Affirming the bankruptcy court, a district judge in New York handed down a decision seeming to mean that a leveraged transaction cannot be set aside in the Second Circuit as a fraudulent transfer if the professionals properly structure the transaction to invoke the so-called safe harbor in Section 546(e).
If followed elsewhere, the September 13 decision by District Judge George B. Daniels allows the structuring of a transaction to avoid the consequences of Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883 (Sup. Ct. Feb. 27, 2018). There, the Court held that the presence of a financial institution as a conduit in the chain of payments in a leveraged buyout was insufficient to invoke the safe harbor in Section 546(e). That section provides that a trustee may not avoid a “settlement payment . . . made by or to (or for the benefit of) . . . a financial institution.”
Merit Management held that Section 546(e) only applies to “the transfer that the trustee seeks to avoid.” More particularly, Justice Sonia Sotomayor said that “the relevant transfer for purposes of the Section 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid.” Id. at 888, 893.
The Leveraged Recapitalization
At the risk of oversimplification, the highly complex leveraged recapitalization worked like this:
The operating company borrowed about $1 billion by taking down new credit facilities secured by its assets. The operating company transferred the loan proceeds to a bank account of its parent holding company. The holding company had no assets other than ownership of the operating company.
The holding company then transferred the loan proceeds to a second bank, which distributed the funds to equity holders in redemption of their warrants and equity interests and to pay a dividend.
More than three years later, the operating company was in chapter 11. The plan paid only the first-lien lender. Subordinate lenders, owed hundreds of millions of dollars, received nothing more than the right to distributions from whatever the liquidating trustee could recover in lawsuits.
The liquidating trustee filed a fraudulent transfer suit under state law, alleging that the operating company was insolvent at the time of the leveraged restructuring. Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., granted the defendants’ motion for summary judgment. Holliday v. K Road Power Management LLC (In re Boston Generating LLC), 617 B.R. 442 (Bankr. S.D.N.Y. June 18, 2020). To read ABI’s report, click here.
Where Judge Grossman needed 82 pages to dismiss, Judge Daniels affirmed in only 20 pages.
The Relevant Transaction
On appeal, the trustee argued that the relevant transfer under Merit Management was the initial transfer from the operating company to the holding company’s first bank account. Under the trustee’s theory, the safe harbor would not come into play because the first transfer was not in connection with a settlement payment for securities.
Judge Daniels disagreed. In substance, he compressed the first two transfers into one. In other words, the relevant transfer put the loan proceeds into the hands of a financial institution that made the distributions to equity holders. The transfer was a settlement payment that invoked the safe harbor.
Furthermore, Judge Daniels said, the parent holding company was a financial institution itself protected by the safe harbor. Why, you say?
In Section 101(22), a non-financial institution becomes a financial institution if a financial institution is acting as its agent. In the case on appeal, Judge Daniels decided as a matter of common law that a bank was serving as the holding company’s agent, thus making the holding company a financial institution itself protected by the safe harbor.
Bound by Second Circuit authority from Note Holders v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litigation), 818 F.3d 98 (2d Cir. 2016), Judge Daniels also upheld the ruling by Judge Grossman that the safe harbor in Section 546(e) preempted the trustee’s fraudulent transfer claims under state law.
Affirming the bankruptcy court, a district judge in New York handed down a decision seeming to mean that a leveraged transaction cannot be set aside in the Second Circuit as a fraudulent transfer if the professionals properly structure the transaction to invoke the so-called safe harbor in Section 546(e).
If followed elsewhere, the September 13 decision by District Judge George B. Daniels allows the structuring of a transaction to avoid the consequences of Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883 (Sup. Ct. Feb. 27, 2018). There, the Court held that the presence of a financial institution as a conduit in the chain of payments in a leveraged buyout was insufficient to invoke the safe harbor in Section 546(e). That section provides that a trustee may not avoid a “settlement payment . . . made by or to (or for the benefit of) . . . a financial institution.”
Merit Management held that Section 546(e) only applies to “the transfer that the trustee seeks to avoid.” More particularly, Justice Sonia Sotomayor said that “the relevant transfer for purposes of the Section 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid.” Id. at 888, 893.