|June 11, 2014|
Previously published on May/June 2014
In Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 503 B.R. 348 (Bankr. S.D.N.Y. 2014), the U.S. Bankruptcy Court for the Southern District of New York held that the "safe harbor" under section 546(e) of the Bankruptcy Code for settlement payments made in connection with securities contracts does not preclude claims brought by a chapter 11 plan litigation trustee on behalf of creditors under state law to avoid as fraudulent transfers pre-bankruptcy payments to shareholders in a leveraged buyout ("LBO") of the debtor. By its ruling, the Lyondell court contributed to a split among the courts in the Southern District of New York, aligning itself with the district court in In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013), and against the district court in Whyte v. Barclays Bank PLC, 494 B.R. 196 (S.D.N.Y. 2013). Lyondell and Tribune appear to signal that even in the Second Circuit, where courts have liberally interpreted the scope of the Bankruptcy Code's financial safe harbors, the reach of section 546(e) is not without bounds.
Bankruptcy Avoidance Powers and Limitations
The Bankruptcy Code gives a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") the power to avoid, for the benefit of the estate, certain transfers made or obligations incurred by a debtor, including fraudulent transfers, within a specified time prior to a bankruptcy filing. Fraudulent transfers include transfers that were made with "actual" fraudulent intent—the intent to hinder, delay, or defraud creditors—as well as transfers that were "constructively" fraudulent, because the debtor received less than "reasonably equivalent value" in exchange and, at the time of the transfer, was insolvent, undercapitalized, or unable to pay its debts as such debts matured.
Fraudulent transfers can be avoided by a bankruptcy trustee or DIP for the benefit of the estate under either: (i) section 548 of the Bankruptcy Code, which creates a federal cause of action for avoidance of transfers made or obligations incurred up to two years before a bankruptcy filing; or (ii) section 544, which gives the trustee or DIP the power to avoid transfers or obligations that may be avoided by creditors under applicable nonbankruptcy law. Some state fraudulent transfer laws that may be utilized under section 544 have a reach-back period longer than two years.
Section 546 of the Bankruptcy Code imposes a number of limitations on these avoidance powers. Specifically, section 546(e) prohibits, with certain exceptions, avoidance of transfers that are margin or settlement payments made in connection with securities, commodity, or forward contracts. The purpose of section 546(e) and other financially focused "safe harbors" in the Bankruptcy Code is to minimize "systemic risk" to the securities and commodities markets that could be caused by a financial contract counterparty's bankruptcy filing. Like sections 544 and 548, section 546(e) is expressly directed at a bankruptcy trustee or, pursuant to section 1107(a), a DIP: "Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment . . . or settlement payment . . . ." (emphasis added).
The Bankruptcy Clause of the U.S. Constitution grants authority to Congress to establish a uniform federal law of bankruptcy. U.S. CONST., art. I, cl. 8. The Supremacy Clause of the Constitution mandates that federal laws, such as those concerning bankruptcy, "shall be the supreme Law of the Land; . . . [the] Laws of any State to the Contrary notwithstanding." U.S. CONST., art. VI, cl. 2. Thus, under the doctrine of preemption, "state laws that interfere with or are contrary to federal law are preempted and are without effect pursuant to the Supremacy Clause." In re Loranger Mfg. Corp., 324 B.R. 575, 582 (Bankr. W.D. Pa. 2005); accord Hillsborough County v. Automated Medical Labs, Inc., 471 U.S. 707, 712 (1985). Through the years, three types of federal-law preemption over state law have been developed by the courts: (i)express preemption; (ii)field preemption; and (iii)conflict preemption. In re Nickels Midway Pier, LLC, 332 B.R. 262, 273 (Bankr. D.N.J. 2005). Express preemption applies "when there is an explicit statutory command that state law be displaced." Id. Field preemption applies when federal law "is sufficiently comprehensive to warrant an inference that Congress ‘left no room' for state regulation." In re Miles, 294 B.R. 756, 759 (B.A.P. 9th Cir. 2003); Hillsborough County, 471 U.S. at 713. Conflict preemption applies if state law conflicts with federal law such that: "(1)it is impossible to comply with both state law and federal law; or (2)the state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress." Nickels Midway Pier, 332 B.R. at 273.
In Lyondell, the court considered, among other things, whether section 546(e), either by its own terms or under preemption principles, bars state-law fraudulent transfer claims with respect to a prepetition LBO, which claims were assigned as part of a chapter 11 plan to a post-bankruptcy litigation trust established for the benefit of creditors.
In December 2007, Basell AF S.C.A. acquired Lyondell Chemical Company ("Lyondell") through an LBO. The transaction was financed entirely by debt and was secured by the assets of the target company rather than the acquirer. As a result of the LBO, Lyondell took on approximately $21 billion of secured indebtedness. About $12.5 billion of the amount borrowed was paid to Lyondell stockholders, many of which were investment banking houses, brokerage firms, or other financial institutions.
In early January 2009, just 13 months after the LBO, Lyondell and numerous affiliates filed for chapter 11 protection in the Southern District of New York. Ultimately, the bankruptcy court confirmed a chapter 11 plan for Lyondell that provided for, among other things: (i) the creation of a litigation trust (the "Creditor Trust") to which certain estate causes of action were abandoned; and (ii) the assignment by creditors of their state-law claims, including state-law fraudulent transfer actions, to the Creditor Trust. After the effective date of the plan, the trustee of the Creditor Trust sued all Lyondell shareholders who had received more than $100,000 in connection with the LBO, alleging that the payments were actually or constructively fraudulent and therefore avoidable under state law. The defendants moved to dismiss, asserting, among other things, that the claims were: (i) barred by the terms of the section 546(e) safe harbor; and (ii) preempted by section 546(e).
