Category Archives: Bankruptcy litigation

Controversial Safe Harbor: Supreme Court to Address Circuit Split of Clawback Protection in Bankruptcy Code

The Supreme Court recently agreed to review the applicability of the safe harbor provision in section 546(e) of the Bankruptcy Code after differing interpretations of the statute created a split among the circuit courts.   The ultimate outcome on the issue currently before the Supreme Court will undoubtedly impact how parties choose to structure their debt and asset transactions going forward.

Section 546(e) of the Bankruptcy Code states that the debtor “may not avoid a transfer that is . . . a transfer 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 . . . .”   In other words, section 546(e) limits a debtor’s avoidance powers with respect to certain types of securities-related transactions.  Indeed, legislative history suggests the purpose of the safe harbor was to minimize instabilities in the commodities and securities markets by allowing for more certainty and finality in related transactions.

While certain transactions clearly fall within the safe harbor, like the sale of publicly traded securities by a brokerage firm or other financial institution, courts have been left with the difficult task of determining whether private transactions of securities should also be afforded the protection.  Indeed, many private company transactions flow through financial institutions or financial participants or involve financial institutions as third-party lenders for leveraged buyouts and could implicate the safe harbor based on a straightforward reading of the statute.  A majority of circuits addressing this issue have adopted the plain-reading, pass-through theory—a broad interpretation of the statute finding that such a transfer was “by or to” a financial institution as set forth by its plain language.

In the case taken up by the high court, FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, the Seventh Circuit rejected the majority view and took a narrow view of section 546(e), finding that the pass‑through of a security through a financial institution and the lending provided by a third‑party did not trigger the safe harbor provision under section 546(e).  The case arose from a bankruptcy involving racetrack operator Valley View Downs, LP.  Prior to its bankruptcy, Valley purchased equity of an additional racetrack, Bedford Downs, through a $55 million leveraged buyout financed by Credit Suisse.  Citizens Bank of Pennsylvania, serving as escrow agent, held the Bedford Downs shares, until Valley completed the transaction.

FTI, appointed as litigation trustee to pursue Valley’s estate’s avoidance actions, commenced a fraudulent transfer action against Merit, a 30% stakeholder in Bedford Downs, to recover Merit’s portion of the proceeds from the equity purchase.  Merit argued that the transaction was protected by section 546(e) because the transaction was made “by or to” certain financial institutions, namely Citizens Bank and Credit Suisse.

The District Court agreed with Merit and found that the section 546(e) safe harbor protected the transaction based on a plain language reading of the statute, finding that the transaction was “by or to” a financial institution because the transaction involved the two financial institutions.  FTI appealed.

Upon appeal, the Seventh Circuit reversed the decision of the District Court.  Finding the language of 546(e) to be ambiguous, the Seventh Circuit reviewed the intended purpose of the safe harbor provision, finding such purpose is to “protect the market from systematic risk and allow parties in the securities industry to enter into transactions with greater confidence—to prevent one large bankruptcy from rippling through the securities industry.”  Determining that the transaction at issue of private stock for cash between two entities did not fall under the intended purpose of section 546(e), the Seventh Circuit ruled the safe harbor provision did not apply.

The Seventh Circuit’s interpretation of 546(e) is in line with a divided opinion from the Eleventh Circuit, Munford v. Valuation Research Corp., finding that a similar transaction involving a financial institution as merely a conduit did not trigger a section 546(e) safe harbor protection from clawback.  However,  the Second, Third, Sixth, Eighth, and Tenth Circuits all disagree, finding both the language of section 546(e) to be unambiguous and that an intermediary financial institution that touches a securities transaction set forth in the statute triggers the safe harbor protections, often citing the dissent in Munford.

Should the Supreme Court overturn the Seventh Circuit and agree with the majority of Circuits on this issue, it would cement the significant barrier created by section 546(e) for a debtor or its successor even to attempt a clawback of any major transaction.  Given the Court’s relative speed in taking up the matter and its recent rulings on statutory interpretation, it may be the Court will do just that, leaving it to Congress to amend section 546(e) to provide the protections in line with its intended purpose.

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Ninth Circuit Rules That A Purchaser of An Insider’s Claim Should Not Be Deemed an Insider for the Purposes of Voting on a Plan of Reorganization

Before a bankruptcy court may confirm a chapter 11 plan, it must determine if any of the persons voting to accept the plan are “insiders,”i.e., individuals or entities with a close relationship to the debtor.  Because the Bankruptcy Code’s drafters believed that insider transactions warrant heightened scrutiny the classification of a creditor as an “insider” can have a profound impact on a debtor’s ability to reorganize. One particularly important example is section 1129(a)(10) of the Code, which requires that at least one class of impaired claims (claims that are not paid in full) votes in favor of the plan, not counting the votes of insiders provided that certain other Code requirements are met.

In U.S. Bank N.A. v. The Village at Lakeridge, LLC (In re The Village at Lakeridge, LLC), the Court of Appeals for the Ninth Circuit considered whether a close associate of a board member of the debtor’s owner qualified as an “insider” for plan voting purposes.  Because of the unique nature of the debtor’s capital structure, the confirmability of the debtor’s plan and the viability of the debtor’s business as a going concern hung in the balance.

