Contributed by Ginger Ellison.
S.D.N.Y. Holds that Section 546(e) Safe Harbor Provision Does Not Preempt State Law Constructive Fraudulent Transfer Claims Brought on Behalf of Individual Creditors
On January 14, 2014, the United States Bankruptcy Court for the Southern District of New York held in Weisfelner v. Fund 1 (In re Lyondell Chemical Co.) that the safe harbor provision contained in section 546(e) of the Bankruptcy Code offers no protection against state law constructive fraudulent transfer claims brought on behalf of individual creditors against shareholders of the target company in a leveraged buyout. As a consequence, former shareholders who received distributions under a failed LBO may be subject to certain fraudulent conveyance claims that a debtor would otherwise be precluded from pursuing under section 546(e).
In December 2007, Basell AF S.C.A. bought Lyondell Chemical Company through an LBO entirely financed by debt that was secured by the target company’s assets. As a result of the merger, Lyondell’s balance sheet became encumbered with approximately $21 billion of additional secured debt. $12.5 billion of the loan proceeds were used to cash out Lyondell’s shareholders.
When Lyondell filed for chapter 11 in the Southern District of New York just less than thirteen months later, its unsecured creditors’ claims stood behind the colossal $21 billion secured loan. Lyondell’s assets, however, had previously been depleted by the $12.5 billion payment of loan proceeds to stockholders, “who, under the most basic principles of U.S. insolvency law, are junior to creditors in right of payment.”
As part of its plan of reorganization, Lyondell created numerous litigation trusts, each of which received the right to assert specific legal claims that arose as a result of the LBO and its related transactions for the benefit of Lyondell’s unsecured creditors. Pursuant to Lyondell’s plan, once the Lyondell estate abandoned its rights under section 544 of the Bankruptcy Code to bring fraudulent transfer actions under state law, the unsecured creditors assigned their claims to the LB Creditor Trust. Certain creditors holding unsecured trade claims, funded debt claims, and senior and subordinated secured deficiency claims assigned their rights to pursue state law fraudulent transfer suits to the LB creditor trust. The LB Creditor Trust then brought constructive fraudulent transfer actions in state court, pursuant to which it sought to recover approximately $6.3 billion of the $12.5 billion in payments made to the former stockholders of Lyondell who received the largest distributions in connection with the LBO.
A group of primarily institutional stockholder defendants removed the state proceeding to the bankruptcy court and filed a motion to dismiss the state law claims. They advocated that the safe harbor provisions contained in section 546(e) immunized stockholder recipients of LBO proceeds from constructive fraudulent transfer claims—even where such claims were brought by individual creditors under state law, by a trustee under the Bankruptcy Code. Section 546(e) of the Bankruptcy Code provides a safe harbor for certain transfers relating the purchase and sale of securities. At issue was whether section 546(e) applied to fraudulent transfer claims brought by, or on behalf of, creditors under state law and whether it preempts state law fraudulent transfer claims.
Relying heavily on its recent decision in In re Tribune, the court held that the section 546(e) safe harbor provision neither protects against nor preempts state law constructive fraudulent transfer claims brought on behalf of individual creditors.
Noting that the provision provides only that “the trustee may not avoid a transfer” the court held that Congress did not intend to make section 546(e) applicable to claims brought by or on behalf of individual creditors and dismissed the argument that section 546(e) might apply to individual creditors’ state law claims.
The court next turned to the creditors’ preemption arguments. Whereas the defendants argued that section 546(e) reflected Congress’s intent to protect securities-contract transfers, thereby favoring preemption, the court held that this narrow interpretation of section 546(e)’s objectives was false and misleading, for several reasons. To begin, it held that “Congress pursues a host of other aims through the Bankruptcy Code, not least making whole the creditors of a bankruptcy estate. It is not at all clear that Section 546(e)’s purpose with respect to securities transactions trumps all of bankruptcy’s other purposes.”
The court paid further tribute to the Tribune court’s decision in noting that by enacting section 544(b)(2), Congress expressly preempted state fraudulent transfer laws that would permit individual creditors to recover with respect to charitable contributions so long as the contribution did not exceed a Congressionally-prescribed amount. As such, the court concluded that it is safe to assume that Congress could have elected to preempt individual creditors’ state law claims but purposefully opted against doing so with respect to section 546(e).
Finally, the court noted that Congress’s intent in drafting section 546(e) was to guard the financial markets against a “ripple effect” caused by the insolvency of one commodity or security firm. In interpreting this objective, the court emphasized that “[p]rotecting the financial markets is not necessarily the same thing as protecting investors in the public markets, even if they happen to be stockholders who are major investment banks.” The concern, the court noted, has been that of protecting market intermediaries and protecting the markets—in each case to avoid “falling dominos.” Thus, even ignoring all other bankruptcy policy and focusing solely on Congress’s desire to protect against “ripple effects” that caused section 546(e) to come into existence, in the context of an action against cashed-out beneficial stockholders at the end of the asset dissipation chain, the court held that state law fraudulent transfer laws would not frustrate Congress’s objectives.
The court distinguished the case at bar from Whyte v. Barclays Bank PLC, a district court decision in which the court held that the section 546(g) safe harbor impliedly preempted state law fraudulent conveyance actions seeking to avoid swap transactions. In Whyte, the court reasoned that avoiding the swap transactions would create disruption in the markets.
The bankruptcy court distinguished Whyte along the same lines as it did in its Tribune decision, noting that the plan of reorganization in Whyte had provided for a single trust to serve in the capacity of both the trustee and the representative of outside creditors, thereby permitting the trust to pursue causes of action on the estate’s behalf that section 546(g) prevented the trustee from pursuing. The bankruptcy court also questioned the court’s rationale in Whyte, stating that the Whyte court incorrectly declined to apply the presumption against implied preemption and that Whyte failed to consider the purposes and objectives of Congress beyond protection of the financial markets, including “longstanding and fundamental principles that insolvent debtors cannot give away their assets to the prejudice of their creditors.”
Following this ruling, the Lyondell court dismissed several types of claims—namely, certain state law intentional fraudulent conveyance claims on the basis of inadequate pleadings, claims assigned to LB Creditor Trust by secured lenders of the LBO who had already ratified their loans and thus were barred from arguing that they were defrauded by the transactions in question, and claims asserted against entities that behaved as conduits by passing payments to others as these entities did not qualify as beneficial owners and thus could not be held liable as recipients of fraudulent transfers.
By tracing back the legislative history of section 546(e) and taking into account the varied objectives that the Bankruptcy Code seeks to promote, the court found no support for the argument that state law constructive fraudulent transfer claims are preempted by federal law. Whether section 546 safe harbors protect shareholders against state law avoidance actions brought by creditors following the confirmation of a plan of reorganization remains a murky issue. Nevertheless, as a result of the court’s rulings in Lyondell and Tribune, former shareholders who received distributions under a failed LBO may be subject to certain fraudulent conveyance claims brought by or on behalf of individual creditors that a debtor would otherwise be precluded from pursuing under section 546(e).