Avoidance actions are an important source of recovery for the creditors of a bankruptcy estate. Although estate representatives are given significant avoidance powers under the Bankruptcy Code, section 546(e)'s safe harbor prevents the unwinding of certain transactions that, if undone, could cause disruption to the securities and commodities markets. Recently, in Grede v. FCStone, LLC, 746 F.3d 244 (7th Cir. 2014), the U.S. Court of Appeals for the Seventh Circuit confirmed courts' view of the expansiveness of the 546(e) safe harbor when it overruled a district court's "equitable" approach to creditor distributions. The Seventh Circuit held that, among other things, a trustee could not avoid a prepetition transfer to a favored customer (an investor in one of the debtor's securities investment portfolios) as a constructively fraudulent transfer because the transferred funds came from the debtor's sale of securities. The court reasoned that the distribution to the customer from its investment account, like the payment made by the purchaser to the debtor for securities whose proceeds were deposited into the account, qualified as a "settlement payment" and was made "in connection with a securities contract."
The 546(e) Safe Harbor
In 1982, Congress broadened a limited safe harbor for securities transactions then set forth in section 764(c) of the Bankruptcy Code, which applied only in commodity-broker liquidation cases under chapter 7, by replacing the provision with section 546(e) (then designated as section 546(d), until renumbering in 1984).
Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, including the power to avoid certain preferential and/or fraudulent transfers. Section 546(e) provides:
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of [the Bankruptcy Code], the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of [the Bankruptcy Code], or settlement payment as defined in section 101 or 741 of [the Bankruptcy Code], 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, as defined in section 741(7) [of the Bankruptcy Code], commodity contract, as defined in section 761(4) [of the Bankruptcy Code], or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of [the Bankruptcy Code].
The purpose of section 546(e) is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583, 1982 WL 25042. The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id.
If a transaction falls within the scope of section 546(e), it may not be avoided unless the transfer is avoidable under section 548(a)(1)(A) of the Bankruptcy Code because it was made with actual fraud (i.e., with the intent to hinder, delay or defraud creditors). However, in determining whether a preferential or constructively fraudulent transfer (i.e., the debtor did not receive reasonably equivalent value in exchange and was insolvent, undercapitalized, unable to pay its debts or paid an insider under an employment agreement) is shielded from avoidance under section 546(e), key issues are often whether the transfer qualifies as a "settlement payment" and whether the transfer is made under a "securities contract." In addition, to be within the scope of the safe harbor, a transfer must have been "made by or to (or for the benefit of)" a commodity broker, a forward contract merchant, a stockbroker, a financial institution, a financial participant or a securities clearing agency.
The Seventh Circuit examined these issues in Grede.
Grede
Sentinel Management Group Inc. ("Sentinel") was in the business of managing investments for various clients, including futures commission merchants, hedge funds, financial institutions and individuals. To invest, a customer deposited cash with Sentinel, which used the funds, pursuant to an investment agreement, to purchase securities that satisfied the guidelines of each customer's chosen investment portfolio.
Under SEC and CFTC regulations, Sentinel was obligated to hold customer property in trust segregated from its own property. Nonetheless, Sentinel comingled cash and securities and failed to comply with the risk guidelines established for each portfolio.
Sentinel also engaged in proprietary trading. Its trades were financed by the Bank of New York ("BNY"). The debt was secured by a lien on a BNY-maintained account (the "Lien Account") that originally held only Sentinel assets. However, as time progressed, Sentinel began moving customer securities from segregated customer accounts into the Lien Account to fund its continued trading activities.
In the summer of 2007, Sentinel was undone when the subprime mortgage industry collapsed and credit markets tightened. It filed for chapter 11 protection on August 17, 2007 in the Northern District of Illinois, shortly after BNY notified Sentinel that the bank would liquidate the Lien Account collateral (which included both Sentinel and customer securities) unless Sentinel repaid the approximately $370 million loan in full.
