Southern District Of New York Deepens Internal Split Over Loophole In Bankruptcy Safe Harbor For Capital Markets Transactions

Keywords: bankruptcy, safe harbor, capital markets transactions, trustee, debtor

The Bankruptcy Court for the Southern District of New York recently held in Edward S. Weisfelner, as Litigation Trustee of the LB Creditor Trust v. Fund 1., et al. (In re Lyondell Chemical Company, et al.)1 ("Lyondell"), that section 546(e) of the Bankruptcy Code does not bar fraudulent transfer claims when such claims are brought by an entity other than the bankruptcy trustee (or its successors) under state fraudulent transfer laws rather than the Bankruptcy Code. Section 546(e) is the Bankruptcy Code's safe harbor for certain prebankruptcy transfers made in connection with securities contracts by, to or for the benefit of financial institutions.

This decision expands upon another recent decision by the District Court for the Southern District of New York in litigation related to the Tribune chapter 11 bankruptcy ("Tribune")2 that similarly limited the scope of the section 546(e) safe harbor.

Notably, the Lyondell decision also went to great lengths to distinguish and challenge the reasoning of a recent conflicting decision by the District Court for the Southern District of New York in litigation related to the SemGroup chapter 11 bankruptcy ("SemCrude")3 that, in contrast to the Lyondell and Tribune decisions, held that state law fraudulent transfer claims brought by a litigation trust organized pursuant to a chapter 11 plan are impliedly preempted by a similar Bankruptcy Code safe harbor for swap transactions.

While it remains to be seen how this split of authority will be resolved, the Lyondell decision would seem to embolden further efforts by creditors to obtain recoveries on state law fraudulent transfer claims that would otherwise be barred by the Bankruptcy Code safe harbors if brought by a trustee, a debtor or a representative of the debtor.

The Section 546(e) Safe Harbor

The Bankruptcy Code contains several provisions that allow the bankruptcy trustee (or its successors) to unwind and avoid certain prebankruptcy payments and transfers made by the debtor if such payments or transfers are preferential or are either constructively or intentionally fraudulent. These "avoidance" powers normally operate to recover assets that were transferred away from the bankruptcy estate, thereby ensuring greater equality in treatment among creditors. With respect the recovery of fraudulent transfers, the Bankruptcy Code allows bankruptcy trustees to assert claims under both the Bankruptcy Code and under applicable state law fraudulent transfer provisions.

However, because of the systemic risk to securities and other financial markets that might occur if such markets were subject to these avoidance powers, Congress enacted (and, over time, expanded the scope of) section 546(e) of the Bankruptcy Code. Section 546(e) provides a "safe harbor" exempting from avoidance by "the trustee" any "margin payments," "settlement payments" and transfers in connection with "securities contacts," "forward contracts" and "commodity contracts" made by, to or for the benefit of certain parties such as stockbrokers and financial institutions. Section 546(e) provides, in relevant part:

"... the trustee may not avoid a transfer that is a margin payment ... or settlement payment ... 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...