The Evolution of a Majority Rule: Two Circuits Rule Payments to Shareholders in Private LBOs Shielded From Avoidance by Settlement Payment Defense

There is little debate concerning the efficacy of the “settlement payment defense” in shielding from avoidance as constructively fraudulent payments made to shareholders during the course of a leveraged buyout transaction (“LBO”). However, whether the LBO transaction can involve privately held as well as publicly traded securities has been the subject of considerable debate in the courts. Two federal circuit courts of appeal recently had an opportunity to weigh in on this important issue—the Eighth Circuit in Contemporary Industries Corp. v. Frost and the Sixth Circuit in In re QSI Holdings, Inc. Both courts concluded as a matter of first impression that section 546(e) of the Bankruptcy Code applies to both public and private securities transactions, establishing a majority rule among the circuits on the issue.

Section 546: Limitations on Avoiding Powers

The Bankruptcy Code empowers a bankruptcy trustee or chapter 11 debtor in possession to invalidate certain transfers (or obligations incurred) by a debtor during prescribed periods immediately prior to (and even after) filing for bankruptcy protection. Among these are the ability to “avoid” transfers that are fraudulent by design or because an insolvent transferor did not receive fair consideration in exchange, the power to avoid transfers that unfairly prefer one creditor over others, and the ability to avoid post-bankruptcy transfers that are not authorized by the Bankruptcy Code or the court.

Section 546 of the Bankruptcy Code, however, imposes important limitations on the rights and powers granted to the trustee or debtor in possession elsewhere in the Bankruptcy Code. These include, among others, statutes of limitation for avoidance actions (section 546(a)), limitations based upon the perfection rights afforded under applicable nonbankruptcy law to entities with interests in the debtor’s property (section 546(b)), and limitations based upon reclamation rights arising under applicable nonbankruptcy law (sections 546(c) and 546(d)). The restrictions also include provisions prohibiting avoidance in most cases of: (i) transfers that are margin or settlement payments made in connection with securities, commodity, or forward contracts (section 546(e)); (ii) transfers made by, to, or for the benefit of a repo participant or financial participant in connection with a repurchase agreement (section 546(f)); (iii) transfers made by, to, or for the benefit of a swap participant or financial participant under or in connection with a pre-petition swap agreement (section 546(g)); and (iv) transfers made by, to, or for the benefit of a “master netting agreement participant” under certain circumstances and subject to two exceptions (section 546(j)).

Section 546(e) provides as follows:

Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.

Prior to the enactment of the Bankruptcy Code in 1978, U.S. bankruptcy law did not protect margin payments or settlement payments from avoidance, and such payments were held to be avoidable. Lawmakers changed this by including section 764(c) of the Bankruptcy Code as part of the Bankruptcy Reform Act of 1978. The provision, which applied only in commodity broker liquidation cases under chapter 7, prohibited a trustee from avoiding a transfer that was a margin payment or a deposit with a commodity broker or forward contract merchant, or a transfer that was a settlement payment by a clearing organization. Its purpose was to facilitate pre-bankruptcy transfers, promote customer confidence in commodity markets, and ensure the stability of the commodities market.

Section 764(c) was repealed in 1982 and replaced by a provision that was later designated subsection (e) of section 546 in 1984. Section 546(e) clarified prior section 764(c) and made it applicable to both the securities and commodities markets, again in an effort to ensure the public’s confidence in and the stability of the commodities and securities markets. Congress expanded the safe harbor in 1984 to include protection (under section 546(f)) for repo participants in connection with repurchase agreements. Most recently, sections 546(e) and (f) were amended in 2005 under the Bankruptcy Abuse Prevention and Consumer Protection Act to include the term “financial participant” within the protection of repurchase agreements, and in 2006 by the Financial Netting Improvements Act to clarify and expand their scope.

