Tribune II: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.

The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.

Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.

Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.

In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.

For Roundtable’s other posts on Tribune, see Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune, Tribune Fraudulent Conveyance Litigation Roundup. For Roundtable discussions relating to the 546(e) safe harbor, please refer to the tag #Safe Harbors.

Second Circuit Fumbles Tribune on Reconsideration

Daniel J. Bussel

By Daniel J. Bussel (UCLA School of Law)

The Second Circuit recently issued its revised opinion in Tribune Company Fraudulent Conveyance Litigation, determining that a debtor-transferor that effectuates a transfer involving a securities contract in its capacity as the customer of a commercial bank is itself a “financial institution” within the meaning of the Bankruptcy Code section 101(22)(A) and therefore the transfer is protected under section 546(e).

This ruling has critically important implications for the avoiding powers of the bankruptcy trustee. Section 546(e) insulates all transfers involving securities by or to a financial institution from avoidance except as an “actual fraud” under section 548(a)(1)(A). Virtually all transferors are customers of commercial banks and almost any transfer can be effectuated with funds transferred through the agency or in the possession of a commercial bank. The result is the virtual repeal of the avoiding powers as to any transfer involving securities that is not an actual fraud on creditors, undoing centuries of fraudulent transfer and preference law.

These considerations are powerful enough that the Second Circuit, if necessary in light of the statute’s plain language, should have striven mightily to avoid interpreting the term “financial institution” so as to include the customers of commercial banks. The Code’s avoiding power sections read as a whole make no sense if limited only to cases involving transfers by entities that are not customers of commercial banks. Moreover, such a reading of section 101(22) flies in the face of Merit Management, the recent, directly applicable, Supreme Court precedent.

The full article is available here.

For more posts on the scope of section 546(e), see Ralph Brubaker, Understanding the Scope of the § 546(e) Securities Safe Harbor Through the Concept of the “Transfer” Sought to Be Avoided.

How Much Value Was Destroyed by the Lehman Bankruptcy?

The Federal Reserve Bank of New York’s Liberty Street Economics Blog has run a series of five posts seeking to estimate the total value destroyed by the Lehman Brothers Holdings Inc.’s Chapter 11 and Lehman’s investment bank affiliate’s liquidation through separate Securities Investor Protection Act (SIPA) proceedings.

Erin Denison, Michael Fleming, and Asani Sarkar, of the Federal Reserve Bank of New York’s Research and Statistics Group, estimate the total value destruction for Lehman, its creditors, and stakeholders to be approximately between $46 billion to $63 billion (between 15 to 21 percent of Lehman’s pre-bankruptcy consolidated assets), excluding expenses from the SIPA proceedings (an additional $1.4 billion) and the costs of resolving Lehman’s foreign subsidiaries. These estimates also exclude boarder spillover effects on the economy caused by Lehman’s collapse.

Denison, Fleming, and Sarkar suggest the main drivers of value destruction include: professional fees and expenses ($5.9 billion for Chapter 11 proceedings with an additional $1.36 billion for SIPA proceedings); liquidity costs for creditors during the lengthy proceeding ($15 billion); and lost relationships between Lehman and its equity underwriting clients ($23 billion). They break down these estimates of the value destroyed through a series of four posts, analyzing the direct costs (expenses paid to third parties for services provided during bankruptcy) and the indirect costs (opportunity costs for the firm, its creditors, and its stakeholders).

The first post on Creditor Recovery in Lehman’s Bankruptcy can be found here. The second post on Lehman’s Bankruptcy Expenses can be found here.  The third post on Customer and Customer and Employee Losses in Lehman’s Bankruptcy can be found here.  The fourth post on Indirect Costs of Lehman’s Bankruptcy can be found here.  The final summary post can be found here.


 

For previous Roundtable posts on the valuation and resolution of Lehman, see Steven Lubben, “Lehman’s Derivative Portfolio”; Mark J. Roe, and Stephen D. Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio.”

(This post was authored by Ryan Rossner, J.D. ’19.)

Senate Judiciary Committee Hearing on Bankruptcy for Banks and Proposed Chapter 14

On November 13, 2018, the Senate Judiciary Committee held a hearing on “Big Bank Bankruptcy: 10 Years After Lehman Brothers,” in connection with the proposed “Taxpayer Protection and Responsible Resolution Act” (“TPRRA”). The TPRRA would add a new chapter 14 to the Bankruptcy Code, providing a recapitalization mechanism for bank holding companies or some other financial companies.

