Treatment of Securities and Derivatives Transactions in Bankruptcy Part II

Treatment of Securities and Derivatives Transactions in Bankruptcy Part II

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Editor's Note: Part I appeared in the July/August 2005 issue.

Part I of this article summarized the basic concepts underpinning derivatives transactions and outlined the provisions in the Bankruptcy Code (Financial Market Provisions) where these types of transactions and securities transactions are accorded special treatment. The table summarizes the basic structure of the Financial Market Provisions described in greater detail in Part I.

Note the additional references in the table to Master Netting Agreements, the provisions for which were inserted into the Code by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Master Netting Agreements were not specifically discussed in Part I as a separate category of "protected contracts"1 because the provisions relating to these agreements largely supplement the protections relating to the five types of protected contracts. The provisions relating to Master Netting Agreements (as well as other amendments made by BAPCPA) now make it clear that the financial market participants identified in the Financial Market Provisions ("protected participants") can close out and set off or "net" mutual claims against the debtor arising not only under or within specific types of protected contracts, but also across two or more types of protected contracts. Thus, a protected participant can set off a claim it has against the debtor under a forward contract against an amount it owes the debtor under a separate swap agreement. The master netting provisions, however, will not apply unless the protected participant is first entitled to the protections afforded with respect to each individual protected contract for which close-out or other netting is sought.

Settlement Payments, the Stockbroker Defense and the Enron Cases

As discussed in Part I of this article, several subsections of §546 of the Code limit the ability of a trustee or debtor-in-possession (DIP) to avoid a transfer of property that constitutes a margin, settlement or other similar payment (a "protected payment") made by or to a protected participant.2 With respect to securities transactions, §546(e) has been referred to as the "stockbroker defense,"3 referring to the fact that the settlement of securities contracts often is accomplished by and through one or more protected participants that are stockbrokers. The scope of this defense, however, has been the subject of much litigation and conflicting opinions among the courts.

The stockbroker defense turns on the definition of the term "settlement payment" as defined by Code §741(8).4 Several courts considering application of §546(e) have interpreted "settlement payment" in §741(8) in an extremely broad manner as essentially any payment made toward the completion of any type of securities transaction.5 Some courts, however, have balked at giving the term such a broad meaning in cases where the multi-party clearing system of intermediaries and guarantees used in the public securities markets is not implicated. For these courts, protecting transactions not involving this system would do damage to one of the primary policies behind the use of avoidance powers in bankruptcy cases, i.e., the preservation of the debtor's estate for all creditors.6 A split of authority is evident in cases involving failed leveraged buyouts of publicly traded securities where the cash and securities are distributed through a financial intermediary.7

It should be noted, though, that not all securities cases (not even all LBO cases) involve publicly traded securities. In cases involving purely private transactions, the courts appear to be more aligned in refusing to apply §546(e).8

In another recent trend, courts have also declined to apply §546(e) to protect transactions tainted by fraud, illegality or other irregularities.9 While §546(e) does not protect settlement payments determined to be intentionally fraudulent transfers received by a transferee in bad faith, in many cases intentional fraud and bad faith may not be present or provable. Nevertheless, in the Adler Coleman Clearing and Grafton Partners cases, the courts specifically found that under the circumstances in which the disputed payments were made, the payments were not of the type "commonly used in the securities trade" and thus were not settlement payments under §546(e). In two recently published opinions arising out of the Enron cases, the U.S. Bankruptcy Court for the Southern District of New York also addressed issues of whether payments under certain arguably unusual (if not intentionally fraudulent) transactions constituted settlement payments under §546(e).10

The first case, Enron I, involves an equity forward transaction in which Enron agreed to purchase shares of its own publicly traded common stock from Bear, Stearns International Limited and Bear, Stearns Securities Corp. (Bear Stearns) at a specified price per share and at a specified future termination date. The original terms of the transaction, entered into in May 2000, required Enron to purchase 323,000 shares of Enron stock at a per share price of $79.415 (subject to certain adjustments) on May 24, 2001. While the parties subsequently amended the terms of the transaction, Enron ultimately settled the forward transaction on Aug. 22, 2001, (three and one-half months before the initial bankruptcy filing) by paying Bear Stearns approximately $26 million in exchange for the 323,000 shares. Enron Corp.'s stock was only trading at $36.68 per share on the agreed termination date.

