Second Circuit Expands Settlement Payment Defenses

By: Tianja Samuel

St. John’s Law Student

American Bankruptcy Institute Law Review Staff 

In In re Enron Creditors Recovery Corp.,^[1] the Second Circuit greatly expanded the settlement payment defenses of section 546(e) of the Bankruptcy Code (the “Code”)[2] by rejecting Enron’s attempt to avoid a repayment of debt, because the repayment was structured as a redemption.  This case stemmed from a series of transactions in which Enron used a clearing agency—that merely acted as an intermediary and never took title to the commercial paper—to retire commercial paper before the maturity date. Enron later filed bankruptcy and sought to avoid the more than $1.1 billion it paid, in the 90 days prior to its bankruptcy filing, to retire the commercial paper.[3] 

In reaching its conclusion, the court rejected Enron’s three main arguments: (1) section 741(8)[4] of the Code excludes redemption payments because they are not “commonly used in the securities trade,”[5] (2) settlement payments only include transactions in which title to the securities change hands, and (3) section 741(8) does not apply to transactions, such as the one at issue, where a financial intermediary does not take title to the securities.[6] The court found that Enron’s first argument lacked merit because it misconstrues the statutory language. In addition, Enron’s interpretation would always require a factual determination of what transactions are common in the securities trade.[7] Because factual determinations tend to create uncertainty, creating a rule that always required these determinations would be inconsistent with Congressional intent to create certainty in the law. Enron relied on S.E.C. v. Sterling Precision Corp.,^[8] to support its second argument. In Sterling, the Second Circuit held that “paying a note prior to maturity . . . would not be regarded as a purchase.”[9] Enron relied on this holding to argue that securities transactions necessarily involve purchases or sales because these transactions include a transfer of title.   The court disagreed and refused to read a purchase requirement into the statutory definition. Instead it relied on Contemporary Industries Corp. v. Frost,^[10] to support its conclusion, even though the transaction at issue in that case also involved a transfer of title. In Contemporary, the Eighth Circuit held that a debtor’s payments to purchase securities were exempt as settlement payments because settlement payments merely involve a transfer of cash or securities to complete a securities transaction.[11] The Second Circuit found that the transactions in Contemporary were more analogous to the transactions in Enron. Finally—in rejecting Enron’s third argument as an improper basis to deny safe harbor protection—the court cited the decisions of three other circuit courts that have all held that section 741(8) applies even where a financial intermediary does not take title to the securities.[12]

In dissent, District Judge Koeltl, sitting by designation, agreed with Enron’s second argument and predicted that the decision will “threaten routine avoidance proceedings in bankruptcy courts.”^[13]   Judge Koeltl’s major concern was that the decision will provide a way to shield preference payments on debts represented by written instruments.^[14] Thus far, Judge Koeltl’s concerns seem justified. In In re Quebecor World Inc.,^[15] the Bankruptcy Court for the Southern District of New York held that because the transactions at issue were settlement payments, as defined by Enron, they are protected under section 546(e) of the Code.^[16] These transactions were similar to the ones at issue in Enron in that they did not involve a transfer of title; however, there was also no financial intermediary. Nevertheless, this Quebecor court made it clear that had it not been for Enron, the case would have been decided differently.^[17] 

As Judge Koeltl emphasized in his dissent, the Enron holding severely limits the scope of section 547(b) of the Code.^[18] This section codifies an equitable principle that has been enforced in bankruptcy courts for centuries: “any act of preferring one creditor over another is invalid.”^[19]  This decision has created a loophole in this principle and allows some creditors to be “preferred” so long as the transaction is not structured as a repayment of debt. 

[19] Armstrong v. Rickey, 1 F.Cas. 1144 (N.D. Ohio 1869).