United States: A Narrow Interpretation Of Section 546(e)

Last Updated: April 11 2013
Article by Matthew P. Kremer

Most Read Contributor in United States, October 2018

FCStone, a New York-based commodities brokerage firm, was recently ordered to return a transfer of $15.6 million to the bankruptcy estate of Sentinel Management Group. Approximately $1.1 million of this amount constituted a prepetition transfer of proceeds the debtor obtained from the sale of securities, which proceeds the debtor distributed to a certain segment of its customers, including FCStone.

Judge James B. Zagel of the United States District Court for the Northern District of Illinois in Grede v. FCStone LLC (N.D. Ill. 2013), determined that this prepetition transfer constituted a preference that was not protected under the safe harbor of section 546(e), which immunizes certain settled financial transactions from avoidance.

Judge Zagel declined to analyze whether or not the transaction in question constituted a "settlement payment" or a transfer made "in connection with a securities contract" pursuant to a "literal interpretation" of section 546(e), but instead relied on the public policy considerations underlying the section. Judge Zagel's approach represents a departure from the Second Circuit's approach in In re Enron Creditors Recovery Corp. v. Alfa SAB de CV, 651 F.3d 329 (2d Cir. 2011), in which the court of appeals broadly interpreted the language of section 546(e) to protect a transaction that did not involve the traditional purchase or sale of securities, albeit under a distinguishable set of facts.

The Purpose of Section 546(e)

The Bankruptcy Code contains several provisions that grant special protections for participants in the financial markets. Section 546(e) restricts the ability for a trustee to avoid certain transactions — including, among others, settlement payments, margin payments and commodity contracts — even when these transactions would otherwise constitute constructively fraudulent conveyances or preferential payments.

Congress's stated intent in enacting section 546(e) was "to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." H.R. Rep. 97-420, at 2 (1982). Specifically, Congress was concerned with a "ripple effect" that would occur if a participant in settled financial transactions filed for bankruptcy and sought to unwind such transactions in bankruptcy, placing its counterparties and other downstream participants at undue risk.

Factual Background

Sentinel was an investment advisory firm that specialized in offering CFTC-compliant investment programs for its customers — primarily future commission merchants and other participants in the futures and commodities market. Sentinel customers deposited funds into particular investment programs and received a pro rata beneficial interest in the securities that backed that investment group. Pursuant to applicable CFTC regulations, Sentinel was required to segregate commodity customer funds from those of other customer groups and from Sentinel's own assets.

Starting in 2001, however, Sentinel improperly entered into a number of repurchase agreements (or "repos") that were collateralized by certain of the same securities that Sentinel used to support its investor programs, which left the customer accounts chronically underfunded. The collapse of the subprime mortgage industry resulted in several repo counterparties closing out positions in Sentinel's repo portfolio and demanding cash payments. Eventually, Sentinel was unable to service the repayment demands or to meet its collateral maintenance obligations and was forced to file Chapter 11.

On Aug. 16, 2007, in a hasty effort to begin selling securities to redeem customer funds, Sentinel sold to Citadel numerous securities allocated to certain customer accounts. The next day, before filing for bankruptcy, Sentinel distributed $22.5 million from the Citadel sale to certain customers, including FCStone, which received approximately $1.1 million.

Additionally, on Aug. 21, 2007, just days after filing bankruptcy, Sentinel sought and obtained an order from the bankruptcy court approving the turnover of the Citadel sale proceeds to certain customer accounts, pursuant to which order FCStone received another $14.5 million. In total, FCStone recovered nearly 70 percent of what it invested in Sentinel, whereas the majority of other customers in the same investment group recovered approximately 32 percent.

Sentinel's plan of liquidation established a liquidating trust, which was administered by Fredrick J. Grede, as liquidating trustee. In September 2008, the trustee sought to avoid certain transfers, including the transfer of $15.6 million to FCStone.

The Decision

Judge Zagel determined that the debtor's postpetition transfer of $14.5 million to FCStone constituted a transfer of property of the estate that was not authorized by the Bankruptcy Code or bankruptcy court and, accordingly, was avoidable as an unauthorized postpetition transfer pursuant to section 549.1 The court also determined that the prepetition transfer of $1.1 million on Aug. 17, 2007, constituted a preference under section 547(b).