This version of chapter 14 would implement the “Single Point of Entry” financial company resolution model in bankruptcy. (The SPOE model contemplates that only a financial company’s top-level holding company would go into bankruptcy proceedings, with losses borne by its creditors, while material subsidiaries continue to operate as going concerns. For more, see here.) The bill contemplates a proceeding where the bank’s holding company would have a large amount of its long-term debt turned into equity over a 48 hour (likely weekend) period. The firm’s subsidiaries would continue to operate, but would be transferred over to a new, debt-free bridge company. The old holding company’s shareholders and creditors would have their claims handled through a bankruptcy process. The bill also included a 48 hour automatic stay on Qualified Financial Contracts (QFCs), but effectively requires their assumption by the new bridge company.

In his opening remarks, Senator Grassley noted that several similar bank bankruptcy proposals have been incorporated into bills introduced into both the Senate and House over the past several Congresses. (For Roundtable coverage of the 2016 and 2017 FIBA bills, click here, here, here, and here.) A principal difference, stressed by Senator Coons in his opening statement, was that the current bill would not affect Title II of the Dodd-Frank Act, as some prior provisions would have. The view that a special chapter 14 should complement, rather than replace the FDIC’s Orderly Liquidation Authority (OLA) is consistent with the U.S. Department of the Treasury’s report on OLA, recommending against its repeal, released earlier this year. (For Roundtable coverage of the OLA, click here and here.)

The Hearing featured testimony by Donald Bernstein (Davis Polk), Professor Mark Roe (Harvard Law School), and Stephen Hessler (Kirkland & Ellis).

Video and testimonies available here.


For previous Roundtable posts on the resolution of financial institutions, see Howell Jackson & Stephanie Massman, “The Resolution of Distressed Financial Conglomerates“; Stephen Lubben & Arthur Wilmarth, “Too Big and Unable to Fail“; Mark Roe’s “Don’t Bank on Bankruptcy”; Mark Roe & Stephen Adams, “Restructuring Failed Financial Firms in Bankruptcy: Selling Lehman’s Derivatives Portfolio”; David Skeel’s “Bankruptcy for Banks: A Tribute (and a Little Plea) for Jay Westbrook”; and, “Financial Scholars Submit Letter to Congress Opposing Repeal of Title II.”

(This post was authored by Ryan Rossner, J.D. ’19.)

Bankruptcy for Banks: A Tribute (and Little Plea) to Jay Westbrook

By David A. Skeel, Jr. (University of Pennsylvania Law School)

Over the past several years, Congress has considered various versions of a legislative reform that would amend the Bankruptcy Code to facilitate the prompt reorganization of systemically important financial institutions (“SIFIs”). The reform would adapt the “Single Point of Entry” strategy devised for use under Title II of the Dodd Frank Act to bankruptcy. In each context, the assets, short term liabilities, and secured debt of the troubled SIFI would be transferred to a newly created bridge institution, leaving behind its stock and long-term debt. The newly recapitalized bridge institution would be fully solvent, and could contribute liquidity to the troubled subsidiaries as necessary. Although the bankruptcy for banks legislation appears to have strong support in Congress, its reception among bankruptcy scholars has been mixed.

In this short essay, I take the opportunity of a celebration of the work and influence of Jay Westbrook to explore his and his fellow critics’ opposition to bankruptcy for banks. I begin the essay by surveying Jay’s wide-ranging contributions to bankruptcy scholarship. Jay’s functional analysis has had a profound effect on scholars’ understanding of key issues in domestic bankruptcy law, and Jay has been the leading scholarly figure on cross-border insolvency. After surveying Jay’s influence, I turn to the topic at hand: bankruptcy for banks. Jay has been a strong critic of the proposed reforms, arguing among other things that financial institutions need to be resolved by regulators and an administrative process, not bankruptcy. After addressing these and other objections, I ask Jay if he might reconsider his opposition if the legislation were amended to respond to several of his primary concerns.

The essay is available here.