After Enron commenced its bankruptcy cases, the company brought an adversary proceeding against Bear Stearns claiming that the $26 million payment was avoidable as a constructively fraudulent transfer under §§544(a) and 548(b)(1)(B), and that the payment violated Oregon state law11 as an unlawful distribution to a stockholder while the company was insolvent. Bear Stearns filed a motion to dismiss the adversary proceeding, asserting the stockbroker defense of §546(e). Bear Stearns also asserted that the avoidance action was barred by §546(g) as a payment under and in connection with a swap agreement. Finally, Bear Stearns argued that the Financial Market Provisions of the Code preempted any contrary Oregon state law.

Significant portions of the parties' briefs focused on the conflicting case law regarding the stockbroker defense. Bear Stearns argued that the $26 million payment was clearly a "settlement payment" to a stockbroker under §546(e), citing the cases that interpreted the term broadly. Citing Munford and Wieboldt, Enron argued that the transaction was a "one-off" private transaction between two parties that, if unwound, would have no impact on the public markets. In other portions of the briefs, the parties argued at length as to whether the equity forward transaction constituted a forward contract or swap agreement under the Code.

In the end, the court focused on Enron's argument that the payment violated Oregon's corporation law as an unlawful distribution to a shareholder while the company was insolvent. Citing Adler Coleman Clearing, Enron had argued that the illegal and void payment could not be considered a settlement payment "commonly used" in either the securities or forward contract trade. The court seemed to accept this argument, assuming for the purposes of the motion to dismiss that Enron was insolvent at the time, or as a result, of the payment. The court went a step further, however, by holding that there was no settlement payment because there was no valid securities transaction to settle.12 Since under Oregon law the payment and the transaction as a whole were deemed void (as opposed to voidable) and legal nullities, the protection offered to settlement payments by §546(e) would not apply.

The court employed the same reasoning in holding that the payment under a void transaction was not protected as a payment under or in connection with a swap agreement under §546(g). Based on its findings regarding Oregon law, the court summarily dismissed Bear Stearns's preemption argument by holding that the consequence that the transaction was null and void was "simply a function of state law that was not preempted" by the Code.13 Bear Stearns's motion to dismiss was therefore denied.

The case will presumably move forward along with the multitude of other avoidance actions in the Enron cases on the primary issue of whether Enron was insolvent when the payment was made. Since Enron filed very similar adversary proceedings against three other financial institutions seeking the return of additional amounts exceeding $883 million, the decision could ultimately significantly affect the level of distributions in the Enron cases.

It is less clear what impact the decision will have on future cases. The court itself apparently believed that its holding will be narrowly applied because of the unique nature of the case and the minority view taken by the Oregon courts as to the consequences of unlawful shareholder distributions—i.e., that the payment was void and not merely voidable.14 Indeed, in holding as it did, the Enron court distinguished the case of PHP Liquidating LLC v. Robbins.15

In PHP, the successor entity to the debtor under a liquidating chapter 11 plan attempted to avoid the debtor's pre-petition redemption of stock from insiders because the redemption violated the Delaware General Corporate Law's prohibition on making such distributions while the company is insolvent. The PHP court found that §546(e) would have barred any avoidance action on behalf of the estate.16 The Enron court noted that, while potentially voidable, the settlement payment in PHP was valid until avoided and therefore unavoidable under §546(e).17 The Enron court's opinion therefore suggests that it would have likely decided Enron I differently had Oregon law merely provided that the payments were voidable instead of void.

It is interesting to note that the PHP court did not discuss the argument made in Enron I to the effect that because the redemption payment was illegal under applicable state law, the payment was not "commonly used in the securities trade" and therefore not a "settlement payment" under the Code. It would seem that this argument could be made with equal force even if the applicable state law only made the payment voidable. Since the argument rests on an interpretation of the definition of the term "settlement payment," preemption is not an issue. The Enron I decision could be seen as lending some credence to this argument by its implicit endorsement of the Adler Coleman Clearing and Grafton cases.18

The question of whether certain payments were, in fact, "commonly used in the securities trade" was determined to be an issue reserved for trial in Enron II. In that case, Enron is seeking to recover certain payments it made within 90 days of its bankruptcy filing on account of unsecured and uncertificated short-term commercial paper notes it had previously issued through J.P. Morgan. The offering memorandum pursuant to which the notes were issued provided that the notes were not redeemable or subject to voluntary prepayment prior to maturity. Nevertheless, in a series of transactions shortly before its bankruptcy, Enron paid more than $1 billion to the defendants on account of the notes. The payments were made to and through J.P. Morgan and certain other securities brokers.

