Expanding the Scope of the Bankruptcy Safe Harbor for Securities Transactions

In 2019, the U.S. Court of Appeals for the Second Circuit made headlines when it ruled that creditors' state law fraudulent transfer claims arising from the 2007 leveraged buyout ("LBO") of Tribune Co. ("Tribune") were preempted by the safe harbor for certain securities, commodity or forward contract payments contained in section 546(e) of the Bankruptcy Code. The Second Circuit concluded that a debtor may itself qualify as a "financial institution" covered by the safe harbor, and thus avoid the implications of the U.S. Supreme Court's decision in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), by retaining a bank or trust company as an agent to handle LBO payments, redemptions and cancellations.

Picking up where the Second Circuit left off, the U.S. Bankruptcy Court for the Southern District of New York recently held in Holliday v. K Road Power Management, LLC (In re Boston Generating LLC), 2020 WL 3286207 (Bankr. S.D.N.Y. June 18, 2020), that: (i) section 546(e) preempts intentional fraudulent transfer claims under state law because the intentional fraud exception expressly included in section 546(e) applies only to intentional fraudulent transfer claims under federal law; and (ii) payments made to the members of limited liability company ("LLC") debtors as part of a pre-bankruptcy recapitalization transaction were protected from avoidance under section 546(e) because the debtors were "financial institutions," as customers of banks that acted as their depositories and agents in connection with the transaction.

The Section 546(e) Safe Harbor

Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, which include the power to avoid certain preferential and fraudulent transfers. Section 546(e) provides that the trustee may not avoid, among other things, a pre-bankruptcy transfer that is a settlement payment "made by or to (or for the benefit of) a … financial institution [or a] financial participant…, or that is a transfer made by or to (or for the benefit of)" any such entity in connection with a securities contract, "except under section 548(a)(1)(A) of the [Bankruptcy Code]." Thus, the section 546(e) "safe harbor" bars avoidance claims challenging a qualifying transfer unless the transfer was made with actual intent to hinder, delay, or defraud creditors under federal law, as distinguished from being constructively fraudulent because the debtor was insolvent at the time of the transfer (or became insolvent as a consequence) and received less than reasonably equivalent value in exchange.

Section 101(22) of the Bankruptcy Code defines the term "financial institution" to include:

[A] Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity and, when any such Federal reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer (whether or not a "customer", as defined in section 741) in connection with a securities contract (as defined in section 741) such customer…. 

11 U.S.C. § 101(22) (emphasis added).

The purpose of section 546(e) is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982). The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id.

In Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 818 F.3d 98 (2d Cir. 2016) ("Tribune 1"), the U.S. Court of Appeals for the Second Circuit affirmed lower court decisions dismissing creditors' state law constructive fraudulent transfer claims arising from the 2007 LBO of Tribune. According to the Second Circuit, even though section 546(e) expressly provides that "the trustee" may not avoid certain payments under securities contracts unless such payments were made with the actual intent to defraud, section 546(e)'s language, its history, its purposes, and the policies embedded in the securities laws and elsewhere led to the conclusion that the safe harbor was intended to preempt constructive fraudulent transfer claims asserted by creditors under state law.

Prior to the Supreme Court's ruling in Merit, there was a split among the circuit courts of appeals concerning whether the section 546(e) safe harbor barred state law constructive fraud claims to avoid transactions in which the financial institution involved was merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. The Second Circuit ruled that the safe harbor applied under those circumstances in In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013). The Supreme Court resolved the circuit split in Merit.

In Merit, a unanimous Supreme Court held that section 546(e) does not protect transfers made through a "financial institution" to a third party, regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, the relevant inquiry is whether the transferor or the transferee in the transaction sought to be avoided overall is itself a financial institution. Because the selling shareholder in the LBO transaction that was challenged as a constructive fraudulent transfer was not a financial institution (even though the conduit banks through which the payments were made met that definition), the Court ruled that the payments fell outside of the safe harbor.

In a footnote, the Court acknowledged that the Bankruptcy Code defines "financial institution" broadly to include not only entities traditionally viewed as financial institutions, but also the "customers" of those entities, when financial institutions act as agents or custodians in connection with a securities contract. The selling shareholder in Merit was a customer of one of the conduit banks, yet never raised the argument that it therefore also qualified as a financial institution for purposes of section 546(e). For this reason, the Court did not address the possible impact of the shareholder transferee's customer status on the scope of the safe harbor.

In April 2018, the Supreme Court issued an order that, in light of its ruling in Merit, the Court would defer consideration of a petition seeking review of Tribune 1. The Second Circuit later suspended the effectiveness of Tribune 1 "in anticipation of further panel review." In a revised opinion issued in December 2019, In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), reh'g denied, No. 13-3992 (L) (2d Cir. Feb. 6, 2020) ("Tribune 2"), the Second Circuit reaffirmed the court's previous decision that creditors' state law constructive fraudulent transfer claims were preempted by the section 546(e) safe harbor.

The Second Circuit acknowledged that one of the holdings in Tribune 1 (as well as its previous ruling in Quebecor) was abrogated by Merit's pronouncement that the section 546(e) safe harbor does not apply if a financial institution is a mere conduit. However, the court again concluded that section 546(e) barred the creditors' state law avoidance claims, but for a different reason.

The Second Circuit explained that, under Merit, the payments to Tribune's shareholders were shielded from avoidance under section 546(e) only if either Tribune, which made the payments, or the shareholders who received them, were "covered entities." It then concluded that Tribune was a "financial institution," as defined by section 101(22)(A) of the Bankruptcy Code, and "therefore a covered entity."