The limitations in section 546(e) expressly do not apply to section 548(a)(1)(A) of the Bankruptcy Code, which authorizes avoidance of transfers made or obligations incurred with the actual intent to hinder, delay, or defraud creditors. Section 546(e), however, does apply to actions to avoid constructively fraudulent transfers under section 548(a)(1)(B) or 544 (the latter of which authorizes, among other things, the pursuit of constructively fraudulent transfers under applicable state law). In addition, section 546(e) does not restrict the trustee’s rights and powers with respect to post-petition transfers under section 549 of the Bankruptcy Code. Although not mentioned in section 546(e), avoidance of pre-petition setoffs involving margin payments and settlement payments is prohibited under section 553(b)(1) of the Bankruptcy Code.

Section 546(e) applies when a “margin payment” or “settlement payment” is made by, to, or for the benefit of a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, all of which are defined elsewhere in the Bankruptcy Code, prior to the commencement of a bankruptcy case. The payment may be made by any of these entities to a third party, or by a third party to one of the entities listed.

Section 101(51A) defines “settlement payment” as “a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade.” The term is similarly defined with respect to the “securities trade” in section 741(8), which applies to stockbroker liquidation cases. Most courts interpret the term “settlement payment” broadly to include any transfer of securities in connection with the completion of a securities transaction. Qualifying transfers include both routine securities transactions and, according to four of the federal circuit courts of appeal, more complicated transactions, such as the transfers made during the course of an LBO.

Even so, there is significant disagreement among courts as to whether the section 546(e) defense is limited to transfers made in connection with the public securities markets or whether the provision also encompasses transfers related to nonpublic transactions. Some courts, relying in part on section 546(e)’s legislative history, reason that the provision was enacted to protect U.S. financial markets against instability caused by the reversal of settled securities transactions, that reversing private transactions does not implicate such concerns and, therefore, that lawmakers did not intend that the scope of section 546(e) should extend to nonpublic transactions. The Eighth and Sixth Circuit Courts of Appeal addressed this issue in Contemporary Industries and QSI Holdings, both concluding that section 546(e) applies to privately traded securities transferred in a leveraged buyout transaction.

Contemporary Industries

Contemporary Industries Corporation (“CIC”), a privately held Nevada corporation headquartered in Omaha, Nebraska, once operated 146 convenience stores throughout the Midwest. In 1995, CIC’s shareholders sold their stock to an outside investment group in an LBO that involved the creation of a new holding corporation, significant loans to the holding corporation, the pledge of CIC’s assets to secure the acquisition financing, and payment from the loan proceeds of more than $26 million to the old shareholders for their stock. The transaction was not effected directly, but through a collateral agent bank, with which the holding company deposited the purchase amount and the shareholders deposited their stock.

After CIC filed for chapter 11 protection in Nebraska in 1998, CIC commenced an adversary proceeding seeking to avoid the payments to the old shareholders as constructively fraudulent transfers under section 544 of the Bankruptcy Code and the Nebraska Uniform Fraudulent Transfer Act. The complaint also alleged that the old shareholders were unjustly enriched by the payments and that the payments violated Nebraska law as excessive and/or illegal shareholder distributions. The shareholders moved for summary judgment, asserting that the payments were exempt from avoidance under section 546(e). The bankruptcy court agreed, further concluding that CIC’s claims for unjust enrichment and illegal dividend were pre-empted because they sought essentially the same relief as the avoidance claims precluded by section 546(e). The district court affirmed.

CIC fared no better on appeal to the Eighth Circuit Court of Appeals, which considered the question of section 546(e)’s applicability to private securities transactions as a matter of first impression. Initially, the court examined whether the payments were “settlement payments” within the meaning of the statute. That term, the court explained, has been deemed by three sister circuits to be “extremely broad” in scope and, because it is “one of art in the securities trade,” it “should be given its established meaning in the industry.” According to the Eighth Circuit, “settlement” refers to “the completion of a securities transaction,” and a “settlement payment is generally the transfer of cash or securities made to complete [the] securities transaction.”

