To Avoid or Not to Avoid? Section 546(e) and the Private Stock Transaction (No Transaction Is an Island?)

The bankruptcy court in Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.),[1] recently concluded that the safe harbor of § 546(e) of the Bankruptcy Code precluding avoidance of “settlement payments” does not apply to transfers made to shareholders of a privately held corporation.[2] A review of the background of the transaction is necessary to understand how the bankruptcy court reached this conclusion, a decision on its face at odds with three decisions in 2009 from Circuit Courts of Appeal.

Case Background
In July 2007, three individual shareholders of the debtor, each owning 31 percent of its issued and outstanding stock, entered into a stock purchase agreement to sell their stock to the debtor. To fund this stock purchase, the debtor executed a loan and security agreement with a lender, which agreed to loan the debtor $1.15 million. The closing of both the loan and the stock purchase agreement occurred on Aug. 31, 2007, with the lender, at the direction of the debtor, making payments to these three shareholders from the loan proceeds. The lender wire-transferred the various amounts to the shareholders at their accounts at financial institutions. The debtor granted the lender a security interest in substantially all of its assets at the time of the closing of the loan, a typical LBO transaction, although certainly this one was smaller than most.[3]

The Fraudulent-Transfer Action
After the bankruptcy filing, the chapter 11 trustee filed a fraudulent-transfer action against these three shareholders, seeking to avoid and recover the payments they received in connection with the stock purchase agreement. The shareholders filed a summary judgment motion in which they asserted that the safe harbor of § 546(e) applied to the transfers, thereby precluding the trustee from avoiding the payments made to them.[4] The trustee countered that § 546(e) was not applicable to this particular private stock sale.[5] Section 546(e) of the Bankruptcy Code, which exempts certain transfers from avoidance, provides as follows:

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, as defined in section 101, 741 or 761 of this title, or settlement payment as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of ) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contact, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title. [6]

The bankruptcy court in MacMenamin’s Grill noted that some courts have looked beyond the “apparent plain meaning” of § 546(e) of the Bankruptcy Code and reviewed the legislative history of the statute to determine that § 546(e) does not provide a safe harbor from avoidance for private stock transactions.[7] Various other courts have concluded that the meaning of § 546(e) is plain and that it applies not only in the realm of publicly traded securities, but also in the context of private stock transactions.[8]

The shareholders contended that the transfers the chapter 11 trustee was trying to avoid as constructively fraudulent came within the safe harbor of § 546(e). First, they asserted that the transfers to them were “settlement payments” made by a financial institution (the lender) and also to a financial institution (the shareholders’ banks) within the plain meaning of that statute. Alternatively, the shareholders asserted that the payments to them were transfers by and to a financial institution in connection with a securities contract, also within the plain meaning of the statute.[9]

The court acknowledged that the plain meaning of a statute is usually conclusive, except in those exceptional situations where applying the statute in a literal and strict manner either is dramatically at odds with the drafters’ intent or will produce an absurd result.[10] However, in discussing the split among the courts, the bankruptcy court used the qualifier “apparent” at several points throughout its opinion in referring to the “plain meaning” of § 546(e), thereby signaling its willingness to look beyond the plain meaning of the statute in the context of avoidance of private stock sales.[11] The court in MacMenamin’s Grill ultimately determined that examining the legislative history behind § 546(e) was warranted and appropriate.[12] In arriving at this determination, the bankruptcy court noted that § 546(e) exempts a “settlement payment” made by or to a financial institution from avoidance and that this particular term is defined in § 701(28) of the Bankruptcy Code as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade.”[13]

The bankruptcy court pointed out that this definition of “settlement payment” is circular and ambiguous, although also admittedly broad.[14] In addition, the bankruptcy court emphasized that this safe-harbor provision makes specific reference to §§ 741 and 761 of the Bankruptcy Code, which are contained in subchapters of chapter 7 that govern stockholder liquidations and commodity broker liquidations, respectively.[15] Given this context, the court concluded that it was “logical to assume, therefore, that the cross-references in section 546(e) to the definitions found in sections 741 and 761 relate to the business of being a broker, engaged in markets”[16] and that, as a result, § 546(e) applies to the “business of engaging in securities transfers.”[17] Emphasizing that the stated purpose of Congress in enacting § 546(e) and various amendments thereto was to reduce a systemic risk to the financial markets, the bankruptcy court in MacMenamin’s Grill opined that providing a safe harbor from avoidance to a private stock sale for a relatively modest amount (approximately $1.15 million) like that at issue had little to do with this stated purpose.[18] The court accordingly concluded that the shareholder defendants had not come forward with any evidence that the avoidance of the transfers made to them presented any systemic risk or danger to the functioning of any securities market.[19] Furthermore, the court concluded that the shareholders did not present any evidence to establish that avoiding the challenged transactions “involved any entity in its capacity as a participant in any securities market.”[20] The court also stated that exempting the stock purchase agreement from avoidance actions “is so far removed from achieving Congress’ professed intent to protect the financial markets that it would be absurd to apply section 546(e) to the…well established and important avoidance powers”[21] found in the Bankruptcy Code.