Enron alleged that the payments amounted to prepayments of the notes prior to maturity and, further, that the par value paid on the notes was significantly more than the notes' market value. Enron therefore sued to recover the payments as both preferential and fraudulent transfers. Various of the defendants filed motions to dismiss the claims, arguing that the payments were not prepayments on the debt evidenced by the notes but were instead settlement payments on account of the purchase price for the notes, which were securities. Thus, the defendants argued that the stockbroker defense of §546(e) applied to bar Enron's preference and fraudulent transfer claims.

The court denied the motions to dismiss, holding that a number of factual issues would have to be determined at trial, including the issue as to whether the payments were made on account of antecedent debt or for the purchase of securities as that term is defined in the Bankruptcy Code. Assuming that the notes were securities, however, the court also held that evidence must be presented as to whether payments prior to the maturity date at significantly above-market prices and contrary to the offering memorandum could constitute settlement payments commonly used in the securities trade. While it is impossible to predict what may happen at any trial on this issue, the tone of the court's opinion suggests that the court had its doubts as to whether the defendants could make the necessary evidentiary showing. Thus, as was the case in Enron I, the decision in Enron II may ultimately result in a big recovery for the Enron estate.

The Enron decisions will undoubtedly give many in the securities and other financial market industries pause for concern. It should be noted that the International Swaps and Derivatives Association, Securities Industry Association and Bond Market Association filed a joint amicus curiae brief supporting Bear Stearns's motion to dismiss in Enron I. The Bond Market Association filed another amicus curiae brief supporting the defendants' motions to dismiss in Enron II. These industry observers and other market participants are likely to argue that the decisions represent an overly restrictive view of §546(e) and the Code's other similar Financial Market Provisions, and that these types of decisions could ultimately put financial markets at risk. Denying application of §546(e) in Enron II could mean the unwinding of a large number of payments to close to a hundred defendants.

On the other hand, the Financial Market Provisions such as §546(e) were primarily designed to protect ordinary or routine transaction payments. Certainly, one could legitimately question whether the payments made by Enron under the circumstances of the above-described cases were ordinary or "common" in the securities trade. While there may be legitimate reasons (and it may be perfectly lawful or ordinary in most circumstances) for large corporations to enter into transactions involving their own publicly traded securities, these types of transactions raise characterization issues that are simply not present in cases where the underlying securities are issued by a third party.19

Perhaps the lesson for financial institutions is that when they engage in transactions that, either by themselves or due to their use in a particular situation, push the boundaries of what is common in the industry, they risk having the payments they receive in connection with such transactions exposed to attack as constituting preferential or fraudulent transfers. In sum, financial institutions should not assume that §546(e) will protect every payment that a party to the transaction might label a "settlement payment."

 


Footnotes

1 Identified in Part I and in the Code as securities contracts, commodity contracts, forward contracts, repurchase agreements and swap agreements. Return to article

2 See Code §§546(e)-(g) and new §546(j) (added by BAPCPA). Return to article

3 Jewel Recovery L.P. v. Gordon (In re Zale Corp.), 196 B.R. 348, 352 (N.D. Tex. 1996). Return to article

4 Code §741(8) 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." Return to article

5 Bevill, Bresler & Schulman Asset Mgmnt. Corp. v. Spencer Sav. & Loan Ass'n., 878 F.2d 742, 751 (3d Cir. 1989); Jonas v. Resolution Trust Corp. (In re Comark), 971 F.2d 322, 326 (9th Cir. 1992); Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel Corp.), 952 F.2d 1230, 1237 (10th Cir. 1991); Kaiser Steel Corp. v. Charles Schwab & Co. Inc., 913 F.2d 846, 848 (10th Cir. 1990). Return to article

6 See, e.g., Jackson v. Mishkin (In re Adler, Coleman Clearing Corp.), 263 B.R. 406, 479 (S.D.N.Y. 2001); Jewel Recovery, 196 B.R. at 352. Return to article

