Category Archives: Third Circuit

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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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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Filed under Absolute Priority Rule, Gifting, Third Circuit