In March, the Second Circuit handed down Note Holders v. Large Private Beneficial Owners (In re Tribune Co.), slamming the door on virtually every theory finding a loophole in Section 546(e), one of the safe harbor provisions in the Bankruptcy Code barring suits to recovery payments made in securities transactions.
Bankruptcy Judge Kevin Gross in Delaware wrote a decision on June 20 where he disagreed with Tribune. Saying that Second Circuit authority is not binding on him, Judge Gross adopted the approach taken in the 2014 Lyondell Chemical Co. opinion, where former Bankruptcy Judge Robert E. Gerber of Manhattan held that the safe harbor only bars trustees from suing, not creditors from asserting claims of their own.
Judge Gross’ opinion reads like a brief to the Third Circuit, distinguishing Tribune and explaining why the Second Circuit was wrong by holding that Congress intended to preempt state laws in adopting Section 546(e).
The Facts in Physiotherapy
A company called Physiotherapy Holdings Inc. filed under chapter 11 not long after being acquired in a leveraged buyout where two controlling shareholders sold 90% of the stock they controlled. A litigation trust filed suit against the controlling shareholders to recover almost $250 million they received by selling their stock in the LBO.
Pre-LBO senior noteholders assigned their claims to the litigation trust, constituting the backbone of the suit. The complaint alleged that the LBO was both a constructive fraudulent transfer and a fraudulent transfer with “actual intent.” The complaint asserted claims under both Section 548 and parallel provisions in Pennsylvania’s Fraudulent Transfer Act.
According to the complaint, the defendants were not innocent selling shareholders. The trust alleged that the controlling shareholders knew the company was issuing false financial statements grossly overstating net income, thus enticing the purchaser to acquire the company in the LBO.
The selling shareholders filed a motion to dismiss. Judge Gross denied the motion with respect to the actual fraud claim under Section 548(a)(1)(A) and the senior noteholders’ constructive fraud claim under state law. He dismissed the complaint’s claims for constructive fraudulent transfers under Section 548(a)(1)(B) and the trustee’s claims for actual and constructive fraudulent transfers under state law.
The Safe Harbor and Tribune
The safe harbor in Section 546(e) provides that “the trustee may not” sue for recovery of a “settlement payment” made in connection with a “securities contract” unless the suit is brought under Section 548(a)(1)(A) for recovery of a fraudulent transfer within two years of bankruptcy made with actual intent to hinder, delay or defraud creditors.
The statute’s reference to a trustee prompted litigation contending that the safe harbor does not bar suits based on the creditors’ own claims, as opposed to claims brought by a trustee. Judge Gross’ opinion analyzes the decisions coming down on both sides of the issue. His focus, of course, is on Tribune and Lyondell.
In Tribune, the bankruptcy judge had allowed company retirees, along with pre-LBO unsecured bondholders, to sue selling shareholders using constructive fraudulent transfer theories. After plan confirmation, the litigation trust took over prosecution of the creditors’ claims. In the Second Circuit’s March decision, the appeals court dismissed the creditors’ state law claims under Section 546(e) on a theory of implied preemption of state law.
The Second Circuit held that state law constructive fraudulent transfer claims were preempted because “unwinding settled securities transactions” would “seriously undermine” the markets.
The Tribune opinion effectively overruled Lyondell, which held that the safe harbor does not preclude fraudulent transfer suits based on state law, nor does it protect selling shareholders who ultimately received proceeds from allegedly fraudulent transfers.
Judge Gross’ Analysis
Saying that Lyondell’s reasoning was “more persuasive” than Tribune, Judge Gross adopted Lyondell’s holding. He said that Lyondell “more accurately addresses the history and function of the safe harbor.” He cited the Supreme Court’s Wyeth decision from 2009, which said that the states’ police powers cannot be superseded “unless that was the clear and manifest purpose of Congress.”
Quoting from the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 with regard to the history and purpose of Section 546(e), Judge Gross said the safe harbor was designed to avoid a “ripple effect” in the securities markets if transfers of securities were set aside in bankruptcy.
Judge Gross does not believe that allowing state law claims to proceed would destabilize the securities markets. He pointed out that that no public shareholders were involved, and the controlling shareholders had 90% of the stock. He also said that the statute only limits a trustee’s ability to sue and is “silent with regard to a creditor’s ability to bring such a claim.”
In contrast to his case where the selling shareholders allegedly were aware of false financial statements enabling the LBO, Judge Gross noted that the selling shareholders in Tribune “were not alleged to have acted in bad faith.” Therefore, he said that barring suit would “run counter to Congress’ policy of providing remedies for creditors who have been defrauded by corporate insiders.”
The language of the statute nonetheless constrained Judge Gross to dismiss claims explicitly precluded by the safe harbor.
To read ABI’s discussion of Tribune, click here.