Swaps, like other financial contracts (repurchase agreements, securities contracts, commodities contracts, forward agreements and master netting agreements), receive special treatment under the Bankruptcy Code. Their acceleration, liquidation and termination is not prohibited as an ipso facto clause and the exercise of setoff rights is not subject to the automatic stay. Transfers made in connection with these contracts are also exempt from avoidance as preferences and constructive fraudulent transfers as well as actual fraudulent transfer under state law. But their scope is not always free from doubt. Are provisions that modify the debtor’s priority of payment upon bankruptcy protected as well? Are provisions that the swap incorporates by reference protected? Must the swap counterparty itself exercise the right to liquidate, terminate and accelerate the swap? The Second Circuit just answered these questions.
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.
By Jonathan C. Lipson (Temple University Beasley School of Law), Adam J. Levitin (Georgetown Law Center), Stephen J. Lubben (Seton Hall University School of Law)
Recently, we (along with colleagues at other law schools) asked that an examiner be appointed in the Purdue Pharma chapter 11 bankruptcy case, pending in the Southern District of New York. Although the Bankruptcy Court has not yet acted on that request (technically, it was in the form of a letter to the United States Trustee), it has generated controversy and media attention (e.g., WSJ, WaPo, Rachel Maddow), which will likely persist until there are credible answers to the questions that motivated our request:
What was the role of the Sackler family (the owners of Purdue) in Purdue’s role in the opioid crisis? and
To what extent did the Sacklers or other insiders strip assets out of Purdue in anticipation of bankruptcy?
Chapter 11 of the Bankruptcy Code governs corporate reorganizations, such as Purdue Pharma’s, and provides that an examiner can be appointed if, among other things, it is in the interests of creditors and the debtor’s bankruptcy estate. Here, we argued that there is an overwhelming public interest which overlaps with the estate’s interest. This makes the need for an independent report on these two questions compelling.
As is well known, Purdue Pharma is at the center of the opioid crisis in America, having developed and marketed Oxycontin (among other drugs). This crisis has generated more than 2600 lawsuits against Purdue and the Sacklers, many brought by state and local governments that have had to bear the costs of drug addiction. The debtors and the Sacklers have proposed a settlement under which the Sacklers would cede the company to a “public trust” and make additional contributions, in exchange for releases. The settlement is alleged to be between $10 and $12 billion, with $3 billion of that coming from the Sacklers directly. While some plaintiffs have agreed to the settlement, others have not, and are fighting the bankruptcy process.
Like many mass tort debtors—from Johns-Manville to PG&E—Purdue seeks to channel and control its liability through bankruptcy reorganization. Bankruptcy Judge Robert Drain, of the Southern District of New York, has stayed the lawsuits, not just against Purdue, but also against the Sacklers, even though they are not debtors in bankruptcy—in order to permit the debtors to negotiate a plan of reorganization that would embody the proposed settlement.
We argued that an independent examination would answer the two key questions more credibly and efficiently than other mechanisms in bankruptcy for three reasons.
First, unlike many mass-tort bankruptcies, these cases appear to shield non-debtors (the Sacklers) from discovery and potential liability, even though there are credible allegations that they may have actively contributed to the opioid crisis and/or stripped assets from the debtors. The important question is not whether the Sacklers are making a contribution to a bankruptcy plan in exchange for a release from future liability, but whether their contribution is appropriate in light of the answers to our two questions. It will be very difficult to assess that without an independent examiner’s report.
Second, because Purdue Pharma is privately held, it is hard to know what happened at the company before bankruptcy. The debtors have appointed a special committee of the board to look into the pre-bankruptcy transfers, but because the Sacklers apparently still control the debtors, it is hard to know how independent this committee was, or can be. The committee is, for example, represented by the same counsel as Purdue Pharma, which may hamper the committee’s independence. In any case, even where other high profile debtors, such as Enron, have used independent committees to investigate allegations of wrongdoing, courts have nevertheless appointed bankruptcy examiners to assess, verify, and supplement the work of those committees. It is hard to see why Purdue should be different.
Third, and perhaps most important, the opioid crisis is not like other mass torts because it has generated extraordinary public interest. Victims of the opioid crisis understandably want their day in court—which is something that bankruptcy tends to eliminate. While thousands of lawsuits would be wasteful, failing to take seriously the dignitary interests of victims of the opioid crisis could threaten the legitimacy and integrity of the bankruptcy system. At the same time, if an independent examiner exonerates the Sacklers, this may help provide the redemption that they presumably want.
