in Whyte, the claims were based on constructive fraud theories under state law.  These claims, however, were never assigned to a trustee, and instead were asserted by creditors in their own right.  The defendants, including many thousands of public shareholders who merely tendered their securities via public securities markets, moved to dismiss the action on the grounds, (i) that the section 546 safe harbor preempts the state law claims (the view adopted by Judge Rakoff in Whyte), and (ii) that individual creditors lacked “standing” to pursue the actions.

Regarding preemption, Judge Sullivan found no express language of preemption, as section 546(e) refers only to claims brought by a bankruptcy estate “trustee” and makes no reference to individual creditors’ state law constructive fraudulent conveyance claims.  Tribune, 499 B.R. at 316-20.  The court found Whyte distinguishable because of the switching of hats.  Id. at 319.  The Litigation Trust “could not simply take off its trustee hat, put on its creditor hat, and file an avoidance claim.”  Id.  By contrast, the Tribune creditors were not “creatures of a Chapter 11 plan” and not identical to the bankruptcy trustee.  Id.

Still, Judge Sullivan granted the motion to dismiss on the ground that the automatic stay under the Bankruptcy Code precludes fraudulent conveyance actions by individual creditors where the trustee is simultaneously suing to avoid the same transactions.  Id. at 325.  The decision left open the possibility that individual creditors may assert constructive fraudulent transfer claims that the Code precludes the trustee from asserting, but only if the trustee essentially abandons avoidance claims based on the same transactions.  Defendants argue that this could create a massive loophole in section 546 safe harbor protections and defeat its purpose to reduce uncertainty in financial market transactions.

Motion for Expedited Briefing and Panel Assignment

The plaintiffs in Tribune filed an unopposed motion seeking an expedited briefing schedule and assignment to the Second Circuit panel hearing the SemGroup appeal.  The movants argued that “[b]oth cases present critically important and recurring questions concerning the construction of 11 U.S.C. § 546 and the scope of its limitation on fraudulent transfer claims.”  Whyte v. Barclays Bank PLC, et al., Case 13-2653 (2d Cir.), ECF No. 142 at 9.  The movants point out that “at least two other billion-dollar bankruptcy proceedings already pending [in the Second Circuit] involve similar issues, and the parties’ organization of their affairs in those cases and others to follow will be influenced by the outcome of these appeals.”  Id. at 11.  On November 12, 2013, the Second Circuit entered an order to hear the appeals in tandem, with argument as early as the week of February 10, 2014.  Id. at ECF No. 198; Case 13-3992 (2d Cir.), ECF No. 33.

*          *          *

The outcome of the Whyte and Tribune cases may clarify the extent of safe harbor protection for financial market transactions in the Second Circuit, and may illuminate as well the court’s views on implied preemption and trustee standing.  Affected members of the financial community will no doubt stand by with interest.