In keeping with the broad definition of “settlement payment,” both the Third and Tenth Circuits have concluded that payments made to selling shareholders during an LBO qualify as settlement payments under section 1146(e). The Eighth Circuit adopted their approach, rejecting CIC’s contention that the rulings were distinguishable because they involved public rather than privately held securities:

[W]e conclude the term “settlement payment,” as used in [sections 546(e) and 741(8)], encompasses most transfers of money or securities made to complete a securities transaction . . . . That is exactly what we have before us: the payments at issue were transfers of money made to complete a securities transaction, namely the sale of [the CIC stock]. Nothing in the relevant statutory language suggests Congress intended to exclude those payments from the statutory definition of “settlement payment” simply because the stock at issue was privately held. Section 741(8) is certainly not expressly limited to public securities transactions, and neither is § 546(e). Similarly, we do not believe § 741(8)’s concluding phrase “or any other similar payment commonly used in the securities trade” evinces an intent to exclude payments for privately held stock. To the contrary, the phrase follows a long list of various kinds of settlement payments and so we think it is most naturally read as a catchall phrase intended to underscore the breadth of the § 546(e) exemption.

In addition, the Eighth Circuit concluded that the payments were made “by or to a . . . financial institution” as required by section 546(e). It rejected CIC’s argument, based upon the Eleventh Circuit’s 1996 ruling in Munford v. Valuation Research Corp (In re Munford, Inc.), that this requirement was not satisfied because the collateral bank, as a “mere conduit,” never obtained a beneficial interest in the funds and was consequently not a transferee in the LBO. According to the Eighth Circuit, Munford “cannot be squared” with the plain language of section 546(e), “which does not expressly require that the financial institution obtain a beneficial interest in the funds.”

The court similarly made short shrift of CIC’s contentions that construing section 546(e) to cover private securities transactions would lead to an “absurd result” or invite abuse by “encouraging savvy investors and counsel to funnel any and all payments for stock through banks and to thereby immunize the payments from later avoidance in bankruptcy.” No absurdity would result from applying section 546(e) to private market transactions, the court emphasized, particularly as, due to the great amount of money at stake, “we can see how Congress might have believed undoing similar transactions could impact those markets, and why Congress might have thought it prudent to extend protection to payments such as these.” Addressing the potential for abuse, the Eighth Circuit noted that a “safety valve” exists to address such situations because, by definition, a settlement payment must be commonly used in the securities trade “and it is unlikely that a transaction that is a clear abuse could be said to be commonly used in that trade.”

Finally, the Eighth Circuit agreed with the courts below that CIC’s state-law claims were pre-empted because such claims sought recovery of the same payments that had already been deemed to be exempt from avoidance under section 546(e). To hold otherwise, the court concluded, would render the section 546(e) exemption meaningless. Contrary rulings, the court explained, are distinguishable because they involved underlying state law making the transfers at issue void rather than voidable.

QSI Holdings

The Sixth Circuit Court of Appeals confronted a substantially similar scenario in QSI Holdings—also as a matter of first impression—and reached the same conclusion. Quality Stores, Inc. (“Quality”), was a privately held corporation that operated a chain of retail stores specializing in agricultural and related products. In 1999, Quality and certain of its principal shareholders entered into a merger agreement with Central Tractor Farm and Country, Inc., and its parent company (“Central Tractor”) whereby Quality merged into Central Tractor (with the merged entity assuming the Quality name) and Quality’s existing shareholders were paid $208 million in cash and stock for their equity interests. The assets of both Quality and Central Tractor were pledged to secure loans, $115 million of the proceeds of which were used to purchase the old stock. Rather than directly, the transaction was effected through an exchange agent bank and, for shareholder employees of Quality, the agent bank as well as the trustee of an employee stock ownership trust.

Financial difficulties caused in part by the substantial integration costs associated with the merger and a costly expansion plan culminated in an involuntary bankruptcy filing against Quality in October 2001 and a voluntary chapter 11 filing by Quality in Michigan the following month. Quality commenced a proceeding two years afterward seeking to avoid the shareholder payments as constructively fraudulent transfers under section 544 of the Bankruptcy Code and the Michigan Uniform Fraudulent Transfer Act. The defendants moved to dismiss, asserting that the transfers were exempt from avoidance under section 546(e). The bankruptcy court granted the motion and was upheld on appeal by the district court.