On the eve of bankruptcy, Sentinel engaged in several transactions that greatly improved the position of certain favored customers. For example, Sentinel removed from the Lien Account $264 million worth of securities belonging to a favored customer group and replenished the Lien Account with $290 million worth of securities belonging to another customer group. Hours before the bankruptcy filing, Sentinel also distributed $22.5 million in cash to certain favored customers, including $1.1 mnillion to FCStone, LLC ("FCStone").
After the bankruptcy filing, Sentinel continued to favor certain customers. Among other things, it filed an emergency motion seeking court authority to sell $300 million worth of securities and distribute the proceeds to the customers, including FCStone, which received nearly $14.5 million. The bankruptcy court subsequently clarified that its order did not "authorize" the distribution within the meaning of section 549 of the Bankruptcy Code, which provides for the avoidance of unauthorized post-bankruptcy transfers, because authorization necessarily would have been premised on a ruling that the transferred property belonged to the estate—a ruling that the court stated it had not made.
The bankruptcy court later appointed a chapter 11 trustee for Sentinel. The trustee sued the favored customers, among other things, to avoid Sentinel's prepetition payments to those customers as preferences under section 547(b) of the Bankruptcy Code and to avoid the postpetition transfers described above under section 549. The FCStone transfers were litigated as the first test case in the district court, which had withdrawn the reference of the avoidance action to the bankruptcy court because it found that the actions raised significant and unresolved issues of non-bankruptcy law.
The district court held that the assets transferred postpetition to FCStone were property of Sentinel's estate and that the postpetition payment was unauthorized under section 549 notwithstanding the bankruptcy court's original order approving the payment. In concluding that the distribution to FCStone was not authorized, the district court deferred to the bankruptcy court's subsequent clarification of its original order.
The district court also held that the prepetition payment to FCStone was avoidable as a preference. Relying largely on policy grounds to justify avoidance, the district court concluded that section 546(e) did not apply, without addressing the litigants' specific arguments regarding the scope of the safe harbor. The district court reasoned that it was "inconceivable" that Congress could have intended section 546(e) to apply in the circumstances before it.
The court distinguished between an insolvent debtor selling a security to a buyer shortly before filing for bankruptcy and an insolvent debtor distributing the proceeds of the sale of a customer's security. According to the district court, shielding the transaction between the debtor and the buyer would serve section 546(e)'s purpose of preventing destructive ripple effects in the case of a bankruptcy. However, in the district court's view, shielding the debtor's distribution of the sale proceeds to the customer would destabilize the financial system because it would be impossible to predict who would receive money in the event of a bankruptcy.
Applying the safe harbor to shield the prepetition payments to FCStone, the court wrote, "would create the very type of systemic market risks that Congress sought to prevent." According to the court, where the debtor is a financial institution that sells securities on behalf of third-party customers, "§ 546(e) is invoked not to shield the actual exchange between Debtor and Buyer but to uphold the manner in which Debtor distributes exchange proceeds to its customers." See Grede v. FCStone, LLC, 485 B.R. 854, 885 (N.D. Ill. 2013). Moreover, the court reasoned, declining to apply the safe harbor would "not result in the unwinding of completed securities and commodities transactions that Congress sought to protect." FCStone appealed to the Seventh Circuit.
The Seventh Circuit's Ruling
A three-judge panel of the Seventh Circuit reversed. At the outset, the court noted that the district court's findings of fact clearly indicated that FCStone was a "commodity broker," the prepetition transfer to FCStone qualified as a "settlement payment" and the transaction was effected "in connection with a securities contract," as required by section 546(e).
