The Seventh Circuit deepened an existing split among the courts of appeals by holding that a transfer through a financial institution as a conduit does not by itself invoke the safe harbor in Section 546(e) and immunize the entire transaction from avoidance as a fraudulent transfer.
The July 28 opinion by Chief Circuit Judge Diane P. Wood stands for the proposition that routing consideration for a leveraged buyout of a non-public company through a financial institution cannot preclude a fraudulent transfer attack if it turns out that the seller was rendered insolvent. It is less clear what the decision means for LBOs of public companies.
Judge Wood cited the Second, Third, Sixth, Eighth and Tenth Circuits as applying the safe harbor when a financial institution is nothing more than a conduit. She noted that the Eleventh Circuit “agrees with us.”
Since Circuit Judge Richard A. Posner was on the panel along with Circuit Judge Ilana D. Rovner, the chances of persuading the court to hold rehearing en banc are remote.
If there is a petition for certiorari, the Supreme Court will have a chance to decide whether the safe harbors should be interpreted broadly, like the Second Circuit opinions in Enron, Quebecor, Madoff and, recently, Tribune.
The case in the Seventh Circuit was similar to a leveraged buyout. One company bought another, in part with money borrowed from a bank. Another bank served as escrow agent, holding the purchase price before passing it along to the seller.
Employing a constructive fraudulent transfer theory, the litigation trust established in the buyer’s bankruptcy sued the 30% owner of the seller for $16.5 million, representing its share of the $55 million purchase price. Invoking Section 546(e), the district court dismissed the suit, holding that the safe harbor applied because the transfer was “made by or to” a financial institution.
The safe harbor precludes a trustee from attacking a transfer of a “settlement payment” that is “made by or to” a “financial institution,” or a transfer “by or to” a “financial institution . . . in connection with a securities contract.” Since the purchaser was buying stock, it was clear to Judge Wood that the transfers were either a settlement payment or a payment in connection with a securities contract.
Judge Wood said it was therefore only necessary to decide whether the safe harbor protects transactions “simply [because they were] conducted through financial institutions.” In typical Seventh Circuit fashion, the opinion is an exploration of the judges’ understanding of the purpose of the statute, largely unaided by citation to authorities.
Although the Seventh Circuit previously had held that the safe harbor should be interpreted “broadly,” that “does not mean that there are no limits,” Judge Wood said. She declined to “interpret the safe harbor so expansively that it covers any transaction involving securities that uses a financial institution or other named entity as a conduit for funds.” Instead, she said “it is the economic substance of the transaction that matters.”
Judge Wood analyzed the purpose of the avoidance and safe harbor statutes because there are “multiple plausible interpretations” of the statutory language “made by or to.” She also said the parenthetical “for the benefit of,” added in 2006, “is also ambiguous.”
Invoking the safe harbor simply because the parties used a bank conduit would “render any transfer non-avoidable unless it were done in cold hard cash, and that conflicts with Section 548(c)’s good faith exception,” the opinion says. Instead, the safe harbor applies “only where the debtor incurred an actual obligation” to the financial institution that received the transfer.
Judge Wood also found support in the history of the safe harbor, which was designed to prevent a domino effect “‘rippling through the securities industry.’” She said the safe harbor applies when the transferor or transferee is a financial institution. Tagging the selling shareholder with liability “will not trigger bankruptcies of any commodity or securities firm,” the opinion says.