New York District Court Expands the Scope of the Bankruptcy Safe Harbor for LBO Payments

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 set forth in section 546(e) of the Bankruptcy Code. In In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), petition for cert. filed, No. 20-8-07102020, 2020 WL 3891501 (U.S. July 6, 2020) ("Tribune 2"), 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 held in Holliday v. K Road Power Management, LLC (In re Boston Generating LLC), 617 B.R. 442 (Bankr. S.D.N.Y. 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) provision applies only to intentional fraudulent transfer claims under federal law; and (ii) payments made to the members of limited liability company debtors as part of a pre-bankruptcy recapitalization transaction were protected from avoidance under section 546(e) because for that section's purposes the debtors were "financial institutions," as customers of banks that acted as their depositories and agents in connection with the transaction.

The U.S. District Court for the Southern District of New York joined the Tribune 2 bandwagon in In re Nine W. LBO Sec. Litig., 2020 WL 5049621 (S.D.N.Y. Aug. 27, 2020), appeal filed, 20-3290 (2d Cir. Sept. 25, 2020). The court dismissed $1.1 billion in fraudulent transfer and unjust enrichment claims brought by a chapter 11 plan litigation trustee and an indenture trustee against shareholders, officers, and directors of women's clothing retailer Nine West Holding Inc. ("Nine West"). Citing Tribune 2, the district court ruled that the payments were protected by the section 546(e) safe harbor because they were made by a bank acting as Nine West's agent. According to the court, "When, as here, a bank is acting as an agent in connection with a securities contract, the customer qualifies as a financial institution with respect to that contract, and all payments in connection with that contract are therefore safe harbored under Section 546(e)."

Further developments on this issue are likely—the U.S. Supreme Court has been asked to review Tribune 2, and Nine West has been appealed to the Second Circuit.

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 section 548, 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). "Customer" and "securities contract" are defined broadly in sections 741(2) and 741(7) of the Bankruptcy Code, respectively. Section 741(8) 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, or any other similar payment commonly used in the securities trade." A similar definition of "settlement payment" is set forth in section 101(51A).

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 lead 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 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. For its part, 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 in Merit 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—Tribune 2—the Second Circuit reaffirmed the court's previous decision that the creditors' state law constructive fraudulent transfer claims in that case 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) 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."

In Boston Generating, the bankruptcy court dismissed state law intentional and constructive fraudulent transfer claims asserted by a liquidating chapter 11 plan trustee seeking to avoid and recover $1 billion paid to the members of the debtors' holding company as part of a 2006 leveraged recapitalization transaction in the form of unit redemptions, warrant redemptions, and other distributions. The court held that: (i) section 546(e) preempted the state law intentional fraudulent transfer claims because the plain language of the provision excepts only intentional fraudulent transfer claims under federal law; and (ii) the payments were protected from avoidance by the section 546(e) safe harbor because the debtors were "financial institutions," as customers of the banks that acted as the debtors' agents in connection with the recapitalization.

Nine West

In 2014, private equity firm Sycamore Partners Management, L.P. ("Sycamore") acquired The Jones Group, Inc. ("Jones"), a fashion retail company, through an LBO. The transaction involved the merger of Jones into a new Sycamore subsidiary that was ultimately renamed Nine West Holdings, Inc. ("Nine West"). Transfers made to Jones shareholders, directors, and officers as part of the LBO included: (i) $1.1 billion paid to public shareholders by canceling and converting each share of common stock to the right to receive $15 in cash; (ii) $78 million paid to directors and officers by canceling and converting each of their restricted stock and stock equivalent units to the right to receive $15 in cash; and (iii) $71 million in "change in control" payments to certain directors and officers.

Payments with respect to common stock were made by a paying agent "pursuant to a paying agent agreement in customary form" that empowered the paying agent, among other things, to "act as [Nine West's] special agent for the purpose of distributing the Merger Consideration." Payments with respect to restricted stock, stock equivalent units, and unpaid dividends as well as change-in-control payments "were processed through the payroll and by other means."

Nine West filed for chapter 11 protection in the Southern District of New York four years after the LBO was completed. In February 2019, the bankruptcy court confirmed a chapter 11 plan for Nine West that was made possible by Sycamore's contribution of $120 million for the benefit of unsecured creditors, in exchange for a release of any liability related to the LBO. The plan assigned unreleased potential causes of action arising from the LBO to a litigation trustee and empowered the indenture trustee for certain Nine West noteholders to prosecute state law fraudulent transfer claims.