Section 741(8) of the Bankruptcy Code, the court explained, circularly defines a settlement payment 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." The Seventh Circuit (among others) has held that "swapping shares of a security for money" falls within the definition. See Peterson v. Somers Dublin Ltd., 729 F.3d 741, 749 (7th Cir. 2013); accord In Official Comm. of Unsecured Creditors of Quebecor World (U.S.A) Inc. v. Am. Life Ins. Co. (In re Quebecor World (U.S.A.) Inc.), 719 F.3d 94, 98 (2d Cir. 2013) (defining a settlement payment as a "transfer of cash made to complete a securities transaction") (quoting Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329, 339 (2d Cir. 2011)).
The trustee argued that Sentinel's customers had no right to buy, sell or obtain the securities, but rather were entitled only to share in the value of the portfolio in which they invested. This meant that Sentinel, as distinguished from the customer, transacted to sell the securities in order to finance customer redemptions (i.e., distributions). In other words, the trustee argued that the relevant securities transaction, for purposes of considering whether section 546(e) applied, should have been the sale transaction between Sentinel and the purchaser of the securities, as distinguished from the redemption transaction between Sentinel and its customers—who only had an indirect beneficial interest in the securities sale transaction. However, the Seventh Circuit panel found the payment from Sentinel to FCStone to be a "settlement payment" because customer redemptions "were meant to settle, at least partially, the customers' securities accounts with Sentinel."
The Seventh Circuit panel also held that the transfer to FCStone was made "in connection with a securities contract." Section 741(7) of the Bankruptcy Code, the court explained, defines a "securities contract" broadly to include a "contract for the purchase, sale, or loan of a security." The court reasoned that, because Sentinel was expected to purchase and sell securities on behalf of its customers pursuant to investment agreements it entered into with its customers, the investment agreements qualified as securities contracts. The fact that that the customers were entitled to cash rather than to the securities themselves, the court wrote, "does not change the fact that these customers' investment agreements were contracts for the purchase and sale of securities." The court was unmoved by the fact that at least some of the funds distributed to FCStone may not have come from the sale of securities held within FCStone's portfolio because the funds were intended to satisfy Sentinel's obligations under the parties' investment agreement.
The Seventh Circuit faulted the district court's conclusion that transfers of the kind made to FCStone transfer were not intended to be protected by Congress. The court wrote that, "[b]y enacting § 546(e), Congress chose finality over equity for most pre-petition transfers in the securities industry—i.e., those not involving actual fraud." Section 546(e), the court reasoned, "reflects a policy judgment by Congress that allowing some otherwise avoidable pre-petition transfers in the securities industry to stand would probably be a lesser evil than the uncertainty and potential lack of liquidity that would be caused by putting every recipient of settlement payments in the past 90 days at risk of having its transactions unwound in bankruptcy court." "We understand the district court's powerful and equitable purpose" in attempting to resolve the conflict between the wronged customers fairly, the court wrote, "but its reasoning runs directly contrary to the broad language of § 546(e)."
The Seventh Circuit panel also ruled that held that the postpetition transfer to FCStone could not be undone under section 549 of the Bankruptcy Code because the transfer was authorized by the bankruptcy court. Despite the bankruptcy court's attempt to "clarify" (i.e., modify) its order to permit the trustee to avoid the transfer, the Seventh Circuit panel found the initial order to have been clear on its face and the "clarification" to have been an abuse of discretion. According to the Seventh Circuit panel, "[w]e doubt whether a bankruptcy court can ever authorize a transfer without authorizing it under § 549, but that's a larger puzzle we leave for another day." Given its conclusion that the postpetition transfer was authorized within the meaning of section 549, the court declined to decide whether the funds at issue were property of Sentinel's estate.
Outlook
Grede is yet another illustration of the broad interpretation given by most courts to the section 546(e) safe harbor to protect the securities and commodities markets—irrespective of a result that may arguably lead to inequality in creditor distributions and despite indications of a debtor's prepetition misconduct. Ultimately, unless there is a sound claim for actual fraud under section 548(a)(1)(A), estate representatives face an uphill battle in seeking to avoid a transaction that falls within section 546(e)'s broad definition of "settlement payment" or a transfer made "in connection with a securities contract
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