Rough Waters Could Be Ahead for Those Seeking Protection of Section 546(e) Safe Harbor

A recent decision by the Bankruptcy Court for the District of Delaware in PAH Litigation Trust v. Water Street Healthcare Partners L.P. (In re Physiotherapy Holdings, Inc.), Case No. 13-12965 (KG) (Bankr. D. Del. June 20, 2016), may limit the types of transactions that are subject to the “safe harbor” protections of section 546(e) of the Bankruptcy Code.  On June 20, 2016, Judge Kevin Gross issued an opinion holding that state law fraudulent transfer claims may be actionable even where such claims might be barred by the safe harbor if brought under federal law.

Section 546(e) of the Bankruptcy Code provides a “safe harbor” for certain transfers involving the purchase and sale of securities and protects those transfers from avoidance in bankruptcy proceedings as preferences or constructively fraudulent conveyances.  Specifically, section 546(e) insulates transfers that are “settlement payments” used in the securities trade, as well as other transfers made to or from certain parties, including financial institutions, financial participants and stockbrokers, in connection with a securities contract.  Section 741(8) of the Bankruptcy Code defines “settlement payment” somewhat circularly, 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.”

As we have noted in previous editions of Absolute Priority, courts have increasingly applied the section 546(e) safe harbor to shield virtually all transactions that concern a purported transfer of securities, both public and private, from avoidance.  The Second Circuit reinforced the broad scope of the safe harbor in Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Company Fraudulent Conveyance Litigation), 818 F.3d 98 (2d Cir. Mar. 24, 2016), holding that the safe harbor preempted state fraudulent transfer laws.  When state and federal laws conflict, federal law displaces, or preempts, state law, pursuant to the Supremacy Clause of the United States Constitution. Applying the preemption doctrine, the Second Circuit found that permitting state law fraudulent transfer claims would undermine numerous policies codified in federal securities laws, discourage investors from maintaining diversified portfolios, and harm the efficient maintenance of secondary markets for common stocks.

In PAH Litigation Trust v. Water Street Healthcare Partners L.P., the debtor, Physiotherapy Holdings was a leading provider of outpatient physical therapy services that operated 650 clinics in 33 different states.  Six years before filing for bankruptcy, Physiotherapy’s common stock was acquired by two private equity funds.  By 2009, Physiotherapy’s financial condition had deteriorated and its equity interests were sold to Court Square, which issued $210 million in senior secured notes that Physiotherapy agreed to assume.

Two years after confirmation of Physiotherapy’s prepackaged plan of reorganization, Physiotherapy’s litigation trustee brought an adversary complaint alleging that in order to finance the prepetition sale of Physiotherapy to Court Square, Physiotherapy’s former controlling shareholders orchestrated a scheme to make it appear that Physiotherapy was worth approximately twice its value.

The complaint alleged that the offering memorandum for the senior secured notes fraudulently overstated Physiotherapy’s revenue stream and its overall firm value, leading Court Square to acquire an insolvent company and the noteholders to receive debt instruments worth far less than their face value. The trustee, on behalf of certain noteholders who helped finance the Court Square transaction, sought to recover payments made to Physiotherapy’s former controlling shareholders in exchange for their equity in Physiotherapy under both state and federal fraudulent transfer laws.

The shareholder defendants filed a motion to dismiss the complaint, arguing that the payments were immune from avoidance under the safe harbor as settlement payments to a financial institution in connection with a securities contract.  The trustee responded, in part, by arguing that the safe harbor does not apply to creditors asserting fraudulent transfer claims under state law.

Judge Gross agreed with the trustee’s argument that the safe harbor does not preempt claims asserted by a litigation trust under state fraudulent transfer law.  In arriving at this conclusion, Judge Gross disagreed with Tribune’s holding that permitting state law fraudulent transfer claims would undermine federal securities laws.  Instead, relying upon other bankruptcy court decisions, Judge Gross concluded that the safe harbor does not preempt state law fraudulent transfer claims where only private stock is involved because there is no risk of destabilizing financial markets by increasing systemic risk.

Physiotherapy has significant implications for the viability of the safe harbor exception in the context of privately held companies and chips away at the broad protections of the safe harbor.  At the same time, Physiotherapy’s holding was limited to circumstances where (1) the transaction sought to be avoided did not pose a threat of “ripple effects” in the relevant securities markets; (2) the transferees received payment for non-public securities; and (3) the transferees were corporate insiders that allegedly acted in bad faith.  In circumstances where those factors are not present, such as a transaction where public securities are involved, the safe harbor may still preempt state law fraudulent transfer claims.  However, it is unclear whether Physiotherapy represents meaningful precedent for future cases because Judge Gross’s conclusions appear to have been largely driven by the facts of the case.  The shareholder defendants filed a motion for leave to appeal on July 15, 2016, and it is possible that an appellate court will overturn Physiotherapy and follow the Second Circuit’s decision in Tribune.

