Bankruptcy Judge Criticizes Bankruptcy Code Section 546(e)

The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law recently held hearings regarding certain provisions of the Bankruptcy Code, including the safe harbor from preference and fraudulent conveyance claims for “settlement payments.”

Section 546(e) of the U.S. Bankruptcy Code limits the ability of a trustee to avoid certain transfers, including “settlement payments.”  In recent years, courts have embraced a broad definition of the term “settlement payment,” including in that category any payment related to a “securities trade” regardless of whether the transfer involved any market intermediary or public securities market.

On March 26, 2014, Judge Christopher Sontchi of the U.S. Bankruptcy Court for the District of Delaware testified before the Committee, arguing that the application of 546(e)’s exception to all such transactions is too broad.

In particular, Judge Sontchi testified that he believes “Congress should consider amending section 546(e) of the Bankruptcy Code to significantly narrow its scope.”  The Judge emphasized that “Congress’s intent was to insulate the securities transfer system.”  He explained that “securities industry transferees are generally not the beneficial owners of the subject transactions but, rather, are the conduits.  Subjecting these conduits in the securities transfer system to avoidance actions could trigger a series of unintended and disastrous defaults in the interconnected securities markets.”  In contrast, he argued that shielding “the ultimate beneficial recipients of a settlement payments, including insiders in private transactions” from liability has resulted in providing “officers and directors of bankrupt companies with an almost ‘too good to be true’ defense to preference and fraudulent conveyance actions.”

Judge Sontchi went on to elaborate his views on how the applicability of section 546(e) should properly be limited:

The safe harbor of section 546(e) should protect the securities transfer system, if and when the financial institutions are acting as conduits for payment, regardless of whether the securities involved are public or private.  This safe harbor for the securities industry is important because the initial transferee is not accorded a good faith defense under section 550, potentially exposing the securities industry to large and inappropriate liability for acting as mere intermediaries in securities transactions.  However, section 546(e) should not protect settlement payments or other transfers with respect to the beneficial owners of privately placed debt securities or of equity securities of a closely held entity.  With regard to publicly traded securities, section 546(e) should only protect transfers to the beneficial owners of public securities holders that have acted in good faith.

This testimony, from a sitting bankruptcy judge in the District of Delaware, is notable given the trend in the Third Circuit, the Second Circuit and elsewhere to expansively construe section 546(e).

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