The Sixth Circuit affirmed. Examining the language of section 546(e) to divine its plain meaning, the court emphasized that the critical phrase in section 741(8)’s definition of “settlement payment” is the final one: the payment must be one “commonly used in the securities trade.” More specifically, the court considered whether the logic employed by courts that have ruled that the definition encompasses transfers involving the acquisition of publicly traded securities in a leveraged buyout extends to LBO transfers involving privately traded securities. The Sixth Circuit concluded that it does, even considering section 546(e)’s underlying purpose:

This case . . . considers a transaction with the characteristics of a common leveraged buyout involving the merger of nearly equal companies, and nothing in the statutory language indicates that Congress sought to limit that protection to publicly traded securities. The value of the privately held securities at issue is substantial and there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities.

Finally, the Sixth Circuit adopted the Eighth Circuit’s reasoning in Contemporary Industries, rejecting the approach articulated in Munford and ruling that the “role played by [the agent bank] in the LBO at issue was sufficient to satisfy the requirement that the transfer was made to a financial institution.”


With the rulings in Contemporary Industries and QSI Holdings, a majority rule has been firmly established at the circuit level that: (i) section 546(e) applies to transactions involving privately held securities acquired as part of a typical LBO transaction; and (ii) the facilitating role of intermediary banks in the transaction is sufficient to satisfy the requirement under section 546(e) that the transfer be made to a financial institution. Whether this approach truly comports with lawmakers’ intent in enacting section 546(e) likely will continue to be the subject of considerable debate in the courts. Nevertheless, the approach adopted by the Eighth and Sixth Circuits should provide a significant measure of comfort for shareholders in privately held companies that may be the target of LBO acquisitions. Given a recent report by peHUB and Buyouts magazine that more private equity-backed bankruptcies have been filed in 2009 than in all of 2008, with a total of 53 filings as of August 2009 compared to 49 in all of last year, the prominence of this issue is likely to endure.

Section 546(e) has been the focus of several significant rulings already in 2009. In addition to the decisions in Contemporary Industries and QSI Holdings, a New York bankruptcy court considered whether the safe harbor extends to transactions in which commercial paper is redeemed by the issuer prior to maturity. In In re Enron Creditors Recovery Corp., the court ruled that where commercial paper is redeemed by the issuer prior to maturity, thereby extinguishing the commercial paper, and when the payment made for the commercial paper is equal to the principal plus the accrued interest to the date of payment, the payment made by the issuer is for the purpose of satisfying the underlying debt rather than a sale, such that the transfer does not qualify as a settlement payment under section 546(e).


In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009).

Contemporary Industries Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009).

Kaiser Steel Corp. v. Charles Schwab & Co., 913 F.2d 846 (10th Cir. 1990).

Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.), 952 F.2d 1230 (10th Cir. 1991).

Lowenschuss v. Resorts Int’l, Inc. (In re Resorts Int’l, Inc.), 181 F.3d 505 (3d Cir. 1999).

Jonas v. Resolution Trust Corp. (In re Comark), 971 F.2d 322 (9th Cir. 1992).

Munford v. Valuation Research Corp. (In re Munford, Inc.), 98 F.3d 604 (11th Cir. 1996).

Official Comm. of Unsecured Creditors v. Lattman (In re Norstan Apparel Shops, Inc.), 367 B.R. 68 (Bankr. E.D.N.Y. 2007).

Official Comm. of Unsecured Creditors v. Asea Brown Boveri, Inc. (In re Grand Eagle Co.), 288 B.R. 484 (Bankr. N.D. Ohio 2003).

In re Enron Creditors Recovery Corp., 407 B.R. 17 (Bankr. S.D.N.Y. 2009).