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Lack of Knowledge is No Defense: Seventh Circuit Strips Bank’s Lien on More than $300 Million in Assets

The Seventh Circuit (which covers Illinois, Indiana, and Wisconsin) appears to have added a new and potentially conflicting standard in analyzing  a third-party transferee’s “good faith” defense to a fraudulent transfer claim.  The good faith defense protects a third-party transferee from having to return the value it received from a debtor as a part of a fraudulent transaction so long as that third-party transferee entered into the transaction with the debtor in good faith.  Continue reading

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Illinois Bankruptcy Court Articulates Low Threshold for Equitable Subordination of Insider Secured Loan

For a distressed company running low on capital, an investment from insiders may represent a last best hope for survival. Insiders may be willing to risk throwing good money after bad for a chance to save the company even when any third party would stay safely away. Insiders  of a failing company may also have an ulterior motive for making an eleventh hour capital infusion, as they may use their control over a distressed company to enhance their position relative to the company’s other creditors. The line between a good faith rescue and bad faith self-dealing is often a hazy one. Continue reading

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A Holiday Present from the Third Circuit? The Court of Appeals Upholds a Secured Lender’s “Gift” to General Unsecured Creditors Under Narrow Circumstances

What better time than the holiday season to discuss “gifting” in the context of chapter 11 cases.  “Gifting” commonly refers to the situation where a senior creditor pays (or allocates a portion of its collateral for the benefit of) one or more junior claimholders.  Gifting is often employed as a tool to resolve the opposition of a junior class of creditors, who are typically out-of-the-money, to the manner in which the bankruptcy case is being administered.  For instance, creditors’ committees may seek gifts from senior creditors to guarantee a recovery for general unsecured creditors in cases where a debtor’s administrative solvency or ability to confirm a chapter 11 plan are in doubt.

While gifting may provide flexibility in certain chapter 11 cases, some have argued that the technique runs afoul of the so-called “absolute priority” rule embodied in Section 1129 of the Bankruptcy Code.  The absolute priority rule prohibits confirmation of a plan that provides for a distribution of property to junior creditors unless all senior creditors either receive the full value of their claims or consent to alternative treatment under the plan.

The Third Circuit Court of Appeals, whose rulings bind the Delaware bankruptcy courts in which a significant number of large chapter 11 cases are administered, first addressed gifting in 2005 in In re Armstrong World Industries, Inc.  In that case, the plan provided that if one class of general unsecured creditors rejected the plan, then another class of general unsecured creditors (asbestos personal injury claimants), would receive, but immediately waive receipt of, certain warrants, which would then be issued to equityholders.  While the Third Circuit concluded that such a plan violated the absolute priority rule, it reasoned that the carve out from the secured creditor’s collateral for the benefit of a junior claimant may not offend the absolute priority rule because the property belongs to the secured creditor, not the bankruptcy estate.  Delaware bankruptcy courts have relied on Armstrong and other cases to permit gifting outside of a chapter 11 plan.  This permits secured lenders and third-party purchasers to provide funds to general unsecured creditors where a recovery may not otherwise have been possible.

More recently, in September 2015, the Third Circuit confirmed that a gift made by a secured lender to junior creditors does not offend the absolute priority rule, at least under certain circumstances.  In ICL Holding Company, Inc., the debtors’ senior lenders credit bid approximately 90% of their claims for the purchase of the company.  The offer did not include any cash, though funds were escrowed to pay certain chapter 11 professionals.  Two parties objected to the sale: (i) the creditors’ committee, which argued that the sale only benefited the secured lenders and would leave the estates administratively insolvent, and (ii) the United States Government, which argued that the sale would result in capital gains taxes of approximately $24 million, giving the United States an administrative claim that would go unpaid while other administrative claims (namely professional fees) would be paid in full.  Before the court ruled on the objections, the creditors’ committee struck a deal, withdrawing its objection in exchange for a $3.5 million cash payment from the lenders for the benefit of general unsecured creditors.  The debtors did not reach an agreement with the government.

The Bankruptcy and District Courts rejected the government’s arguments, concluding that the funds set aside for general unsecured creditors and chapter 11 professionals were not property of the Debtors’ estates and therefore not subject to the absolute priority rule.  In an opinion written by Judge Ambro, a former bankruptcy practitioner, the Third Circuit agreed with the lower courts.   Judge Ambro reasoned that because the funds paid by the lenders to general unsecured creditors were not proceeds from the lenders’ liens, never belonged to the debtors, and would never become part of the debtors’ estate even as a pass-through, they were not property of the estates.  The Third Circuit also held that the funds set aside to pay professional fees and other wind down costs were similarly not property of the estates, because any unused escrowed funds were to be returned to the lenders, not the estates.