According to the Second Circuit, the entity Tribune retained to act as depository in connection with the LBO was a "financial institution" for purposes of section 546(e) because it was a trust company and a bank. Therefore, the court reasoned, Tribune was likewise a financial institution because, under the ordinary meaning of the term as defined by section 101(22), Tribune was the bank's "customer" with respect to the LBO payments, and the bank was Tribune's agent according to the common law definition of agency. "Section 546(e)'s language is broad enough under certain circumstances," the Second Circuit wrote, "to cover a bankrupt firm's LBO payments even where, as here, that firm's business was primarily commercial in nature."

Boston Generating

Boston Generating LLC ("BosGen"), its holding company EBG Holdings LLC ("EBG"), and their subsidiaries (collectively, "debtors") owned and operated electric power generating facilities near Boston. In November 2006, BosGen and EBG launched a leveraged recapitalization transaction whereby they borrowed approximately $2.1 billion from lenders, in part to fund a $925 million tender offer for EBG's member units and the distribution of $35 million in dividends to EBG's members. The Bank of New York ("BNY") acted as a depository and agent for both BosGen and EBG in connection with the tender offer.

The $2.1 billion cash infusion from the credit facilities was deposited into BosGen and EBG bank accounts at U.S. Bank National Association ("U.S. Bank") and later transferred to their accounts at BNY. In December 2006, as part of consummating the recapitalization transaction, EBG directed BNY to pay approximately $1 billion to EBG's members in the form of unit redemptions, warrant redemptions, and other distributions (collectively, "payments").

The debtors filed for chapter 11 protection in the Southern District of New York in August 2010. After authorizing the sale of substantially all of the debtors' assets, the bankruptcy court confirmed a liquidating chapter 11 plan for the debtors in August 2011. The plan created a liquidating trust to pursue claims on behalf of the debtors' general unsecured creditors. The liquidating trustee commenced an adversary proceeding seeking, among other things, to avoid and recover the payments as intentional and constructive fraudulent transfers under the New York Debtor & Creditor Law. The defendants moved to dismiss, arguing that the transfers were safe-harbored under section 546(e).

The Bankruptcy Court's Ruling

The bankruptcy court granted the motion to dismiss the liquidating trustee's fraudulent transfer claims. The court ruled that: (i) section 546(e) preempted the claims; and (ii) the payments were protected by the section 546(e) safe harbor because BosGen and EBG were "financial institutions," as customers of U.S. Bank and/or BNY.

Initially, the court acknowledged that, although neither Tribune 1 nor Tribune 2 addressed whether section 546(e) preempts intentional (as distinguished from constructive) fraudulent transfer claims under state law, the court saw "no reason why Tribune's reasoning does not extend to intentional state law fraudulent transfer claims." Examining the plain language of section 546(e), the court declined to extend section 546(e)'s exception for federal intentional fraudulent transfer claims under section 548(a)(1)(A) to include state law intentional fraudulent transfer claims. According to the court:

Congress may have specifically excluded state law intentional fraudulent transfer claims from section 546(e)'s exception having determined the need for stability in the securities markets overrode the potential danger of creditors escaping claims for intentional fraud based on a fear that inconsistent application of fifty (50) states' fraudulent transfer statutes would result in instability in the securities markets.

Looking at the series of transfers involving the payments as an "integrated transaction," the bankruptcy court determined that the payments satisfied the requirements for the safe harbor because: (i) "a transfer of cash to a financial institution made to repurchase and cancel securities—in other words, to complete a securities transaction—qualifies for the safe harbor as a settlement payment"; (ii) the LLC member units and warrants qualified as "securities" under the Bankruptcy Code's broad definition; (iii) the payments were made "in connection with a securities contract"—the tender offer; (iv) BosGen qualified as a "financial institution" by virtue of its relationship with U.S. Bank, which acted as the agent of its customers BosGen and EBG in connection with the tender offer; and (v) additionally, or in the alternative, both BosGen and EBG qualified as "financial institutions" as customers of BNY, which acted as their agent in connection with the tender offers.

Finally, the court also ruled that section 546(e) preempted the liquidating trustee's constructive fraudulent transfer claims under state law—an issue that was conceded by the trustee.


Merit potentially opened the door for state law constructive fraudulent transfer claims against selling equity holders in many LBOs or other recapitalization transactions. Such payments typically pass through financial intermediaries that would be considered "financial institutions" and, before Merit, were considered to be protected from such claims by the safe harbor in many circuits.

Post-Merit case law, however, appears to close the door, at least in the Second Circuit, on such fraudulent transfer claims. In handing down its ruling in Boston Generating, the bankruptcy court employed substantially the same reasoning articulated by the Second Circuit in Tribune 2 and the U.S. District Court for the Southern District of New York in related litigation involving the Tribune litigation trustee's federal constructive fraudulent transfer claims. See In re Tribune Co. Fraudulent Conveyance Litig., 2019 WL 1771786 (S.D.N.Y. Apr. 23, 2019). Each of these decisions suggests that the results of Merit might be avoided by structuring transactions so that the target or recapitalized entity is a "customer" of the financial intermediaries involved. Boston Generating adds an additional gloss to the analysis by concluding that state law intentional fraudulent transfer claims asserted on behalf of creditors are also preempted by section 546(e).

A version of this article is being published in Lexis Practice Advisor. It has been reprinted here with permission.

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