Indiana Bankruptcy Judge Narrowly Reads the Section 546(e) Safe Harbor

Building on Supreme Court authority, Bankruptcy Judge James M. Carr of Indianapolis narrowly interpreted the safe harbor in Section 546(e) by refusing to dismiss a lawsuit against a guarantor whose liability was eliminated by the debtor’s payment to the bank that held the guarantee.

A company was owned by an employee stock ownership plan trust. A private equity investor negotiated a deal to purchase the company by acquiring the stock from the ESOP. The stock owned by the ESOP was not traded publicly.

To complete the acquisition, the buyer obtained a $24.9 million bridge loan from a bank. The buyer was obligated to the bank, but the company being acquired was not liable on the loan. One month after the acquisition was completed, the debtor obtained loans from another bank and paid off the $24.9 million bridge loan for which the buyer had been liable but the debtor was not.

The debtor pledged its assets as security for the new loans that paid off the $24.9 million bridge loan.

The debtor’s business turned sour after the acquisition. Slightly more than two years after closing, creditors filed an involuntary petition, leading to an order for relief in chapter 7.

Because the transfer occurred more than two years before filing, the chapter 7 trustee invoked powers under Section 544(b) to step into the shoes of an actual creditor and sue the buyer for a constructive fraudulent transfer under Indiana law. The trustee alleged that the transfer paying off the bridge loan was “to or for the benefit” of the buyer and that the debtor received no consideration for encumbering its property.

Noting that the new loan paid off a financial institution and was used to buy stock from the ESOP, the buyer filed a motion to dismiss based on the Section 546(e) safe harbor. The subsection provides:

the trustee may not avoid a transfer . . . made by or to (or for the benefit of) a . . . financial institution . . . or that is a transfer made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract, as defined in section 741(7), . . . except under section 548(a)(1)(A) of this title [for a transfer made with actual intent to hinder, delay or defraud].

Judge Carr denied the motion on August 18.

Judge Carr first ruled that the trustee had made a plausible claim for a constructive fraudulent transfer for the benefit of the buyer and then turned to the buyer’s safe harbor defense.

In the 1984 amendments giving rise to Section 546(e), Judge Carr said that Congress intended “to clarify that the safe harbor applies to all transfers (other than actual fraudulent transfers) made to designated financial intermediaries in connection with their facilitation of trades executed through the Securities Clearance and Settlement System or the commodities clearance system.”

Even given “this clear legislative intent,” Judge Carr said that

courts have no clear mandate in the language of § 546(e) to apply the safe harbor to shield transfers that do not implicate the Securities Clearance and Settlement System. Courts should be particularly reluctant to do so where, as here, the transfer under attack does not implicate the national System for trades of publicly-held securities or pose a systemic risk to the financial marketplace.

Judge Carr said that the buyer wanted “a liberal interpretation of the broadly defined terms of the safe harbor . . . even though the underlying purchase of stock was a private transaction that did not in any sense involve the System that § 546(e) was intended to protect.”

Quoting the Seventh Circuit, Judge Carr said that “a strictly literal interpretation (without any consideration of the statutory purpose) is disfavored when it ‘would frustrate the overall purpose of the statutory scheme, lead to absurd results, or contravene clearly expressed legislative intent.’”

To invoke the safe harbor, Judge Carr said there must be a “sufficient nexus” between the transfer and a securities contract to conclude that the transfer was made “in connection with” a securities contract.

For definition of “in connection with,” Judge Carr cited Chadbourne & Parke LLP v. Troice, 571 U.S. 377, 387 (2014), where the Supreme Court said in a suit under SLUSA that “in connection with” “suggests a connection that matters.” The Court went on to eschew an overly broad construction to avoid interfering “with state efforts to provide remedies for victims of ordinary state-law frauds.” Id. at 391.

To Judge Carr’s way of thinking,

an overly expansive interpretation of “in connection with” would not advance any purpose underlying Congress’ enactment of the safe harbor of § 546(e) or the policies underlying the avoidance provisions of the Bankruptcy Code’s chapter 5 or the [state fraudulent transfer law].

Judge Carr saw “no material nexus” between the buyer’s contract to purchase stock from the ESOP and the payoff of the loan to the bridge lender. He said that nothing in the stock purchase agreement “indicates that [it] was executed or performed ‘in connection with’” paying off the bridge loan.

“Instead,” Judge Carr said, the stock purchase and the loan payoff were “two separate transactions” that occurred “one month apart.” He noted that the trustee was not aiming to avoid the payment to the ESOP that effected the stock purchase.

Judge Carr denied the motion to dismiss under the safe harbor because the new loan one month after closing had “nothing to do with the purchase or sale of any securities or any ‘securities contract’” and there was no “sufficient nexus between the [stock purchase agreement] and the [loan payoff] to bring the ‘safe harbor’ of Section 546(e) into play.”