7 Compare, e.g., Lowenschuss v. Resorts Int'l. Inc. (In re Resorts Int'l. Inc.), 181 F.3d 505, 516 (3d Cir. 1999), and In re Kaiser Steel, 952 F.2d at 1239, with Munford v. Valuation Research Corp., 98 F.3d 604, 610 (11th Cir. 1996), and Wieboldt Stores, 131 B.R. at 664. Return to article

8 See Kipperman v. Circle Trust (In re Grafton Partners L.P.), 321 B.R. 527, 529 (BAP 9th Cir. 2005) (finding "nonpublic transactions in illegally unregistered securities are not 'commonly used in the securities trade.'"); American Tissue, Inc. v. Donaldson, Lufkin & Jenrette Securities Corp., 351 F.Supp.2d 79 (S.D.N.Y. 2004) (stating that "it is not clear that the 'reversal of the [transfer at issue in this case] may result in disruption of the securities industry, creating a potential chain reaction that could threaten collapse of the affected market'") (quoting In re Adler Coleman Clearing Corp., 263 B.R. at 480); Zahn v. Yucaipa Capital Fund, 218 B.R. 656, 675-77 (D. R.I. 1998) (finding "stock transfers...had no connection whatsoever to the clearance and settlement system, and allowing avoidance would have no impact at all on that system"); Jewel Recovery, 196 B.R. at 351-53 (finding the "plain language of §546(e) would appear to apply to this transaction," but the "transaction was a private transaction which did not implicate the clearance and settlement process"); Official Committee of Unsecured Creditors v. ASEA Brown Boveri Inc. (In re Grand Eagle Cos.), 288 B.R. 484, 494 (Bankr. N.D. Ohio 2003) (finding "such a simplistic reading of §546(e) ignores the meaning of the term 'settlement payment' within the securities industry and would essentially convert that statutory provision into a blanket transactional cleansing mechanism for any entity savvy enough to funnel payments for the purchase and sale of privately held stock through a financial institution"). Return to article

9 See Adler Coleman Clearing Corp., 263 B.R. at 481 (referring to "phantom fraudulent payments") and Grafton Partners, 321 B.R. at 529 (referring to "illegally unregistered securities"). Return to article

10 See Enron Corp. v. Bear, Stearns Int'l. Ltd. (In re Enron Corp.), 323 B.R. 857 (Bankr S.D.N.Y. 2005) (Enron I) and Enron Corp. v. J.P. Morgan Securities Inc. (In re Enron Corp.), Adv. Pro. No. 03-92677A, 2005 WL 1400099 (Bankr. S.D.N.Y., June 15, 2005) (Enron II). Return to article

11 Enron was incorporated in Oregon. Return to article

12 Enron, 2005 WL 957325 at *18-20. Return to article

13 Id. at *17. Return to article

14 Id. at *19 ("This situation would only arise in the context of a company purchasing its own shares while insolvent or because of which it became insolvent and if that company were incorporated in a state that rendered such a transaction void"). Return to article

15 291 B.R. 592 (D. Del. 2003). Return to article

16 PHP, 291 B.R. at 596. However, since the plaintiff in PHP did not bring its claims as a representative of the estate but as the direct assignee of unsecured creditors, the court also found that §546(e) did not apply. Return to article

17 Enron, 2005 WL 957325 at *18. Return to article

18 This argument could not be used successfully in cases involving swap agreements since the defined term "settlement payment" does not appear in §546(g). That section refers to payments "under" or "in connection with" a swap agreement. In addition, upon the effective date of BAPCPA, the definition of swap agreement will be greatly expanded to include all different kinds of forward agreements and securities transactions. Thus, to the extent a forward or securities transaction qualifies as a swap agreement under the Code (unless the payments are void under applicable state law), payments in connection with such an agreement should be protected from avoidance under §546(g) regardless of whether the payment would be considered "commonly used" in either the securities or forward contract trade. Return to article

19 For instance, had the stock that was the subject of the equity forward agreement in Enron I been issued by an unaffiliated third party, the purchase of the stock could not have been considered a distribution to a shareholder. Similarly, the purchase of notes in Enron II could not be considered a payment of debt if the notes were not issued by Enron. Return to article

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Thursday, September 1, 2005