The Decision: Creditor Trust Claims Are
Not Barred by 546(e) or Preemption Principles
The bankruptcy court denied the defendants' motion to dismiss on the basis of section 546(e). The court concluded that, by its terms, section 546(e) does not apply to claims asserted by or on behalf of creditors; rather, it applies only to claims brought by a bankruptcy trustee or DIP. Furthermore, the court ruled that the state-law claims were not preempted by either section 546(e) or other federal law.
The defendants argued that, even though section 546(e) expressly bars only actions brought by a "trustee" to avoid certain financial transactions as constructively fraudulent transfers, the provision also bars similar state-law claims asserted on behalf of creditors. The court flatly rejected this argument, admonishing that "[w]hile the Movants spend 10 pages in their brief arguing the matter as if sections 544 and 548—and hence section 546(e)—apply to this case, this is not a case about sections 544 and 548." The claims at issue, the court explained, were being asserted not on behalf of the estate, but on behalf of individual creditors. Thus, the court wrote, "there is no statutory text making section 546(e) applicable to claims brought on behalf of individual creditors, or displacing their state law rights, by plain meaning analysis or otherwise." Quoting Tribune, the court emphasized that "if Congress intended section 546(e) to be more broadly applicable, ‘it could simply have said so.' "
Also following the reasoning of Tribune, the court rejected the defendants' position that, under all three types of preemption doctrine, the absence of a safe harbor similar to section 546(e) in state fraudulent transfer laws should mean that the states' "similar but not congruent" constructive fraudulent transfer avoidance statutes are preempted by section 546(e) and therefore invalid. In this regard, the court initially determined that Congress had not expressly preempted any state-law causes of action for fraudulent transfers.
The bankruptcy court also concluded that there was no "field preemption" because "Congress has not evidenced any intention to wholly occupy the fields of avoidance or recovery of fraudulent transfers." Rather, the court explained, the history of state and federal fraudulent transfer law has long demonstrated a shared interest with the states in protecting creditors from constructively fraudulent transfers. Indeed, the court noted, state fraudulent transfer laws predate the federal equivalents, with no subsequent attempt by Congress to preclude enforcement of existing state laws.
Finally, the court found no "conflict preemption." The defendants argued that the congressional policy underlying the enactment of section 546(e) would be undermined by allowing the state-law fraudulent transfer action to proceed. In response, the court concluded that it is not impossible for a party to comply with both federal and state fraudulent transfer laws. The court similarly determined that, considering lawmakers' intent with respect to section 546(e) in the context of general bankruptcy policy:
[A]t least in the context of an action against cashed out beneficial holders of stock, at the end of the asset dissipation chain, state law fraudulent transfer laws do not "stand as an obstacle" to the "purposes and objectives of Congress"—even if one were to ignore the remainder of bankruptcy policy and focus solely on the protection against the "ripple effects" that caused section 546(e) to come into being.
Accordingly, following much of the reasoning in Tribune, the Lyondell court ruled that the state-law fraudulent transfer laws were not preempted by section 546(e) or any other federal law.
The Lyondell court determined that the defendants' reliance on Barclays, in which the court granted a motion to dismiss state constructive fraudulent transfer claims brought by a litigation trust, was misplaced. According to the Lyondell court, Barclays is factually distinguishable—
in Barclays, the same trust prosecuted both estate and individual creditor claims, whereas in Lyondell, the Creditor Trust held only claims assigned by creditors, and the estate specifically abandoned its section 544 rights.
The Lyondell court also faulted both the Barclays court's ultimate judgment and its reasoning, particularly with respect to preemption. The Lyondell court appeared to be particularly troubled by the Barclays court's focus on the congressional objective of protecting the financial markets and the court's failure to consider other congressional bankruptcy objectives, such as the "longstanding and fundamental principles that insolvent debtors cannot give away their assets to the prejudice of their creditors." According to the Lyondell court, this narrow focus prevented the Barclays court from drawing the proper conclusion that "[p]rotecting market participants is not the same thing as protecting markets." Characterizing the analysis in Barclays as "flawed" and "less thorough than that of Tribune," the Lyondell court ruled that nothing in section 546(e) demands that state-law fraudulent transfer claims be either expressly or impliedly preempted.
Lyondell contributes to a split of authority in the Southern District of New York on the application of section 546(e). Whereas Barclays continued the trend of liberally applying the safe harbor consistent with its purpose to protect financial markets against systemic risk, Tribune and Lyondell have departed from this approach, limiting the reach of section 546(e) by tempering the need to protect markets with other important bankruptcy principles, such as the protection of creditors' rights. Although Tribune and Lyondell both involved specific, somewhat narrow circumstances in which the claims at issue were clearly state-law claims that were not being asserted by the bankruptcy trustee or DIP, the two opinions signal that, even in the Second Circuit (where courts are known for liberally construing the safe harbor), the scope of section 546(e) is not without limits. Furthermore, in the preemption context, Tribune and Lyondell suggest that protection of the financial markets will not always trump other bankruptcy policies.
Both Barclays and Tribune have been appealed to the Second Circuit, which will hear the appeals in tandem and is expected to weigh in on these important issues later this year.