Beyond Common Equity: The Influence of Secondary Capital on Bank Insolvency Risk

By Thomas Conlon (University College Dublin), John Cotter (University College Dublin; UCLA Anderson School of Management); Philip Molyneux (University of Sharjah – College of Business Administration)

Prudential regulation requires banks to hold capital as a buffer in the event of losses and as a means to mitigate risk shifting by shareholders. Under capital regulation, a large menu of securities is permitted to contribute to regulatory capital. While previous studies have predominantly concentrated on the relationship between bank risks and narrow capital measures (such as tier 1 capital or equity capital), we further develop this work by looking at a broader menu of capital components. We examine bank insolvency risk (distance to default) for listed North American and European banks over the period from 2002 to 2014, with a focus on sensitivity to capital other than common equity. Decomposing tier 1 capital into equity and non-core components reveals a heretofore unidentified variation in risk reduction capacity. Greater non-core tier 1 capital is associated with increased insolvency risk for larger and more diversified banks, impairing the risk reducing capacity of aggregate tier 1 capital. Overall, tier 2 capital is not linked with insolvency risk, although a conflicting relationship is isolated conditional on the level of total regulatory capital held. Finally, the association between risk and capital is weakened when the latter is defined relative to risk-weighted assets.

The full article is available here.

A Functional Analysis of SIFI Insolvency

By Stephen J. Lubben (Seton Hall University School of Law)

Since the disgrace of Lehman, the question of how to handle failing SIFIs has been quite vexed.   On the one hand, governmental rescue of shareholders and other investors is beyond annoying, and there is some intuitive sense that if management does a poor job, they and their investor backers should face the consequences, just like any other firm.   That bank managers would have the temerity to pay themselves large bonuses shortly after a taxpayer rescue only emphasizes the point.

On the other hand, there is a widespread understanding that a large bank, or a sufficiently interconnected one, is not quite like Kmart, Enron, or even American Airlines, in that when the bank fails, it tends to take a large chunk of the economy along with it.   Pre-failure regulation can mitigate some of the effects, but by the time we get to insolvency—or “financial distress”—the regulatory string has pretty much played out.   And in the end, we have trouble deciding if we really mean to treat large financial institutions like normal failed firms.

In A Functional Analysis of SIFI Insolvency, I argue that we need to consider what it is that we are trying to achieve in a bank insolvency case, and how that compares with bankruptcy law in general.  Bank insolvency, I submit, is all about special priorities: both ordinal and temporal.  The Bankruptcy Code, on the other hand, takes an “equality is equity” approach to priorities as a baseline, mostly using state law to draw the claim-asset border.

Financial insolvency law expressly rejects this model; it instead is all about protecting some favored group from the effects of insolvency.   There is no equality here, and it was never intended that there would be equality.   And thus it is time to stop pretending SIFI insolvency is “normal” corporate insolvency but bigger.

The full article is available here.

Recent Developments in Bankruptcy Law, April 2018

By Richard Levin (Jenner & Block LLP)

The bankruptcy courts and their appellate courts continue to explore issues of interest to practitioners and academics. This quarterly summary of recent developments in bankruptcy law covers cases reported during the first quarter of 2018.

Most notable were two Supreme Court decisions. Merit Mgmt. Group, LP. v. FTI Consulting, Inc. substantially reduced the scope of the financial contracts avoiding power safe harbor by directing courts to focus on the ultimate recipient of the transfer, rather than on the intermediate financial institutions who participated in the transfer. Village at Lakeridge ducked the substantive bankruptcy law issue of the standard for determining who is a non-statutory insider (although the dissent tackled it) and instead ruled only on the appellate standard of review of such determinations. 

Moving in the opposite direction from the Supreme Court’s reduction of safe harbor protections, the New York district court, on an appeal from the bankruptcy court’s decision, gave a broad reading to the ability of swap counter-parties under section 560 to close out and distribute collateral upon a default. (Lehman Bros.).

The Ninth Circuit took a strong position on the open question in the application of section 1129(a)(10), requiring an impaired consenting class for confirmation, adopting the “per-plan” approach. (Transwest) And the Fourth Circuit gave another boost to reorganizing real estate debtors by permitting a bankruptcy court to value collateral in a partial “dirt-for-debt” plan. (Bates Land).

In a case largely of first impression, the Texas bankruptcy court proposed rules to apply the “single satisfaction” rule of section 550(d) when the trustee settles with some but not all defendants. (Provident Royalties).

