Do Wire Transfers Really Protect Shareholders in Private LBOs?
Not in the 2d—and Perhaps Other—Circuits

(TMA International Headquarters)

In an article in the February edition of The Journal of Corporate Renewal, Faye B. Feinstein and Lauren Nachinson examined the recent decision rendered by U.S. Bankruptcy Court Judge Kevin Gross of the District of Delaware in In re Plassein International Corporation, 366 B.R. 318 (Bankr. D. Del 2007).           

In Plassein, the court ruled that payments made to the shareholders of a private company pursuant to a leveraged buyout (LBO) were protected from avoidance by the so-called “settlement payment” defense codified in U.S. Bankruptcy Code Section 546(e). That section provides that a “trustee may not avoid a transfer that is a…settlement payment…made by or to a…financial institution.”           

In determining whether the payment to shareholders should be considered a “settlement payment,” the court held that the term encompassed any transfer of cash or securities that was made to complete a securities transaction. Further, the court ruled that an LBO payment qualifies as being made by a financial institution if it is made by wire transfer. In light of this ruling and the 3d U.S. Circuit Court of Appeals authorities on which it is based, Feinstein and Nachinson concluded that, in order to insulate LBO payments from attack under fraudulent transfer laws under the settlement payment defense, such payments should be made by wire transfer.           

A review of the decisional authority outside the 3d Circuit, however, reveals that many courts view a broad application of the settlement payment defense with suspicion. Indeed, and contrary to the court’s ruling in Plassein, a recent decision in U.S. Bankruptcy Court for the Eastern District of New York held that Section 546(e) did not bar a fraudulent transfer action against the selling shareholders in a private LBO simply because the payments at issue were made by wire transfer.

Congressional Intent

In In re Norstan Apparel Shops, Inc., et al, 367 B.R. 68 (Bankr. E.D.N.Y. 2007),¹ Chief Judge Carla E. Craig was faced with a set of facts similar to those in Plassein. In Norstan, the official committee of unsecured creditors ini tiated an adversary proceeding against the former shareholders of the debtors, who had received $55 million by wire transfer in exchange for their interests in the company pursuant to an LBO about 2.5 years prior to the commencement of the debtors’ bankruptcy cases. The selling shareholders asked the court to dismiss the proceeding, arguing that the LBO payments constituted settlement payments and thus were protected by the safe harbor provisions of Bankruptcy Code Section 546(e).           

In denying the shareholders’ motion to dismiss, Craig rejected the argument that the settlement payment defense should be read broadly to insulate transfers made pursuant to private LBOs. She noted that “while the term ‘settlement payment’ as used in (Section) 546(e) is to be read broadly, the term is not boundless.” Id. at 76.            

The court observed that Congress enacted Section 546(e) “to minimize the displacement caused in the commodities and securities markets in the event [of] a major bankruptcy affecting those industries,” and “to prevent the ‘ripple effect’ created by the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected industry.” Id. (internal quotations omitted). The court stated that the term “settlement payment” must be understood in light of this purpose.            

Craig also noted that Bankruptcy Code Section 741(8) defines a settlement payment 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.” (emphasis supplied).           

The court concluded that this definition was saved from complete circularity by the concluding phrase, “or any other similar payment commonly used in the securities trade,” and held that this modifying phrase “must be understood, at a minimum, to mean that in order to be encompassed in the statutory definition of ‘settlement payment,’ a transaction must involve the public securities markets.” Id.            

In its ruling, the court observed that “if the term ‘settlement payment’ in (Section) 546(e) is construed to encompass any payment made for securities, whether or not involving a public securities market, then any leveraged buyout, if structured as a direct purchase of stock from the shareholders (like the instant transaction) would fall within (Section) 546(e)’s safe harbor and thereby be immunized from avoidance under (Section) 544 or (Section) 548 of the Bankruptcy Code.” Id. at 74.           