Section 546(e) and Circuit Courts of Appeal
The bankruptcy court’s decision in MacMenamin’s Grill appears to conflict with decisions reached in 2009 by three appellate courts. The Eighth Circuit Court of Appeals in Contemporary Industries Corp. v. Frost[22] considered whether payments made for privately held stock were exempt from avoidance. The court rejected the debtor’s argument the statute is limited to publicly traded stock and determined that the payments at issue totaling approximately $26.5 million were “settlement payments within the plain meaning of §§ 546(e) and 741(8).”[23] The court also noted that “because so much money is at stake, we question…that the reversal of the payments—at least a portion of which were probably reinvested—would in no way impact the nation’s financial markets.”[24] The court did not look beyond the plain meaning of § 546(e); however, the language from the decision quoted in the preceding sentence seems to leave open the possibility of an argument by plaintiffs in the Eighth Circuit against application of § 546(e) if avoidance of the transaction at issue will not create a systemic risk to the functioning of the securities markets, the situation presented in the MacMenamin’s Grill case.

Similarly, in QSI Holdings Inc. v. Alford (In re QSI Holdings Inc),[25] the Sixth Circuit Court of Appeals determined that § 546(e) applied to the privately held securities at issue therein.[26] However, the value of the privately held securities in QSI was substantial (approximately $200 million), and the court specifically stated that “there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities.”[27] Thus, this language also presents at least an opportunity for plaintiffs in the Sixth Circuit to argue against application of § 546(e), particularly if avoidance of the transaction at issue will not pose a danger to the functioning of the securities markets.
  
In Lowenchuss v. Resorts Int’l Inc. (In re Resorts Int’l Inc.),[28] the Third Circuit Court of Appeals concluded that a “payment for shares during [a leveraged buyout] is obviously a common securities transaction, and we therefore hold that it is also a settlement payment” within the ambit of the safe harbor of § 546(e) of the Bankruptcy Code.[29] In 2009, approximately 10 years later, the trustee in Brandt v. B.A. Capital Co. LP (In re Plassein Int’l Corp.),[30] tried to distinguish Resorts by arguing that it involved a publicly traded company, whereas the debtor in Plassein had only acquired private companies. However, the court in Plassein squarely rejected this position, determining that § 546(e)’s safe-harbor provision applies in the private stock sale context. Unlike the Eighth and Sixth Circuits, the Third Circuit in Plassein did not state in its opinion the amounts sought to be recovered from the shareholders, an omission from which one could reasonably infer that the amount at issue was of no import in the Third Circuit’s decision. This presents a more difficult obstacle for plaintiffs in the Third Circuit in trying to overcome application of the safe harbor of § 546(e), even in situations similar to MacMenamin’s Grill.

Conclusion
Approximately two months following the decision in MacMenamin’s Grill, the Second Circuit Court of Appeals entered an order in which it explored some of the parameters of § 546(e), determining that this safe-harbor provision applies in the context of the attempted avoidance of the debtor/issuer’s payments to redeem its commercial paper before maturity.[31] This recent Enron decision can be distinguished from MacMenamin’s Grill because, among other things, the redemption payments at issue therein were in excess of a billion dollars, and thus one could argue (as the Second Circuit recognized) that undoing these transfers would have a substantial effect on the financial markets.[32] However, given that the Second Circuit made several references in its decision to the “plain language” of §§ 546(e) and 741(8)[33] (in contrast to the “apparent plain meaning” language employed repeatedly by the bankruptcy court in MacMenamin’s Grill), the Second Circuit may well have been sending a message of its own, indicating a reluctance to look beyond the plain meaning of the statute.

Consistent with the memorandum opinion in MacMenamin’s Grill, the bankruptcy court entered an order denying the shareholders’ summary judgment motion. Although that order was interlocutory, the shareholders successfully obtained leave from the district court for review of that order on appeal.[34] Review of that interlocutory order is currently pending in the district court and is awaiting the filing this fall of appellate briefs by the parties.[35] The shareholders in MacMenamin’s Grill will certainly make the argument on appeal that the bankruptcy court should not have strayed beyond the plain meaning or plain language of § 546(e). Considering the Second Circuit’s “plain language” references in the recent Enron decision, the district court may well find that to be a winning argument on appeal.