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Weathering the Storm: Second Circuit Affirms an Expansive Interpretation of Section 546(e) of the Bankruptcy Code
Robin E. Phelan, Stephen Manz
On June 28, 2011, in In re Enron Creditors Recovery Corp. v. Alfa,1 the Second Circuit Court of Appeals held that Enron’s redemption of its commercial paper prior to maturity fell within the definition of a “settlement payment” and was protected from avoidance under § 546(e)’s safe harbor provision in Title 11 of the United States Code.2
Congress enacted § 546(e)’s safe harbor in 1982 in order to minimize the potential harm to the commodities and securities markets in the event of a major bankruptcy related to those industries.3 The safe harbor prohibits the avoidance of “settlement payments” made by, to, or on behalf of a number of participants in the financial markets. 11 U.S.C. § 546(e).4
In 2001, Enron collapsed and petitioned for Chapter 11 bankruptcy. In 2003, the reorganized entity sought to avoid and recover redemption payments from approximately two hundred financial institutions, including Alfa and ING. Prior to filing its bankruptcy petition, Enron had redeemed its commercial paper at a price considerably higher than the paper’s market value. Enron alleged the payments were recoverable (1) as preferential transfers under 11 U.S.C. § 547(b) because they were made on account of antecedent debt within ninety days prior to bankruptcy and (2) as constructively fraudulent transfers under 11 U.S.C. § 548(a)(1)(B), since the redemption price for the commercial paper exceeded the market value.5
Alfa and ING moved to dismiss Enron’s complaint because they alleged that the redemption payments were “settlement payments” protected by § 546(e). The bankruptcy court denied the motion to dismiss, and Alfa and ING then moved for summary judgment. The bankruptcy court held that “settlement payments” include only payments to buy or sell securities, not payments made to retire debt. Therefore, the safe harbor in § 546(e) did not protect Enron’s payments from avoidance, and summary judgment was denied.6 Alfa and ING were then granted interlocutory review of the bankruptcy court’s ruling. The district court reversed and remanded the bankruptcy court’s decision, with instructions to enter summary judgment in favor of Alfa and ING.7 The district court held that the definition of “settlement payment” in 11 U.S.C. § 741(8) is not restricted to payments that are “commonly used” in the securities trade, and therefore the circumstances of a specific payment do not bear on whether that payment fits within the definition of a settlement payment. The district court also held that a “settlement payment is any transfer that concludes or consummates a securities transaction.”
In a case of first impression in the courts of appeals, the Second Circuit had to determine “[w]hether the § 546(e) safe harbor applie[d] to an issuer’s redemption of commercial paper prior to maturity, effected through the customary mechanism of transacting in commercial paper through the Depository Trust Company, without regard to extrinsic facts, such as the motives and circumstances of redemption.”
The Majority’s Analysis
In analyzing whether the redemption of commercial paper prior to maturity qualified as a “settlement payment,” the court rejected each of Enron’s three contentions: (1) the definition of “settlement payment” excludes all payments that are not common in the securities trade, (2) the definition of “settlement payment” includes only transactions where title to the securities changes hands, and (3) a “settlement payment” requires that a financial intermediary take title to the transacted securities.
Enron’s first argument addressed the definition of a “settlement payment.”8 The court acknowledged that the Second Circuit had not yet addressed the scope of § 741(8)’s definition of a “settlement payment,” but that other circuits have held it to be “extremely broad.” Enron alleged that the phrase “commonly used in the securities trade” modifies all the preceding terms and thereby excludes from the definition all uncommon payments. This reading of the phrase would have limited the definition of a “settlement payment.” The court disagreed with Enron’s interpretation of the definition and concluded that the phrase “commonly used in the securities trade” modifies only the term “any other similar payment.” Therefore, the court read the phrase as a “catchall phrase intended to underscore the breadth of the § 546(e) exemption.”
In Enron’s second argument, it alleged that the redemption payments were not settlement payments because they involved the retirement of debt, not the acquisition of title to the commercial paper. The court concluded that there was no basis in the Bankruptcy Code or case law to interpret § 741(8) as excluding the redemption of debt securities and that because Enron’s redemption payments completed a transaction in securities, they were settlement payments. Additionally, the court stated that § 741(8) does not have a purchase or sale requirement.