During the first quarter, the bankruptcy courts also expanded the reach of chapter 15 and its effectiveness. (Manley Toys, B.C.I. Finances Pty Ltd., Energy Coal S.P.A., Avanti, and Platinum Partners).

The full memo, discussing these and other cases, is available here, and the full (900-page) compilation of all prior editions is available here.

Merit Management v. FTI: Law Firm Perspectives

On February 27, the Supreme Court decided Merit Management Group, LP v. FTI Consulting, Inc., holding unanimously that the § 546(e) safe harbor does not protect allegedly fraudulent transfers “in which financial institutions served as mere conduits.” The Court’s decision resolves a circuit split on the reach of § 546(e). In reaching its conclusion, the Court focused on the “end-to-end transfer” that the trustee seeks to avoid, rather than any “component parts of the overarching transfer.” In FTI, because the overarching transfer was made between two parties not otherwise shielded by the safe harbor, the transfer will now fall outside the safe harbor.

As many law firms recognize, this decision will have wide-ranging implications on the finality of securities transactions effected through financial institutions, especially leveraged buyouts. Mayer Brown notes that as the decision enhances a trustee’s ability to recover fraudulent transfers, it also increases the bankruptcy estate’s leverage against recipients of pre-petition transfers. Cleary observes that “debtors or trustees may strategically frame avoidance actions in order to limit the scope of the safe harbor.” Mayer Brown concludes that the decision may also expose investors, investment funds and similar entities to fraudulent transfer litigation risks.

The bottom line, as Davis Polk notes, is that the § 546(e) safe harbor is no longer a blanket safe harbor for the recipients of transactions that pass through financial institutions. But the safe harbor will still shield financial institutions operating as escrow agents or clearinghouses, as the Court expressly stated that a financial institution under § 546(e) is protected whether the institution acts as a principal or as an intermediary.

Firms have noted that the decision also left open some ambiguities. First, Schulte Roth & Zabel writes that the Court leaves open possible arguments that any “customer” of a “financial institution” is also itself a “financial institution” under § 546(e). Second, Mayer Brown points out that the Court did not address whether the transaction at issue actually qualified as a transfer that is a “settlement payment” or made in connection with a “securities contract” under § 546(e). These ambiguities will draw the attention of defendants in future fraudulent transfer litigation.

Finally, Weil notes that the decision raises the question of how the preemption of state-law creditor remedies under § 546(e) will be applied in light of the Supreme Court’s now-narrow construction of the safe harbor.

By Jianjian Ye, Harvard Law School, J.D. 2018.

The roundtable has posted on FTI before. Some of those posts are: an analysis of the FTI oral argument, the Amici Curiae Brief of Bankruptcy Law Professors, an article by Ralph Brubaker on the meaning of § 546(e), and a roundup of law firm perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

Mandatory Contractual Stay Requirements for Qualified Financial Contracts

By Erika D. White and Donald S. Bernstein of Davis Polk & Wardwell LLP.

The U.S. banking agencies have issued rules that require U.S. G-SIBs and the U.S. operations of foreign G-SIBs to amend their swaps, repurchase agreements and other qualified financial contracts (QFCs) to include certain provisions designed to mitigate the risk of destabilizing close-outs of QFCs in the event the G-SIB enters resolution. The rules are part of a package of reforms implemented by the industry, Congress and the U.S. banking agencies since the financial crisis in an attempt to ensure that the largest financial institutions can be resolved in an orderly manner. Specifically, the rules seek to (1) mitigate the risk that the FDIC’s stay-and-transfer powers with respect to QFCs under Title II of the Dodd-Frank Act and the Federal Deposit Insurance Act may not be recognized and given effect outside of the United States and (2) improve the likelihood of success of a single-point-of entry resolution strategy under the Bankruptcy Code by limiting the ability of counterparties to terminate their QFCs with a solvent and performing operating entity based on cross-defaults triggered by the bankruptcy of the operating entity’s parent or other affiliate. The QFC Stay Rules do not, however, affect the rights of counterparties to terminate QFCs under the safe harbor provisions of the Bankruptcy Code in the event the operating subsidiary itself were to enter bankruptcy proceedings.

 

The full visual memo is available here.

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