Which Hat Hides the Ball?: Courts Test Extent of Safe Harbor Protections in Financial Transactions

December 10, 2013 - When a legal right depends on the capacity in which a party purports to act, it won’t be long before the lawyers are talking about “hats.”  In two bankruptcy cases now pending before the Second Circuit, the hat in question is that of the trustee under section 546 of the Bankruptcy Code and the right in question is the right to seek avoidance of a fraudulent transfer within the “safe harbor” provisions of section 546.  The purpose of the safe harbors is to provide stability and certainty in markets for financial instruments like securities and swap agreements by confining the bankruptcy avoidance risk to cases of actual fraud.  Thus, section 546 bars the “trustee” from bringing an avoidance action based on constructive fraud (which does not require a fraudulent state of mind), whether asserted under the Bankruptcy Code or state creditor protection laws.  Section 546 is silent as to actions brought by persons other than the “trustee,” leaving open the question whether creditors may still invoke state law rights to seek avoidance without a showing of actual fraud.

In Whyte, accepting creditors under a plan were required to assign their claims to the trustee, who then asserted state law constructive fraud claims in her capacity as assignee of creditor rights, asserting that the actual fraud limitation of section 546 became irrelevant when she switched hats.  Judge Rakoff held that the section 546 safe harbors were not negated by this “clever argument,” and that the state claims were impliedly preempted – otherwise the section 546 safe harbors would be rendered a “nullity.”  Whyte v. Barclays Bank PLC, 494 B.R. 196, 199-200 (S.D.N.Y. 2013).  By contrast, in Tribune, Judge Sullivan found that the trustee hat carries with it the exclusive right to challenge a transaction unless this right is abandoned by the bankrupt estate.  In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310, 320-21 (S.D.N.Y. 2013).  At the same time, while noting that the filing of a bankruptcy petition can create “powerful magic,” Judge Sullivan did not find preemption of state law creditor claims, because section 546 refers only to the disability of the trustee, leaving creditor claims unaffected.  Id.  Judge Sullivan also distinguished Whyte as holding merely that a party “could not simply take off its trustee hat, put on its creditor hat, and file an avoidance claim.”  Id. at 319.

Both cases have been appealed, and the Second Circuit will be confronted with complex arguments involving trustee and creditor standing, preemption, and the automatic stay.

SemGroup

The transaction at issue in Whyte is a swap agreement wherein a swap participant paid $143 million for the commodities derivatives portfolio of SemGroup, an energy transport and storage company.  About a month later, SemGroup filed a petition under Chapter 11.  Pursuant to SemGroup’s plan of reorganization, which provided that certain creditors assigned “any and all” of their claims to a SemGroup Litigation Trust, the litigation trustee, as assignee of SemGroup’s creditors, filed suit to avoid the swap on the ground that the transaction was a constructive fraudulent conveyance under New York’s Debtor-Creditor Law.

The swap participant moved to dismiss under section 546(g), which provides that “the trustee may not avoid a transfer” to “a swap participant or financial participant, under or in connection with any swap agreements.”  On June 11, 2013, Judge Rakoff dismissed the SemGroup trustee’s complaint, holding that the transaction was a safe harbored transfer made in connection with a swap agreement.  Whyte, 494 B.R. at 201.  The court found that allowing the trustee to pursue the claim “wearing her non-bankruptcy hat,” would render section 546(g) a nullity and “make a mockery of Congress’s purpose of minimizing volatility in the swap markets.”  Id.  This “absurd result” was avoided under “well-established principles of federal preemption”: section 546(g) “impliedly preempts the Trustee’s attempt to resuscitate fraudulent avoidance claims as the assignee of certain creditors.”  Id. at 199, 200-01.

Tribune

Tribune addressed avoidance claims based on a massive leveraged buyout of the publicly held common stock of the soon-to-be-bankrupt Tribune Company.  As in Whyte, the claims were based on constructive fraud theories under state law.  These claims, however, were never assigned to a trustee, and instead were asserted by creditors in their own right.  The defendants, including many thousands of public shareholders who merely tendered their securities via public securities markets, moved to dismiss the action on the grounds, (i) that the section 546 safe harbor preempts the state law claims (the view adopted by Judge Rakoff in Whyte), and (ii) that individual creditors lacked “standing” to pursue the actions.

Regarding preemption, Judge Sullivan found no express language of preemption, as section 546(e) refers only to claims brought by a bankruptcy estate “trustee” and makes no reference to individual creditors’ state law constructive fraudulent conveyance claims.  Tribune, 499 B.R. at 316-20.  The court found Whyte distinguishable because of the switching of hats.  Id. at 319.  The Litigation Trust “could not simply take off its trustee hat, put on its creditor hat, and file an avoidance claim.”  Id.  By contrast, the Tribune creditors were not “creatures of a Chapter 11 plan” and not identical to the bankruptcy trustee.  Id.

Still, Judge Sullivan granted the motion to dismiss on the ground that the automatic stay under the Bankruptcy Code precludes fraudulent conveyance actions by individual creditors where the trustee is simultaneously suing to avoid the same transactions.  Id. at 325.  The decision left open the possibility that individual creditors may assert constructive fraudulent transfer claims that the Code precludes the trustee from asserting, but only if the trustee essentially abandons avoidance claims based on the same transactions.  Defendants argue that this could create a massive loophole in section 546 safe harbor protections and defeat its purpose to reduce uncertainty in financial market transactions.

Motion for Expedited Briefing and Panel Assignment

The plaintiffs in Tribune filed an unopposed motion seeking an expedited briefing schedule and assignment to the Second Circuit panel hearing the SemGroup appeal.  The movants argued that “[b]oth cases present critically important and recurring questions concerning the construction of 11 U.S.C. § 546 and the scope of its limitation on fraudulent transfer claims.”  Whyte v. Barclays Bank PLC, et al., Case 13-2653 (2d Cir.), ECF No. 142 at 9.  The movants point out that “at least two other billion-dollar bankruptcy proceedings already pending [in the Second Circuit] involve similar issues, and the parties’ organization of their affairs in those cases and others to follow will be influenced by the outcome of these appeals.”  Id. at 11.  On November 12, 2013, the Second Circuit entered an order to hear the appeals in tandem, with argument as early as the week of February 10, 2014.  Id. at ECF No. 198; Case 13-3992 (2d Cir.), ECF No. 33.

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The outcome of the Whyte and Tribune cases may clarify the extent of safe harbor protection for financial market transactions in the Second Circuit, and may illuminate as well the court’s views on implied preemption and trustee standing.  Affected members of the financial community will no doubt stand by with interest.