Proposed modification of US Bankruptcy Code’s fraudulent transfer safe harbor for securities transactions could unsettle LBOs and other M&A transactions

Citing a need to reform the private equity industry,¹ a group of United States Senators and Representatives have proposed the "Stop Wall Street Looting Act of 2021." If adopted, this new legislation would restrict, among other things, the scope of the Bankruptcy Code's Section 546(e) "safe harbor" provision. The safe harbor protects from avoidance certain securities-related transactions made prior to bankruptcy. Through amendment of the safe harbor, the legislation would open to challenge certain transactions which result in change in control of a target company, particularly those in connection with leveraged buy-outs.

Section 548 of the Bankruptcy Code permits a trustee to undo, or "avoid," transfers of a debtor or the incurrence of obligations by the debtor within two years prior to the filing of a bankruptcy, where the transfer was made or the obligation incurred (i) with the intent to hinder, delay or defraud creditors (an "Actual Fraudulent Transfer") or (ii) where the debtor was insolvent or became insolvent as a result of the transfer, and the transfer was not in exchange for reasonably equivalent value (a "Constructive Fraudulent Transfer").

However, there are several limitations on a trustee's avoidance powers. Of pertinence here, Section 546(e) of the Bankruptcy Code provides a safe harbor for (and exempts from avoidance) payments made by and to financial institutions in the settlement of securities transactions or the execution of securities contracts. Specifically, in its current form, Section 546(e) provides:

"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 margin payment […] or settlement payment […], made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made 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 …"

The safe harbor provision can promote stability in financial markets by ensuring that securities transactions will not be unwound as the result of a subsequent bankruptcy. For example, in a leveraged buyout ("LBO"), a buyer may fund the purchase of a target company with the proceeds of a loan secured by the target company's assets. The proceeds from the loan are then used by the target company to "buy out" the existing equity holders. Absent the safe harbor protection of Section 546(e), if the target company subsequently files for bankruptcy, the LBO transaction could be subject to avoidance as a constructive fraudulent conveyance on grounds that the LBO transaction rendered the target company insolvent. In such a litigation, the trustee or other estate representative may sue the former shareholders and seek to recover the funds that they received in the LBO.

The safe harbor provision has been subject to significant scrutiny and criticism, including on grounds that it is overbroad and protects more transactions than Congress intended, has failed to achieve its intended goal of reducing systemic risk in financial markets and that it may diminish incentives for parties to properly ration credit and monitor counterparty risk.²

Recent cases in US federal courts have grappled with the scope of the safe harbor provision, with mixed results. For example, in a 2018 decision, Merit Management Group LP v. FTI Consulting, 138 S. Ct. 883, the United States Supreme Court interpreted the scope of the safe harbor provision narrowly, determining that the safe harbor provision did not shield from avoidance securities-related transfers in which the financial institutions that were involved served as mere conduits to the shareholders in the transaction. The transfer at issue in Merit involved a purchaser (and subsequent bankruptcy debtor) acquiring the shares of a competitor, with the purchasing funds and shares routed through two banks. The Supreme Court reasoned that courts should consider the nature of the overarching transfer rather than its component parts when determining whether the safe harbor provision applies.³ Thus, even though financial institutions were involved in the string of transfers by which the purchaser acquired the shares of its competitor, the court considered only the broader transaction (i.e., between the purchaser and the competitor) to determine whether the safe harbor applied. Though not involving an LBO, the case suggested that courts should take a narrow view in determining whether transfers in connection with the purchase of a target company could fall within the safe harbor provision.

In contrast, however, in a decision following on the heels of Merit, In re Tribune Company Fraudulent Conveyance Litigation, 446 F.3d 66 (2d Cir. 2019), the Second Circuit Court of Appeals held that an LBO transaction was shielded from avoidance because the transaction involved a "securities contract" in which the parties involved were "financial institutions." The transaction at issue concerned a media company's transfer, via a securities clearing agency, of approximately US$8 billion to buy out shareholders. A representative of unsecured creditors of debtor Tribune Company sought to recover amounts paid to Tribune's shareholders in connection with the LBO, on grounds that the price paid for the shares was more than the reasonable value of the company.

The court, however, concluded that the LBO transaction fell within the safe harbor's protections. Specifically, the court determined that the payments made for the purchase and redemption of shares were "in connection with a securities contract," and, notably, that Tribune was a covered "financial institution" under the definition relevant to the safe harbor based on its customer relationship with the bank intermediary which served as the depositary in the transaction.⁴

The Tribune decision has been criticized by some as somehow inappropriately expanding the scope of the safe harbor. For example, Professor Daniel J. Bussel, of the UCLA School of Law, contends that it was "simply bizarre to define the statutory term 'financial institution' to include all commercial bank customers," and that the decision results in a "virtual repeal" of any ability to use the Bankruptcy Code to avoid transactions involving securities transfers.⁵ Similarly, one court has criticized Tribune as a "complete workaround" of the Supreme Court's limits on the safe harbor set forth in Merit.⁶ However, these criticisms seem to ignore that the Second Circuit followed the statutory language that expressly defined a "financial institution" to include a customer of such institution. The Supreme Court in Merit Management did not reach this issue, noting that it was making no decision on definition of "financial institution" since the parties had waived that argument and issue in lower courts. The argument of these critics thus, in reality, is with Congress and the statute.

The proposed Stop Wall Street Looting Act of 2021 would eliminate some of the debate over the scope of the safe harbor exception by removing a broad scope of transactions from the safe harbor's protections. Specifically, the proposed amendment would add language to Section 546(e) to expressly provide that transfers made in connection with a "change in control transaction" are exempt from the safe harbor protection. "Change in control" transactions are, in turn, defined to include transactions or a series of transactions that result in a change in the majority ownership of a company's securities or controlling interest. Additionally, the legislation provides that there is a presumption that such a change in control transaction was a fraudulent transfer for a period of eight years from the date on which a change in control transaction closed. The Act would also expand the look back period to eight years for these transactions, rather than the current period of two years. The drafters of the legislation suggest that these revisions will prevent investors from "hobbling the operations" of acquired companies and ensure the companies are able to make investments necessary for future growth.⁷

The immediate prospects for passage of the Stop Wall Street Looting Act of 2021 appear limited given the closely-divided US Congress. Even so, the potential implications of the Act warrant thorough consideration by private equity funds and other financial institutions, particularly those involved in financing LBO acquisitions or other corporate takeover transactions. Specifically, in situations in which a purchaser acquires a target company that subsequently seeks to reorganize under chapter 11, a trustee could (under the legislation as proposed) avoid distributions made to shareholders for the purchase. Given the expansive eight-year "protected period," the Act could inject significant uncertainty into the securities market, as firms face the prospect of the unwinding of purchase transactions closed long ago.

Stay tuned for further developments.