The litigation trustee sued the public shareholders ("shareholder defendants") and the directors and officers ("D&O defendants") in various federal district courts seeking to avoid the LBO payments as intentional and constructive fraudulent transfers under state law and section 544 of the Bankruptcy Code (all federal avoidance claims were time barred). He also asserted claims against certain D&O defendants for unjust enrichment, disgorgement, and restitution. The indenture trustee separately sued all of the defendants to avoid and recover the payments under state law. All of the litigation was later consolidated in the U.S. District Court for the Southern District of New York.

Invoking the section 546(e) safe harbor as an affirmative defense, the defendants moved to dismiss the litigation (other than the unjust enrichment claims with respect to the change in control payments).

The District Court's Ruling

The district court ruled in favor of the defendants on the motion to dismiss.

District Judge Jed S. Rakoff agreed with the shareholder defendants that the $1.1 billion Nine West paid them in connection with the LBO was a "qualifying transaction" for purposes of section 546(e) because the payments were "settlement payments," as defined by section 741(8) of the Bankruptcy Code, and they were "made in connection with a securities contract," as the term "securities contract" is defined in section 741(7).

He rejected the trustees' efforts to distinguish Tribune 2 on the basis that Tribune 2 involved payments to public shareholders for the redemption of stock, whereas Nine West's LBO involved the cancellation and conversion of common stock to the right to receive cash. According to Judge Rakoff, the two-step LBO transaction in Tribune 2 involved the redemption of common stock followed by post-merger cancellation and conversion of the remaining shares to the right to receive cash. Moreover, he explained, the plain language of section 741(7) covers not only contracts for the repurchase of securities but also includes as a "catch-all" any other "similar" contract or agreement. Judge Rakoff concluded that "[t]here is no substantive or essential difference between an LBO that is effectuated through share redemption and one effectuated through share cancellation."

Alternatively, Judge Rakoff held that the payments made to the shareholder defendants were "settlement payments"—i.e., transfers of cash made to complete a merger—consistent with the Second Circuit's "capacious interpretation of § 741(8)."

Next, guided by Tribune 2, Judge Rakoff determined that Nine West's shareholder payments involved a "qualifying participant" because Nine West qualified as a "financial institution" under section 546(e) as a "customer" of an agent bank that was also a financial institution. In addition, he noted that at least 82 of the shareholder defendants independently qualified as "financial institutions" because they were either registered investment companies or commercial banks.

Also in accordance with Tribune 2, where the Second Circuit held that section 546(e) impliedly preempts state law fraudulent transfer claims by individual creditors that would be barred by the provision if asserted by a bankruptcy trustee, the Nine West district court ruled that the safe harbor preempts both trustees' state law fraudulent transfer claims against the defendants.

Judge Rakoff also concluded that the payments (other than the change-in-control payments) made to the D&O defendants were protected as both settlement payments and transfers made in connection with a securities contract, even though the payments, unlike the shareholder payments, were not processed by Nine West's agent bank. He reasoned that, because Nine West was a financial institution as a customer of the agent bank, section 546(e) safe-harbors all transfers made in connection with the LBO. In so ruling, Judge Rakoff rejected the trustees' "transfer-by-transfer" approach, which would distinguish between payments that were processed by the agent bank and those that were not in construing the definition of "financial institution" under section 101(22) of the Bankruptcy Code. Instead, he opted for the more comprehensive "contract-by-contract" approach, which views the transaction as a whole. This approach, he explained, comports with Merit's holding that "the relevant transfer for purposes of the § 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid" and "not any component part of that transfer."

Finally, the district court held that section 546(e) preempts the litigation trustee's unjust enrichment claims against the D&O defendants because such claims, however denominated, sought recovery of the same payments that were protected from avoidance under the safe harbor. However, the court did not dismiss the unjust enrichment claims with respect to the change-in-control payments because the D&O defendants did not seek dismissal.


Several Second Circuit bankruptcy and appellate courts, including the court of appeals, have now ruled 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. Whether this approach holds up to further appellate scrutiny remains to be seen. Both the U.S. Supreme Court and the Second Circuit (again) now have an opportunity to weigh in on the issue.

Two months after the district court handed down its decision in Nine West, the U.S. Bankruptcy Court for the Southern District of New York invoked section 546(e) to dismiss a chapter 11 plan litigation trustee's complaint seeking to avoid and recover alleged constructive fraudulent transfers made in 2015 by SunEdison Holdings ("Holdings"), a subsidiary of renewable-energy development company SunEdison, Inc. ("SunEdison"), in connection with the acquisition of a wind and solar power generation project ("project").