Although the United States Trustee has not yet sought an examiner, there have been three interesting developments since we sent the letter:
On November 6, 2019 Marshall Huebner, counsel to the debtor in possession, emailed us to say that “the Debtors (likely along with other core stakeholders) intend to strongly oppose the request, which, with apologies to its authors, contains many misstatements of fact.” However, Huebner identified no “misstatements of fact” (much less “many”).
On November 15, 2019, ten days after we sent the letter, the debtors filed a stipulation with counsel to the creditors committee and certain members of the Sackler family. The debtors and the Sacklers agreed to produce certain information to the committee (on a “professional eyes’ only basis”) that may respond to certain of the questions we asked, but in exchange the committee relinquished its right to seek an examiner until mid-April 2020. It is not clear how estate fiduciaries can properly cede such rights.
On December 16, 2019, the debtors filed a redacted version of the “independent” report noted above. It indicates that the Sacklers took about $10 billion in cash out of the debtors since 2008. This is not surprising, since the total value of the proposed settlement would have a face amount of about $10 billion (but a substantially lower present value given its payment schedule, and would not cover interest on the $10 billion).
The takeaway seems to be that, even though no examiner has been appointed, the Sacklers and the debtors in possession have begun to produce some information that may help to answer the questions we believe are central to this case. In this regard, the mere threat of an examiner might be having an effect. However, the ability to assess and verify this information is limited, at least for the time being.
That no one has actually requested an examiner is, at one level, not surprising. It is easy to imagine that managing this case is exceedingly difficult. The insiders in the case—especially counsel to the debtors and the official committee, and Judge Drain—may view an examiner as a wrench in the delicate machinery of the proposed settlement. Parties might therefore prefer to maintain the threat of an examiner, even as they are reluctant to pull the trigger on a motion.
The Purdue bankruptcy is, however, bigger than the financial claims of any of Purdue’s creditors. Purdue is a not a case that can be run like a standard chapter 11 because there is a strong public interest in establishing a clear and independent record of what Purdue and the Sacklers knew and did about the dangers of opioids, and the extent of the Sacklers’ transactions with Purdue. Establishing these facts credibly is important not just for the dignitary interests of opioid victims and their families, but also so that creditors can properly evaluate any settlement that emerges as part of the reorganization process.
Without credible answers to the questions we asked, there will be a shadow over these cases, one that may ultimately threaten the integrity of the reorganization process.
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.
By Adam J. Goldberg, Christopher Harris, Robert J. Malionek, Kevin L. Mallen (Latham & Watkins)
In In re Picard, Tr. for Liquidation of Bernard L. Madoff Inv. Sec. LLC, No. 17-2992(L), 2019 WL 903978 (2d Cir. Feb. 25, 2019), the Second Circuit held that the trustee administering Bernie Madoff’s insolvent estate could use Section 550(a) of the Bankruptcy Code to claw back purely foreign transactions between foreign entities. The money at issue had been initially transferred by Madoff to foreign funds, then subsequently transferred by the foreign funds to the foreign defendants. The defendants argued that the Madoff trustee’s clawback claims were barred by the presumption against extraterritoriality and the principles of international comity.
While the Southern District of New York had focused its analysis on the subsequent transfers by the foreign funds to the foreign defendants, the Second Circuit focused on the initial transfer from Madoff to the foreign funds when determining whether the subsequent transfers could be recovered. The Second Circuit reasoned that since the initial transfers were from New York-based Madoff, the presumption against extraterritoriality and the principles of international comity did not bar the Madoff trustee’s attempts to recover these foreign subsequent transfers. In so holding, the Second Circuit reversed the Southern District of New York’s prior ruling that such foreign transfers could not be recovered, and removed a protection for foreign investors who may not have anticipated that their investments — and their returns — could otherwise be subject to clawback under US law.
by Charles M. Oellermann and Mark G. Douglas (Jones Day).
The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets. Several bankruptcy courts have addressed this issue in recent years, with inconsistent results.
In a recent example, in In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), the U.S. Bankruptcy Court for the Southern District of New York, disagreeing with other courts both within and outside its own district, ruled that the “transfer of an equity interest in a U.K. entity to a Marshall Islands entity was a foreign transfer” and that the Bankruptcy Code’s avoidance provisions do not apply extraterritorially because “[n]othing in the language of sections 544, 548 and 550 of the Bankruptcy Code suggests that Congress intended those provisions to apply to foreign transfers.”
