Second Circuit Affords Safe Harbor Protections to Redemption of Commercial Paper

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Contributed by Lacey Laken

The Court of Appeals for the Second Circuit recently decided, as an issue of first impression, whether section 546(e) of the Bankruptcy Code, which shields “settlement payments” from avoidance actions in bankruptcy, extends to an issuer’s redemption of its commercial paper prior to the maturity date.  In Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron), –F.3d–, 2011 WL 2536101 (2d. Cir. June 28, 2011), the Second Circuit held that Enron’s payments to investors for early redemption of its commercial paper constituted settlement payments and, therefore, were protected from avoidance by the safe harbor provisions of the Bankruptcy Code.  District Judge John G. Koeltl, sitting by designation, dissented.

Prior to Enron’s collapse, it redeemed its unsecured and uncertificated commercial paper prior the maturity date at a cost of about $1.1 billion, a price that was significantly higher than the paper’s market value.  In accordance with customary industry practices, Enron redeemed the commercial paper through accounts held at the Depository Trust Company (“DTC”).  Through the DTC accounts, the appellees, ING and Alfa, transferred their commercial paper (approximately $48.2 million and $5.7 million, respectively) to J.P. Morgan (the broker-dealer) in exchange for the redemption price.  Although DTC held the accounts, it did not hold any beneficial interest in the transferred funds. 

Following the commencement of its chapter 11 case, Enron sought to avoid these redemption payments as preferential and fraudulent transfers pursuant to sections 547 and 548 of the Bankruptcy Code.  ING and Alfa, however, claimed that the redemption payments were protected “settlement payments” under section 546(e) of the Bankruptcy Code.  That section relies upon the definition of “settlement payment,” which section 741(8) of the Bankruptcy Code defines 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.”

The bankruptcy court held that Enron’s redemption payments were not settlement payments because they were made to acquire title to the commercial paper, not to retire debt.  In reaching its decision, the bankruptcy court focused on the unusual set of facts leading to the redemption, including the above-market price paid by Enron, the role of J.P Morgan and other broker-dealers as “intermediaries instead of principals,” and the uncommon nature of pre-maturity redemption of commercial paper. 

Alfa and ING appealed to the district court and were granted interlocutory review of the bankruptcy court’s decision, limited to whether the safe harbor afforded by section 546(e) of the Bankruptcy Code “applies to an issuer’s redemption of commercial paper prior to maturity, effected through the customary mechanism of transaction in commercial paper through the [DTC], without regard to extrinsic facts, such as the motives and circumstances of the redemption.”  In re Enron Creditors Recovery Corp., 422 B.R. at 424.  The district court reversed the bankruptcy court’s decision and found that section 546(e) protected Enron’s redemption payments on the basis that (i) the definition of “settlement payment” is not limited to payments that are commonly used and, as such, the circumstances of a particular payment do not weigh on whether the payment fits within the definition under section 741(8) of the Bankruptcy Code, (ii) a “settlement payment” is “any transfer that concludes or consummates a securities transaction,” and (iii) “Enron’s redemption constitute[d] a securities transaction, regardless of whether Enron acquired title to the commercial paper, because the redemption involved ‘the delivery and receipt of funds and securities.’” Enron appealed to the Second Circuit.

On appeal, the majority for the Second Circuit rejected Enron’s three proposed limitations on the definition of a settlement payment:  (i) the phrase “commonly used in the securities trade” in section 741(8) of the Bankruptcy Code excludes all payments that are not common in the securities industry, (ii) the definition in section 741(8) only includes transactions in which title to the security has changed hands (which was not the case in Enron because the redemption payments were made to retire debt, not to acquire title), and (iii) the redemption payments were not settlement payments because the DTC was not a financial intermediary that took title to the securities.  Instead, the majority found that the redemption payments fell within the plain language of section 741(8) of the Bankruptcy Code and were protected from avoidance under section 546(e). 

The court first addressed Enron’s argument regarding the phrase “commonly used in the securities trade.”  It found that the phrase modifies only the term immediately preceding the phrase (“any other similar payment”), not all of the other transactions defined as “settlement payments” in that provision.  The court noted that the purpose of such phrase was to act as a “catch all” and that Enron’s proposed reading would cause the application of the safe harbor to, in every instance, be based upon a factual determination regarding a transaction’s commonness – a result that would lead to “commercial uncertainty and unpredictability at odds with the safe harbor’s purpose.” 

The Second Circuit then considered Enron’s second argument that the redemption payments were not settlement payments because they involved the retirement of debt rather than the acquisition of title to the commercial paper.  The majority rejected this position and applied an expansive definition of the term “settlement payment,” finding that it includes any payment that completes a transaction of securities, including those payments made by Enron through DTC for the redemption commercial paper.  Enron’s position was that applying the safe harbor to transactions not involving a purchase or sale would undermine decades of case law allowing avoidance of debt related payments.  The court distinguished those cases on the basis that they involved non-tradeable bank loans, not widely issued debt securities (as was the case here) and concluded that interpreting the term “settlement payment” in the context of the securities industry would exclude payments made on ordinary loans from the safe harbor. 

On this point, Judge Koeltl disagreed and issued a dissenting opinion.  The judge found that the majority’s holding “that a settlement payment requires only the transfer of cash to complete a securities transaction, without any purchase or sale of a security, is [] extraordinarily broad” and “would seem to bring virtually every transaction involving a debt instrument within the safe harbor of Section 546(e), thus allowing the settlement payment exception to swallow up the Section 547(b) avoidance provision.”  Judge Koeltl also noted that the majority provided no basis for distinguishing “widely issued debt securities” and “non-tradeable bank loans.”  Consequently, the judge agree with Enron and found that the majority’s reasoning would apply equally to any payment on account of a debt and would imperil “decades of cases that allow the avoidance of debt-related payments” and the ordinary repayment of loans.  Id.

Finally, the Second Circuit addressed Enron’s argument that a settlement payment may only occur when a financial intermediary takes a beneficial interest in the securities.  Enron argued that, unless this occurred, the systemic risks underlying the safe harbor were not implicated.  The court looked to decisions in the Third, Sixth, and Eighth Circuits rejecting similar arguments in affirming application of the safe harbor to leveraged buyouts of private companies that involved financial intermediaries as conduits.  Those courts reasoned that undoing the transactions would have a significant impact on the financial market even though private securities were involved and no financial intermediary took a beneficial interest in the exchanged securities during the transaction.  The Second Circuit in Enron found that undoing Enron’s redemption payments would have a similarly negative and substantial impact on the markets, noting that $1.1 billion was at issue, and approximately two hundred noteholders were involved. 

In addition, the court held that because section 546(e) of the Bankruptcy Code applies to settlement payments made “by or to (or for the benefit of)” various participants in the financial markets, it would be inconsistent with this language to limit the safe harbor by interpreting the definition of “settlement payment” to exclude payments not involving a financial intermediary that takes title to the security.  

The Second Circuit’s Enron ruling is the latest, and perhaps the most significant, case to interpret the protections afforded by the safe harbor provisions of section 546(e) very broadly.   It comes on the heels of Bankruptcy Judge Drain’s decision in MacMenamin’s Grills in which Judge Drain refused to follow the Third Circuit’s interpretation of section 546(e) and did not permit  section 546(e) to apply to a private transaction.  Whether Enron signals an intention by the Second Circuit to interpret section 546(e) as expansively as the Third Circuit remains to be seen, as does its impact on future cases in which trustees seek to avoid payments for other types of non-traditional securities transactions.