While the ICL Holdings decision authorizes a gift from a senior lender to a junior creditor, the facts present a fairly easy case, and there is dicta in the opinion indicating that gifts effectuated through means unlike those at issue in ICL Holdings may be more problematic.  Most notably, Judge Ambro’s opinion explains that a gift effectuated through a carve out of a secured lenders’ collateral for the benefit of a junior class would likely be a gift of property of the estate.  Such a gift may still be permissible, but after ICL Holdings, it will be harder for courts in the Third Circuit to conclude that it does not implicate property of the estate.

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The House Always Wins: Seventh Circuit Broadly Applies “Good Faith” Defense Under Section 550(b)(1) to Fraudulent Transfer Defendant That Lost Millions at Casino

The Court of Appeals for the Seventh Circuit recently issued a decision which may give a trump card to fraudulent transfer defendants seeking to use the “good faith” defense under the Bankruptcy Code’s recovery provision. This defense, set forth in section 550(b)(1), provides that a trustee may not recover a voidable transfer from “a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidablity of the transfer avoided[.]” (emphasis added).

The case, In re Equipment Acquisition Resources, Inc., involved former owners of the debtor – which manufactured and refurbished machinery used in the high-technology sector – who received approximately $17 million in transfers from the debtor as a result of a fraudulent scheme. The former owners, the aptly-named Sheldon Player and his wife, Donna Malone, lost $8 million of these funds gambling at the Horseshoe Casino over approximately 2 years.

The casino observed, but did not act on, various suspect activity of the defendants, including Player’s “walking with chips” (leaving a casino with chips rather than cashing them in) and “passing chips” (giving chips to a third party to cash in). The casino ran credit checks on Player and Malone which revealed that they had understated their liabilities on their credit application by over $2 million, but still extended credit to them. In addition, the casino kept one of the debtor’s accounts on file as a “reference account,” and Player and Malone paid some of their gambling debts from a bank account referring to the debtor’s name.

The bankruptcy court-appointed plan administrator sought to recover the transfers made to the casino pursuant to Code section 550 as a subsequent transferee of the fraudulent transfers. In its summary judgment motion, the casino argued that it was insulated from recovery because it acted without knowledge of the fraud of the debtor, and the district court agreed. On appeal, the Seventh Circuit identified the key issues – whether the casino took the transfers “in good faith” and “without knowledge of the voidability of the transfer avoided.”

With respect to whether the casino took the transfers “without knowledge,” the Court looked to its prior decision in Bonded Financial Services, Inc. v. European American Bank, which held that if a reasonable inquiry would not have led to actual knowledge of voidability, a court cannot impute knowledge. Applying this standard, the Court found that unless the casino had some reason to know that it was receiving funds resulting from a fraudulent transfer, it should not be liable. While the trustee pointed to various “red flags” which he claimed should have alerted the casino that it was receiving fraudulent transfers, the Court was unconvinced that any of the signs were sufficient to impose a duty on the casino to investigate the transfers from the debtor to Player and Malone. The Court further noted that even if the casino had investigated, it likely would not have uncovered the fraud.

With respect to whether the casino took the transfers “in good faith,” the Court found that the casino had “no way of knowing the transactions from [the debtor] to Player were voidable, and thus, was not closing its eyes to the creditors’ plight. There is no indication that any alleged lack of diligence was the product of bad faith.”

The decision certainly serves as a hurdle for trustees, creditors’ committees and other plaintiffs seeking to recover fraudulent transfers from subsequent transferees. Plaintiffs invoking section 550 will now need to plead more than the existence of “red flags” to meet the “without knowledge” standard. Given the difficulties many bankruptcy plaintiffs face in pleading fraud with particularity, the heightened pleading standard could prove exceedingly difficult. Equipment Acquisition Resources provides transferees that ignore or otherwise fail to investigate “red flags” before accepting transfers that are ultimately deemed fraudulent with a basis to avoid liability and breathe a sigh of relief.

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Recent Decision May Assist Challenges to Alleged Fraudulent Transfers

A recent decision by the Bankruptcy Court for the Southern District of New York may enhance the ability of bankruptcy trustees and creditors committees to challenge allegedly fraudulent transfers that could qualify for protection under the “safe harbor” of section 546(e) of the Bankruptcy Code.  Continue reading

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Cooley Selected as Co-Counsel to RadioShack Creditors’ Committee

Cooley’s Corporate Restructuring & Bankruptcy Group was selected as co-counsel by the official committee of unsecured creditors in RadioShack’s chapter 11 proceedings, which began on February 5, 2014.  Quinn Emanuel will also serve as co-counsel to the Committee.   Continue reading

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