Funding for the $350 million project involved: (i) Holdings' formation of a special purpose entity subsidiary ("SPE") that issued secured notes under an indenture among the SPE, SunEdison, as guarantor, and Wilmington Trust, N.A. ("Wilmington"), as collateral agent; (ii) the transfer by Holdings of stock ("Step One Transfer") to the SPE to facilitate the acquisition under a 2014 purchase and sale agreement ("PSA"); and (iii) the SPE's pledge of the stock ("Step Two Transfer") to Wilmington, as collateral agent for the noteholders under a pledge agreement.

Beginning on April 2016, SunEdison, Holdings, and various affiliates filed for chapter 11 protection in the Southern District of New York (the SPE did not file for bankruptcy). In 2017, the bankruptcy court confirmed a chapter 11 plan in for SunEdison, Holdings, and various affiliates. In 2018, the liquidating trustee ("trustee") under the plan sued the SPE and the noteholders (collectively, "defendants") to avoid and recover the Step One Transfer (but not the Step Two Transfer) as a constructive fraudulent transfer under sections 544, 548(a)(1)(B), and 550 of the Bankruptcy Code and New York law. The defendants moved to dismiss, arguing that the section 546(e) safe harbor barred the trustee's constructive fraudulent transfer claims because the transaction included the Step Two Transfer, which was made to a "financial institution" (Wilmington). The trustee responded that he did not seek avoidance of the Step Two Transfer and that, even if Wilmington was a "financial institution," it did not act as the SPE's agent in connection with the Step One Transfer because it did not facilitate the actual transfer of the stock to the SPE.

The court ruled that the safe harbor barred the trustee's constructive fraudulent transfer claims. See SunEdison Litigation Trust v. Seller Note, LLC (In re SunEdison, Inc.), 2020 WL 6395497 (Bankr. S.D.N.Y. Nov. 2, 2020). Under Merit and Boston Generating, the court explained, the "relevant transfer" in this case was "the overarching transfer"—namely, both the Step One Transfer, which did not involve a "qualifying participant," and the Step Two Transfer, which did, because Wilmington received the pledged stock as collateral for the notes. According to the court, "[t]his was an integrated transaction" because the "Step One Transfer would not have occurred without agreement on the Step Two Transfer as well as the other components of the purchase and sale." Because the 2015 transaction was made to Wilmington, a qualified "financial institution," in connection with the 2014 PSA, a "securities contract," the court ruled that section 546(e) shielded the "component steps" from avoidance as a constructive fraudulent transfer.

Moreover, recent rulings regarding the impact of Merit on the scope of section 546(e) safe harbor are not confined to the Second Circuit, and at least one has rejected the Tribune "workaround" approach. In In re Greektown Holdings, LLC, 2020 WL 6218655 (Bankr. E.D. Mich. Oct. 21, 2020), reh'g denied, 2020 WL 6701347 (Bankr. E.D. Mich. Nov. 13, 2020), the U.S. Bankruptcy Court for the Eastern District of Michigan denied a motion for summary judgment filed in avoidance litigation by the recipients of payments made in connection with a pre-bankruptcy recapitalization transaction that involved the issuance of unsecured notes underwritten by a financial institution and payment of a portion of the proceeds to the defendants. Citing Merit, the defendants argued that the transfer was safe-harbored because the transaction was undertaken "for the benefit of" the underwriter, which acted as the debtor-transferor's agent, thereby making the transferor a financial institution as the underwriter's customer.

The court rejected this argument, ruling that the transaction fell outside the section 546(e) safe harbor because: (i) neither the transferor nor the transferees were financial institutions in their own right; (ii) the defendants failed to establish that the transaction was "for the benefit" of the underwriter financial institution by showing that it "received a direct, ascertainable, and quantifiable benefit corresponding in value to the payments"; and (iii) the evidence did not show that the underwriter was acting as either the transferor's agent or custodian in connection with the transaction, such that the transferor itself could be deemed a financial institution. Notably, the court was "not persuaded by the agency analysis in [Tribune 2] as it does not distinguish between mere intermediaries contracted for the purpose of effectuating a transaction and agents who are authorized to act on behalf of their customers in such transactions." Under Tribune 2, the court wrote, "any intermediary hired to effectuate a transaction would qualify as its customer's agent [, which] … would result in a complete workaround of [Merit]."

A version of this article was previously published by Lexis Practice Advisor. It has been reprinted here with permission.

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