This interpretation, the court noted, “flies in the face of the extensive body of jurisprudence under which leveraged buyouts challenged under (Section) 544 or (Section) 548 have been analyzed for fairness and adequacy of consideration.”

Narrower Views

Craig’s decision in Norstan is consistent with decisional authority of the 1st, 5th, 6th, 7th, 9th, and 11th Circuits, in which courts have rejected the broad application of the settlement payment defense adopted by courts in the 3d Circuit.            

In Jewel Recovery, L.P., v. Gordon (In re Zale Corp.), 196 B.R. 348, 352 (N.D. Tex. 1996), for example, the court ruled that section 546(e) did not insulate payments made to shareholders pursuant to an LBO from the reach of the bankruptcy trustee because such transfers were not the type of transaction contemplated by Congress when it enacted Section 546(e). The court drew a distinction between transactions involving the public market and those merely involving private interests. The court noted that applying Section 546(e) to private transactions constituted poor public policy, observing that:The affirmative application of (Section) 546(e) to this transaction would serve to sanction the practice of structuring private stock purchases in an effort to circumvent the avoidance section, merely by utilizing a financial institution. Private transactions lack the impact on the public market trading systems that Congress intended to protect by (Section) 546(e). Accordingly, applying the plain language of (Section) 546(e) to this private trans action conflicts and is inconsistent with Congress’ statutory scheme in Chapter 5 of the Code. Id. at 353.           

This sentiment was echoed by the court in In re Grand Eagle Props., Inc., 288 B.R. 484 (Bankr. N.D. Ohio 2003), which noted that applying Section 546(e) to private securities transactions would “essentially, convert that statutory provision into a blanket transactional cleansing mechanism for any entity savvy enough to funnel payments for the purchase and sale of privately held stock through a financial institution.” Id. at 494.            

Courts in other jurisdictions likewise have limited the application of the settlement payment defense in light of Congress’ intent in enacting section 546(e). See, e.g., In re Grafton Partners, L.P., 321 B.R. 527, 540 (9th Cir. B.A.P. 2005) (holding that Section 546(e) is not applicable to non-public transactions in illegally unregistered securities because “the transaction in question did not occur on a public market and did not involve a process of clearing trades”); Zahn v. Yucaipa Capital Fund, 218 B.R. 656, 676 (D.R.I. 1998) (“[T]he stock at issue was not even publicly traded. The stock transfers thus had no connection whatsoever to the clearance and settlement system, and allowing avoidance would have no impact at all on that system.”); Wieboldt Stores, Inc. v. Schottenstein, 131 B.R. 655, 664 (N.D. Ill. 1991) (noting that requiring selling shareholders in an LBO to return to the trustee the payments that they received through the bank posed “no significant threat to those in the clearance and settlement chain.”).            

Other courts have cited other justifications for their narrow interpretation of the settlement payment defense. The court in In re Munford, Inc., 98 F.3d 604 (11th Cir. 1996), for example, ruled that, although such payments constituted “settlement payments” under Section 741(8), Section 546(e) did not bar the trustee from avoiding LBO payments made by a debtor corporation to its shareholders through a financial institution pursuant to an LBO based on the fact that “the bank here was nothing more than an intermediary or conduit.” Id. at 610. The court was persuaded by the fact that the bank never acquired a beneficial interest in either the payments made to the shareholders or the shares of stock for which the funds were exchanged. Id.

Venue Matters

The application of the settlement payment defense in the context of an LBO has been far from uniform. While courts in the 3d Circuit have utilized Section 546(e) to shield virtually all LBO payments from avoidance, even in the context of private transactions, a significant number of courts have limited the scope of this safe harbor provision.           

Accordingly, the extent to which wire transfers may insulate LBO payments from attack under fraudulent transfer laws will likely be determined as much by the venue of the bankruptcy proceedings as much as the facts of the transaction at issue.  

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¹ The adversary proceeding in Norstan was prosecuted by author Ronald R. Sussman, together with Cooley associate Jeffrey L. Cohen.