The decision further muddies the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow and cross-border transactions become ubiquitous. The split on this issue exists not merely between courts in different jurisdictions, but also among courts in the Southern District of New York, where the majority of cross-border bankruptcy cases have traditionally been filed.
By Ronit J. Berkovich and David Li (Weil, Gotshal & Manges LLP).
The U.S. Supreme Court, in U.S. Bank Nat’l Ass’n v. Village at Lakeridge, LLC, 583 U.S. ___ (2018), offered plenty of hints on an important topic while simultaneously ruling very little about it. In chapter 11, whether a creditor qualifies as an “insider” can have enormous implications on a range of issues, including plan confirmation, fraudulent transfer and preference analyses, and severance payment and employee incentive/retention plan (KEIP/KERP) approvals. Lakeridge involved a dispute as to whether the bankruptcy court properly determined in confirming a plan that the sole impaired accepting creditor (the romantic partner of one of the debtor’s officers) was not a “non-statutory” insider. If the creditor actually were such an insider, then the chapter 11 plan should not have been confirmed.
In granting cert to hear the case, the Supreme Court expressly declined the opportunity to address whether the Ninth Circuit articulated the correct legal test to determine if a person qualifies as a non-statutory insider. Instead, the Supreme Court granted cert only to answer the narrow question of whether the Ninth Circuit applied the correct standard of review to the lower court’s determination. Justice Kagan, writing for the Court, kept to that script by simply affirming the Ninth Circuit’s decision to apply a clear error standard of review. Concurrences by Justices Kennedy and Sotomayor, however, each acknowledged shortcomings in the legal test the Ninth Circuit applied and each appeared to invite lower courts to consider alternative approaches. As a whole, Lakeridge provides little binding guidance, and practitioners can expect further development in non-statutory insider law by the Courts of Appeals.
By Jane Rue Wittstein and Mark G. Douglas (Jones Day)
Courts disagree as to whether the amount that a bankruptcy trustee or chapter 11 debtor-in-possession can recover in fraudulent transfer avoidance litigation should be capped at the total amount of unsecured claims against the estate. The U.S. Bankruptcy Court for the District of Delaware recently weighed in on this issue in PAH Litigation Trust v. Water Street Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), 2017 WL 5054308 (Bankr. D. Del. Nov. 1, 2017). Noting the absence of any guidance on the question from the U.S. Court of Appeals for the Third Circuit, the bankruptcy court ruled that, unlike most state fraudulent transfer laws, which limit a creditor’s recovery to the amount of its unpaid claim against the transferor, section 550 of the Bankruptcy Code imposes no such limitation on the estate’s recovery. The ruling reinforces the idea that federal and state fraudulent transfer avoidance laws are intended to be remedial rather than punitive. Under state law, this understandably means that an avoidance recovery is limited to the amount necessary to make an injured creditor whole. Under federal bankruptcy law, recoveries must benefit the bankruptcy estate, which includes the interests of creditors and other stakeholders.
By Richard J. Cooper and Boaz S. Morag (Cleary Gottlieb Steen & Hamilton, LLP).
On January 3, 2018, the United States Court of Appeals for the Third Circuit dealt a significant blow to Crystallex International Corporation’s long-running effort to recover its $1.2 billion arbitral award and judgment against the Republic of Venezuela for appropriating Crystallex’s rights to the Las Cristinas gold mine. In a 2-1 decision, the Third Circuit reversed a decision of the Delaware district court that had allowed Crystallex to allege a Delaware fraudulent transfer claim against a Delaware corporation wholly owned by the Venezuelan state-owned oil company PDVSA. Instead, the Third Circuit decided that a non-debtor transferor cannot be liable for a fraudulent transfer under the Delaware Uniform Fraudulent Transfer Act (“DUFTA”).
For PDVSA’s secured 2020 bondholders, the decision is welcome news, and makes the chances of any of those transactions being unwound, and the liens granted to 2020 bondholders set aside, even more remote. While Crystallex’s chance at a recovery against PDVSA remains alive if it is successful in its alter ego claims, PDVSA 2020 bondholders can rest easier knowing that they will retain their liens and priority to any proceeds from a sale of their collateral ahead of Crystallex or similar claimants even if such claimants successfully pursue alter ego claims against PDVSA. For other Republic creditors considering a similar strategy to Crystallex, the chances of jumping ahead of the 2020 secured PDVSA bonds or even debt below PDV Holding are now less likely, and with each passing day of litigation, the challenge of collecting any award from the cash-strapped nation only increases.
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.