FCStone contended that each of these payments was protected under section 546(e) as a "settlement payment" as well as a "transfer made in connection with a securities contract." Judge Zagel opted not to analyze whether or not this transaction fell within the meaning of either term and instead stated that, "regardless of whether the distribution of Citadel proceeds fits under a literal interpretation of § 546(e), I find it inconceivable that Congress intended the safe harbor provisions to apply to the circumstances in this case."

The court reasoned that to permit the avoidance of this transfer would manifest the very type of destabilization that Congress sought to prevent by enacting section 546(e). Specifically, Judge Zagel found that, in situations in which the debtor is an investment advisor or financial institution, such as Sentinel, that sells securities on behalf of third-party customers, permitting such a debtor to favor certain customers over others in the distribution of proceeds would itself create systemic risk by leaving the market unable to predict how losses would be apportioned in the event of an investment advisor's bankruptcy.

Furthermore, the court found the often-employed "ripple effect" argument unavailing in light of the fact that investment advisors constitute a larger stake in the economy than futures commission merchants, and thus greater destabilization would be created by not requiring losses to be shared proportionally by the entire customer base in the event of an investment advisor's bankruptcy.

Finally, the court determined that avoiding these transfers would not result in the unwinding of a completed securities transaction because no securities were transferred between Sentinel and FCStone — only between Sentinel and Citadel. Therefore, the court suggested that section 546(e) was inapplicable to a debtor's distribution of proceeds from a completed securities transaction simply because that debtor happens to trade on behalf of third parties.

In sum, Judge Zagel declined to apply the safe harbor of section 546(e) on the basis that to do so would produce a result "demonstrably at odds with the intentions of its drafters."

Testing the Boundaries of Section 546(e)

In the wake of the financial crisis, the majority of the decisions applying section 546(e) have focused on whether certain transactions qualify as a "settlement payment" or "transfer made in connection with a securities contract." In the summer of 2011, in Enron the U.S. Court of Appeals for the Second Circuit provided some clarity in holding that the term "settlement payments" should be construed broadly and required only "an exchange of money or securities that completes a securities transaction." Enron, 651 F.3d at 337.

As a result of the Second Circuit's interpretation, section 546(e)'s reach has been applied broadly by lower courts. For example, Judge James Peck noted shortly following Enron that "[t]he test has become quite simple and all-encompassing and does not lend itself easily to the formulation of nuanced exceptions." In re Quebecor World (USA) Inc., 453 B.R. 201, 206 (Bankr. S.D.N.Y. 2011).2

However, the U.S. District Court for the Northern District of Illinois joined a minority of courts that have relied on the specific legislative intent underlying section 546(e) to hold that the section's scope should be interpreted narrowly. Under this interpretation, a transaction only receives safe harbor protection when its avoidance would implicate the stability of the financial markets.

FCStone has appealed the district court's decision to the U.S. Court of Appeals for the Seventh Circuit. The Court of Appeals may limit its holding to distinguishing the factual circumstances in this case from previous cases that have given a broad scope to 546(e), but which have frequently involved the application of section 546(e) to insulate transfers that were payments made to selling shareholders in a private or public LBO. The court may decide, however, to address how broadly section 546(e) should be applied in future cases and could potentially result in a circuit split depending on the outcome of the appeal.

Footnotes

1. While the bankruptcy court issued an order permitting the distribution of the sale proceeds to Sentinel's customers, the court explicitly stated that it was not determining whether or not the proceeds were property of the estate, and therefore, this order did not constitute bankruptcy court authorization within the meaning of section 549(a)(2)(B).

2. Interestingly, before the Second Circuit ruled in Enron, some bankruptcy judges in the Southern District of New York published opinions restricting the scope of section 546(e). For example, just two months before the Enron decision, U.S. Bankruptcy Judge Robert D. Drain held that Congress clearly "did not intend section 546(e)'s exemption to apply to [a] modest private LBO transaction." In re MacMenamin's Grill, 450 B.R. 414, 421-422 (Bankr. S.D.N.Y. 2011).

Originally published on Law360

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions