Reversing the bankruptcy court, a district judge in Indianapolis broadly read the so-called safe harbor in Section 546(e) and barred the trustee from suing to recover an allegedly fraudulent transfer occurring one month after a leveraged buyout.
The trustee is appealing to the Seventh Circuit. The decision from the appeals court will either continue to interpret the safe harbor broadly, or perhaps more narrowly following the Supreme Court’s decision in Merit Management Group LP v. FTI Consulting Inc., 38 S. Ct. 883, 200 L. Ed. 2d 183 (Feb. 27, 2018). To read ABI’s report on Merit Management, click here.
The Adroitly Structured Leveraged Buyout
The acquisition target was a company 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 raise the purchase price 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 target company being acquired was not liable on the loan. One month after the acquisition was completed, the debtor [that is, the target company] 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 used proceeds from the loan it obtained to pay off the bridge loan for which it had not been liable. The debtor also pledged its assets as security for the new loan that paid off the $24.9 million bridge loan.
The debtor’s business deteriorated after the acquisition. Slightly more than two years after closing, creditors filed an involuntary petition, resulting in 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 to sue the buyer for a constructively 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. In an opinion in August 2022, the bankruptcy court narrowly read the safe harbor and denied the motion to dismiss. Petr v. BMO Harris Bank N.A. (In re BWGS LLC), 643 B.R. 576 (Bankr. S.D. Ind. Aug. 18, 2022). To read ABI’s report, click here.
The bankruptcy court had several reasons for denying the dismissal motion. The bankruptcy court believed that the safe harbor was not implicated because the stock sold by the ESOP was not publicly traded, meaning that avoiding the transfer would not pose systemic risk to the financial markets. The bankruptcy court also believed that the one-month gap between the LBO and paying off the bridge loan meant that the transactions in connection with the bridge loan were separate and apart from the later loan that paid off the bridge loan.
The bankruptcy court authorized an interlocutory appeal to the district court. In an opinion on May 2, District Judge Jane Magnus-Stinson reversed across the board, believing that the safe harbor must be read broadly to immunize properly structured leveraged buyouts.
Reading the Safe Harbor Literally
The appeal called for Judge Magnus-Stinson to interpret the Section 546(e) safe harbor. The subsection provides:
[T]he 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 Magnus-Stinson disagreed with the idea that the safe harbor was not implicated because the stock was not publicly traded. Instead, she focused on whether there was a “securities contract” as defined in Section 741(7) to bring the transactions within the scope of Section 546(e).
“Based on the plain and unambiguous language in Section 546(e),” Judge Magnus-Stinson said that the stock-purchase agreement, the bridge loan and the guarantee given by the buyer all fell under the safe harbor because they were in “in connection with a securities contract.”
The bankruptcy court believed that the safe harbor was inapplicable because the repayment of the bridge loan came one month after the LBO. Judge Magnus-Stinson disagreed, holding that “in connection with” must be read broadly to mean “related to.” She pointed out, however, that the Seventh Circuit has not interpreted “in connection with,” as that term is used in Section 547(e).
Judge Magnus-Stinson held that “the Transfer was made in connection with the Stock Purchase Agreement because it was made to pay off the Bridge Loan that was used to close the Stock Purchase Agreement.”
Next, Judge Magnus-Stinson turned to the question of whether the safe harbor only applies to transactions in publicly traded securities. She answered her own question, saying:
Nowhere in § 546(e) is a distinction drawn between a transaction that implicates publicly traded securities versus one that implicates privately held securities. Instead, as discussed above, § 546(e) refers to the definition of “securities contract” in § 741(7), which similarly does not distinguish between publicly or privately held securities.
“Moreover,” Judge Magnus-Stinson cited the Sixth and Eighth Circuits and said that “numerous courts have applied § 546(e)’s safe harbor to transactions that did not implicate publicly held securities.” She therefore held that the “Bankruptcy Court erred in finding that the Transfer did not fall within § 546(e)’s safe harbor because it did not implicate publicly held securities.”
Judge Magnus-Stinson reversed and remanded, with instructions to dismiss the suit. The trustee is appealing to the Seventh Circuit. The schedule now calls for the last brief to be filed in early September.
Observations
In Merit Management, the Supreme Court was also interpreting Section 546(e), but in a different context. The Court held that the safe harbor only applies to “the transfer that the trustee seeks to avoid.” Merit Management, supra., 38 S. Ct. at 883.
In Merit Management, the parties’ use of a bank as an escrow agent did not persuade the Court to invoke the safe harbor, when the trustee was seeking to recover from the ultimate recipient of the transfer but not from an intermediary bank.
Notably, the Supreme Court upheld the Seventh Circuit in Merit Management. The Chicago-based appeals court had also taken a narrower view of the safe harbor.
These days, the Supreme Court engages in textual analysis and seldom relies on policy notions. In Merit Management, there surely had been a transfer to a financial institution, but that wasn’t the transfer the trustee was seeking to avoid.
Arguably, Merit Management has nothing to say about the question coming to the Seventh Circuit from the decision by Judge Magnus-Stinson. The decision from the Court of Appeals is another chance for the Seventh Circuit to say how broadly or narrowly the safe harbor should be read.
Reversing the bankruptcy court, a district judge in Indianapolis broadly read the so-called safe harbor in Section 546(e) and barred the trustee from suing to recover an allegedly fraudulent transfer occurring one month after a leveraged buyout.
The trustee is appealing to the Seventh Circuit. The decision from the appeals court will either continue to interpret the safe harbor broadly, or perhaps more narrowly following the Supreme Court’s decision in Merit Management Group LP v. FTI Consulting Inc., 38 S. Ct. 883, 200 L. Ed. 2d 183 (Feb. 27, 2018).