Enron’s third argument stated that the redemption of debt was not a protected “settlement payment” because there was not a financial intermediary that took a beneficial interest in the securities during the course of the transaction. The court concluded that the absence of a financial intermediary that takes title to the transacted securities during the transaction is not a reason to deny safe harbor protection.
Ultimately, the court declined to adopt any of Enron’s arguments. The court affirmed the district court’s holding and classified Enron’s redemption of commercial paper prior to maturity as a “settlement payment,” falling within the § 546(e) safe harbor.
The dissent preferred a narrow interpretation of the definition of a “settlement payment.” The dissent concluded that the text of § 741(8) is ambiguous and provides virtually no guidance as to the types of transfers that should be identified as “settlement payments,” so a plain meaning interpretation would not be instructive. The dissent determined that a settlement payment required a purchase or a sale and cited various cases and Judge Friendly’s explanation that “in common speech a maker’s paying a note prior to maturity in accordance with its terms would not be regarded as a ‘purchase.’” According to the dissent, the majority failed to point to a case that held there was not a purchase or sale requirement for a securities transaction, and they did not demonstrate the existence of a common industry understanding that the redemption of commercial paper is a securities transaction.
The dissent feared that the majority’s definition of a “settlement payment” would “bring virtually every transaction involving a debt instrument within the safe harbor of Section 546(e), thus allowing the settlement payment exception to swallow up the Section 547(b) avoidance provision.” Additionally, the dissent stated that the majority’s approach imperils the ordinary repayment of loans.
The majority takes an expansive view of the definition of “settlement payment” and of the § 546(e) safe harbor provision. An expansive interpretation of § 546(e) has also appeared in cases out of the Third, Sixth, and Eighth Circuits, and it suggests a national trend toward a broad interpretation of the § 546(e) safe harbor provision.
Throughout the majority’s opinion, the court appeared to be balancing the sometimes conflicting concerns of systemic risk to the securities market with a literal reading of the statute. For example, private transactions do not create any sort of substantial systemic risk in the securities market, but they were held to be covered in QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.).9
During a hypothetical discussing the purchase or sale requirement, the court made a statement about loans that are repaid prematurely, which could have significant consequences for the financial community. In the hypothetical, the terms of an ordinary promissory note prohibited voluntary early redemption. According to the court, if the borrower decided to buy back the promissory note at a negotiated price, it would be “difficult to characterize this transaction as a redemption rather than a repurchase in order to exclude it from the safe harbor.” This suggests that if a borrower pays off a note in less than the full amount, that § 546(e) might apply. The majority’s hypothetical highlights the dissent’s fear that the “Court’s approach imperils the ordinary repayment of loans.” The court seemed to say that even in a workout context, a payment or settlement prior to maturity could be protected from avoidance by § 546(e). The expansive application of § 546(e) to transactions neither commonly understood to involve settlement payments, nor involving systemic risk to the financial markets, is creating an inconsistent and confusing patchwork of cases that protect from avoidance large numbers of transactions that were apparently not within the contemplation of Congress when § 546(e) was enacted.
For more information, please contact any of the lawyers listed below. You may also view the alert in the PDF linked below.
PDF - Second Circuit Affirms.pdf
Written with the assistance of Megan Dagerman, The University of Texas Law School.
1 No. 09-5122-bk, 2011 U.S. App. LEXIS 13177, at *2 (2d Cir. June 28, 2011).
2 11 U.S.C. § 546(e): Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is…a settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a…stockbroker, financial institution, financial participant, or securities clearing agency…that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
3 Kaiser Steel Corp. v. Charles Schwab & Co., Inc., 913 F.2d 846, 849 (10th Cir. 1990) (quoting H.R. Rep. 97-420, at 2 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583).
4 The court applied the former version of § 546(e) because the action was commenced prior to the 2006 revisions to § 546(e).
5 There are additional statutory requirements for recoveries under § 547 and § 548 not relevant to this alert.
6 In re Enron Creditors Recovery Corp., 407 B.R. 17, 45 (Bankr. S.D.N.Y. 2009).
7 In re Enron Creditors Recovery Corp., 422 B.R. 423, 442 (S.D.N.Y. 2009).
8 11 U.S.C. § 741(8): “settlement payment” means 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.
9 571 F.3d 545, 550 (6th Cir. 2009).