United States: Commercial Paper Redemption "Safe Harbored" from Preference Liability per Second Circuit Court of Appeals

Originally published July 11, 2011

Keywords: commercial paper redemption, Depositary Trust Company, DTC, safe harbor, bankruptcy filing

The US Court of Appeals for the Second Circuit recently held that redemptions of commercial paper made through the Depositary Trust Company (DTC) are entitled to the "safe harbor" protections afforded to settlement payments under Bankruptcy Code Section 546(e), and are, therefore, not preferential transfers, even though such payments were made prior to maturity.¹ The Second Circuit is the first Circuit Court of Appeal to address the issue, which arises out of the Enron bankruptcy case. 

Legal Framework

Generally, payments of antecedent debt made within 90 days of a bankruptcy filing are avoidable as preferential transfers under Bankruptcy Code Section 547. However, Bankruptcy Code Section 546(e) shields certain transactions from preference liability, including any "settlement payment...made by or to (or for the benefit of) a...stockbroker, financial institution, financial participant, or securities clearing agency...in connection with a securities contract...that is made before the commencement of the case, except under section 548(a)(1)(A) of this title."² Bankruptcy Code Section 741(8) in turn 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."

Congress enacted the 546(e) safe harbor in 1982 to protect the securities and commodities industries from the turmoil that would ensue if, after a large bankruptcy, financial firms were required to repay amounts they received in settled security transactions, putting the capital and liquidity of the firms, and ultimately the markets, at risk.³

Factual Background and Lower Court Analysis

In late October and early November of 2001, Enron drew down on its $3 billion lines of credit and used a portion of those funds to redeem more than $1.1 billion of its unsecured and uncertificated commercial paper prior to the paper's maturity. Enron redeemed the commercial paper at par, a considerably higher price than its market value at that time.⁴ Less than one month later, Enron filed for bankruptcy.

In the bankruptcy case, Enron challenged the payments as preferential transfers under Bankruptcy Code Section 547, arguing that it made the redemption payments under pressure from noteholders seeking to recover on their investments amidst rumors of Enron's imminent implosion. The noteholders argued that Enron acted in an "economically rational" manner, redeeming its commercial paper to "calm the irrational markets" and leave a favorable impression that would allow it to reenter the commercial paper market in the near future.

The bankruptcy court held that Enron's redemption payment was not a "settlement payment" within the meaning of Section 546(e), which included only payments made to purchase and sell securities, not payments to retire debt.⁵ On appeal, the district court limited its inquiry to the question of whether the Section 546(e) safe harbor applies to an issuer's redemption of commercial paper prior to maturity, effected through the customary mechanism of transacting in commercial paper through the DTC, without regard to the motives and circumstances of the redemption.

The district court reversed, finding that (i) the Bankruptcy Code's definition of "settlement payment" is not limited solely to payments that are "commonly used," so the circumstances of a payment do not bear on whether such payment fits within the parameters of the Bankruptcy Code, (ii) "a settlement payment is a transfer that concludes or consummates a securities transaction," and (iii) Enron's redemption constituted a securities transaction regardless of whether Enron acquired title to the commercial paper.⁶

The Second Circuit Appeal and Decision

On appeal, the noteholders argued that the redemption payments were settlement payments within the Bankruptcy Code's definition, because they represented a transaction involving the exchange of money for securities. The US Securities and Exchange Commission and the Securities Industry and Financial Markets Association (the latter represented by Mayer Brown LLP) filed amicus briefs in support of the noteholders interpretation of the applicable law. 

Enron first argued that the term "commonly used in the securities trade" contained in Section 741(8) modified the entire definition and, therefore, excluded all payments that are not common in the securities industry, including Enron's redemption payment. Second, Enron argued that the term "settlement payment" only applies to transactions in which title to the securities changes hands. Third, Enron argued that the redemption payments are not settlement payments because they did not involve a financial intermediary that took title to the securities. 

In a split (2-1) decision, the Second Circuit disagreed with Enron on all counts and affirmed the district court. As an initial matter, the Second Circuit held that the term "commonly used" did not modify the entire definition, as Enron's grammatical interpretation of the statute was unsupported, and such interpretation would unduly open each safe harbor case to a determination regarding the commonness of a given transaction. Next, the Second Circuit held that there was no basis to interpret the Bankruptcy Code's definition of settlement payments as excluding the redemption of debt securities. It held that regardless of the fact that the transaction involved the retirement of debt, such redemption was a transaction in securities and constituted a settlement payment within the Bankruptcy Code's definition. The Second Circuit added that the Bankruptcy Code's term "transaction in securities" was not limited to purchases and sales (a belief that was held by the bankruptcy court and the Second Circuit dissent). Finally, the Second Circuit dismissed Enron's argument that lack of a financial intermediary was a basis upon which to deny safe harbor protection, finding no explicit statutory requirement.

Observations

The Enron decision is rather narrow and should be construed as such: that a redemption of commercial paper prior to maturity, constitutes a settlement payment and is protected from attack as a preference. Under the Second Circuit's Enron decision, this safe harbor should be available to all types of securities (whether debt or otherwise), and should protect investors from preference attacks whether or not their securities are redeemed through a financial intermediary.

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Footnotes

1 Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), __ F.3d __ (2nd Cir. June 28, 2011). Available at http://www.ca2.uscourts.gov/opinions.htm.

2 11. U.S.C. 546(e). The 548(a)(1)(A) exception relates to transfers made with actual intent to defraud.

3 In re Enron Creditors Recovery Corp.,at *12-13. See also Kaiser Steel Corp. v. Charles Shwab & Co., 913 F. 2d 846, 849 (10th Cir. 1990); H.R. Rep. 97-420, at 1-3 (1982), reprinted in 1982 U.S.C.C.A.N. 583).

4 Interestingly, the Second Circuit noted that the commercial paper's offering memoranda stated that the paper was not "redeemable or subject to any voluntary prepayment by the Company prior to maturity. This provision prohibited calls and puts: Enron could not force investors to surrender the notes and the investors could not require Enron to prepay them." Id. at *5-6.

5 In re Enron Creditors Recovery Corp., 407 B.R. 17, 45 (Bankr. S.D.N.Y. 2009).

6 In re Enron Creditors Recovery Corp., 422 B.R. 423, 424 (S.D.N.Y. 2009).

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