Lakeridge filed for chapter 11 relief on June 16, 2011 with only two creditors: (i) U.S. Bank, which held a $10 million fully secured claim; and (ii) MBP Equity Partners, Lakeridge’s 100% owner, which held an unsecured claim of $2.76 million.  Shortly after the case was commenced, MBP decided to sell its claim, and Kathie Bartlett, one of its board members, approached Robert Rabkin, a friend and business associate in matters unrelated to Lakeridge, about purchasing the claim.  Rabkin quickly agreed to buy the claim for $5,000, later testifying that he had done so after completing little or no due diligence and with full recognition that his acquisition was a risky investment.

While Bartlett later testified that MBP’s board elected to sell its claim because it believed there were tax advantages in doing so, the claims transfer had a significant additional benefit for Lakeridge’s chances to successfully reorganize.  Indeed, because the MBP claim (the only unsecured claim asserted against the debtor) was initially held by an insider, it could not be counted for the purposes of plan voting.  As a result, at the outset of the case, no unimpaired class of non-insider claims existed and the debtor was unable to propose a confirmable plan.  Subsequent to the transfer, the MBP claim was in the hands of a nominal non-insider, freeing up Lakeridge to propose a restructuring so long as it could comply with the other technical requirements of section 1129 of the Bankruptcy Code.

The transfer of the MBP claim had profound implications for U.S. Bank.  At the start of the case, U.S. Bank stood poised to assert its leverage as a secured creditor to force Lakeridge to sell its assets pursuant to section 363 of the Code or otherwise liquidate its business in a manner that guaranteed it payment in full in short order.  After the transfer, the bank faced the prospect of Lakeridge proposing a so-called “cram-down” plan that, with Rabkin’s support and over the bank’s objection, forced the bank to accept payment over time, the reinstatement of its liens against the assets of Reorganized Lakeridge, or any other package that the bankruptcy court deemed to be the “indubitable equivalent” of its claim.  Faced with the potential of losing control over Lakeridge’s bankruptcy as a result of the sale of the MBP claim to Rabkin, U.S. Bank commenced an action to challenge Rabkin’s designation as a non-insider.

U.S. Bank faced an uphill battle in its attempt to classify Rabkin as an insider.           Bankruptcy law recognizes two types of insiders: “statutory” insiders consist primarily of a debtor’s directors, officers, or managers, while “non-statutory” insiders are those parties who have a close relationship with a debtor and who do not negotiate the relevant transaction with the debtor at arm’s length.  The bank first argued that Rabkin became a statutory insider when he acquired the claim from MBP.  The Ninth Circuit disagreed, distinguishing between the status of a claim and that of a claimant, and finding that Rabkin did not become an insider merely as a result of the type of claim he possessed.  The Ninth Circuit similarly concluded that Rabkin’s relationship with Lakeridge was not so close as to confer “non-statutory” insider status upon him, as the record before it indicated that Rabkin (i) had little knowledge of Lakeridge or MBP prior to acquiring the claim and no control over either entity; and (ii) did not know of Lakeridge’s plan of reorganization or that his vote would be required to confirm it.  While the court acknowledged the existence of the close relationship between Bartlett and Rabkin, it noted that Rabkin had no relationship with any of the other four members of the MBP board (all of whom agreed to sell the MBP claim to Rabkin) and that Bartlett had no authority to bind MBP without the other members’ support.

Notably, the Ninth Circuit’s decision was not unanimous, as a member of the panel issued a partially concurring and dissenting opinion that agreed with the general proposition that a person does not necessarily become an insider solely by acquiring a claim from an insider so long as the claim was acquired by an independent party, for bona fide reasons and “uninfected with the unique motivations of the insider.” But the dissenting portion of the opinion concluded that the claims purchase was not negotiated at arms-length because:

  • Rabkin paid only $5,000 for a $2.76 million claim;
  • MBP did not offer the claim to anyone else;
  • The purchase was not solicited by Rabkin;
  • There was no evidence of any negotiation over price; and
  • After learning that the payment under the plan would be $30,000, he was offered as much as $60,000 from U.S. Bank for the claim and declined the offer.

In light of these facts, the dissent determined that the motivations for MBP and Bartlett to transact with Rabkin were clear: MBP was primarily motivated to place the unsecured claims in the hands of a friendly creditor who could be counted on to vote in favor of the reorganization plan.  As to Rabkin, the dissent found his intentions a bit “murkier.”  After concluding that Rabkin was clearly not acting as economically rational actor in acquiring the claim (and noting that there was no evidence that he had a history of making blinds bets, “say by helping out Nigerian princes or buying the Brooklyn Bridge”), the dissent surmised that Rabkin was simply doing a favor for a friend with the chance of making some money for himself in the process.  As such, the dissent concluded that Rabkin should have been deemed an insider.

As noted by the dissent, the majority opinion in Lakeridge creates a clear path for debtors who want to avoid the limitations of the insider voting restrictions of the Bankruptcy Code.  Under the court’s holding, insiders are free to evade the requirements of section 1129(a)(10) by simply transferring their claims for a nominal amount to a friendly but technically unaffiliated third party, who can cast the vote that the insider could not cast themselves.  Such a result effectively nullifies section 1129(a)(10) in cases in which a debtor has only a few non-insider creditors. This is precisely what occurred in Lakeridge.

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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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Filed under Bankruptcy litigation, Third Circuit

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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