For all practical purposes, District Judge Leonard P. Stark of Delaware has ratified an opinion from June 2016 where Bankruptcy Judge Kevin Gross disagreed with the Second Circuit and held that the safe harbor in Section 546(e) does not bar fraudulent transfer claims brought on behalf of creditors under state law.
In Note Holders v. Large Private Beneficial Owners (In re Tribune Co.), 818 F.3d 98 (2d Cir. 2016), the Second Circuit found no loopholes in Section 546(e) and went so far as to say that the safe harbor bars suits by creditors under state law to recover payments made in securities transactions.
Saying that Second Circuit authority in Tribune was not binding on him, Judge Gross adopted the rationale taken by former Bankruptcy Judge Robert E. Gerber of Manhattan in Lyondell Chemical Co., 503 B.R. 348 (S.D.N.Y. 2014), where he held that the safe harbor only bars trustees from suing, not creditors from asserting claims of their own.
Judge Gross’s opinion was PAH Litigation Trust v. Water Street Healthcare Partners LP (In re Physiotherapy Holdings Inc.), 2016 WL 3611831, 15-ap-51238 (Bankr. D. Del. June 20, 2016). The defendants filed a motion to allow an interlocutory appeal and for a direct appeal to the Third Circuit, contending that the case raised a dispositive issue of law as to which there is evident disagreement.
In an opinion on Dec. 21, Judge Stark denied both a direct appeal and the motion to allow an interlocutory appeal, saying in the process that Judge Gross had founded his opinion on “well-established Third Circuit and Supreme Court law.” While pointing out important factual distinctions between PAH and Tribune, Judge Stark went almost as far as saying that the Second Circuit was wrong about federal preemption of state fraudulent transfer law, at least in cases involving the leveraged buyout of a nonpublic company.
The PAH Facts
Physiotherapy Holdings Inc. filed under chapter 11 not long after being acquired in a leveraged buyout. After confirmation of a plan, the litigation trust filed suit against the controlling shareholders to recover almost $250 million they received by selling their stock in the LBO.
To form the backbone of the suit, pre-LBO senior noteholders assigned their claims to the litigation trust. Asserting claims under both Section 548 and parallel provisions in Pennsylvania’s Fraudulent Transfer Act, the complaint alleged that the LBO was both a constructive fraudulent transfer and a fraudulent transfer with “actual intent.”
Significantly, the complaint alleged that 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 and pay more for the company.
The selling shareholders filed a motion to dismiss. Holding that the Section 546(e) safe harbor was not applicable, 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. However, he held that the safe harbor was applicable and did dismiss the 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.
To read ABI’s discussion of Judge Gross’s decision, explaining why he followed Lyondell while rejecting Tribune, click here.
Judge Stark Agrees with Judge Gross
Judge Stark laid out the standards for allowing interlocutory and direct appeals to the circuit, under 28 U.S.C. §§ 158(d)(2)(A) and 1292(b). He said that the standards for certifying a direct appeal and granting leave to appeal are “essentially the same.” In either instance, there must be “genuine doubt as to the correct legal standard.”
Tribune, the authority that Judge Gross rejected, “determined that Section 546(e) preempts state fraudulent transfer law,” Judge Stark said.
He said that the defendants’ reliance on Tribune “ignores the fact that the Bankruptcy Court’s [ruling that Section 546(e) did not preempt state law] turned on facts specific to this case,” such as the absence of any ripple effect on the markets because the selling shareholders were transferring stock in a non-pubic company. The bankruptcy court also placed reliance on allegations that the selling shareholders “acted in bad faith.”
Judge Stark came close to an outright affirmance when he said that Judge Gross’s “preemption analysis followed well-established Third Circuit and Supreme Court law.”
Summarizing why he was denying an interlocutory and direct appeal and sounding as though he would affirm on the merits, Judge Stark said that the “bankruptcy court’s reading of the safe harbor is supported by the plain language of the statute, and its careful analysis followed controlling Third Circuit and Supreme Court precedent.”
In the PAH suit, discovery will end and dispositive motions will be due in June 2018. Judge Stark’s opinion increases the likelihood that the parties will settle. If that occurs, Judge Stark’s opinion may be cited as tantamount to an affirmance.