Shortly before filing bankruptcy, the debtor made a ~$376 million payment to a financial institution in its capacity as trustee for a group of noteholders in order to repurchase the notes. Normally the payment could have been avoided as a preference. The question for the 2dnd Circuit was whether the payment came within one of the safe harbors in Section 546(e) of the Bankruptcy Code.
As a general matter, a payment (1) to or for the benefit of a creditor (2) on account of an antecedent debt (3) made while the debtor was insolvent and (4) within 90 days before the bankruptcy is filed that (5) allows the creditor to receive more than it would receive in a chapter 7 liquidation can be avoided as a preference under Section 547 of the Bankruptcy Code (subject to certain defenses – for example, transfers for new value or in the ordinary course of business).
However, Section 546 of the Bankruptcy Code includes limitations on bankruptcy avoiding powers, including preference actions. Among other things, Section 546(e) provides (emphasis added):
[T]he 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 benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract... commodity contract,... or forward contract, that is made before the commencement of the case, except [transfers made with actual intent to hinder, delay or defraud a creditor].
In this case a sister company (QWCC) raised $371 million for a group of companies that included the debtor (QWUSA) and their parent (QWI) through a private placement of notes. Under the note purchase agreement (1) QWCC had a right to prepay the notes as long as it paid principal, interest and a "Make Whole Amount," (2) affiliates were prohibited from buying the notes unless they complied with the prepayment provisions, and (3) once the notes were paid in full, they were to be surrendered to QWCC for cancellation.
After the companies ran into financial difficulties, the parent company offered to purchase a portion of the notes in exchange for modifying one of the financial covenants in order to avoid triggering a default and a cross default under a separate revolving credit facility. The noteholders refused, but agreed not to sell their notes to anyone but an existing noteholder.
A couple of months later, QWCC gave notice that it intended to redeem all of the notes. However, it then realized this would have led to severe tax consequences under Canadian law. So the offer was restructured as a two-step transaction, with QWUSA first purchasing the notes from the noteholders for cash, followed by a QWCC redemption of the notes from QWUSA in exchange for forgiveness of inter-company debt. Accordingly, QWUSA transferred ~$376 million to CIBC Mellon Trust Co. (CIBC Mellon), as trustee for the noteholders. CIBC Mellon in turn distributed the funds to the noteholders, who surrendered the notes to QWI in Canada.
QWUSA filed bankruptcy less than 90 days later. Its creditors' committee sought to avoid the payment and recover the cash as a preference under Section 547. In response, the noteholders argued that the payments were exempt from avoidance under Section 546(e), both as settlement payments and as payments in connection with securities contracts.
The bankruptcy court held that the payments constituted exempt settlement payments. It also found that they qualified as transfers made in connection with a securities contract, regardless of whether QWUSA was redeeming or purchasing the notes. The district court affirmed on the basis that the payments were a settlement payment. It did not agree that a transfer to redeem qualified, but concluded that the QWUSA payment was in fact a purchase.
The 2nd Circuit focused on the safe harbor for a transfer made to a financial institution in connection with a securities contract. It noted a split of authority, with three circuits (6th Circuit, 8th Circuit and 3rd Circuit) deciding that any transfer to a financial institution qualifies, even if it is only serving as a conduit or intermediary. Only the 11th Circuit has held that the financial institution must have some interest in the funds for a payment to qualify for the safe harbor. The 2nd Circuit reached the same conclusion as the majority.
The parties agreed that CIBC Mellon was a financial institution, and the note purchase agreement was a securities contract – for both the original purchase and the repurchase of the notes. The 2nd Circuit determined that this qualified as a transfer made to a financial institution in connection with a securities contract, and thus affirmed the lower courts in finding that the QWUSA cash payment was exempt from avoidance as a preference.
It based its decision on the plain language of the statute: In its view, the reference to transfers made "by or to (or for the benefit of)" a financial institution meant that a payment to, but not for the benefit of, an institution was covered. It also found support for its decision in the public policy of minimizing the effect on the commodities and securities markets of a bankruptcy affecting those industries. "A transaction involving one of these financial intermediaries, even as a conduit, necessarily touches upon these at-risk markets." Recognizing the safe harbor promotes stability of the markets.
The limitations in Section 546, particularly subsection (e), have been interpreted by courts as having a very broad reach. (See, for example, Protecting Utilities: Would You Believe a Bill Payment is a Settlement Payment Under a Forward Contract?) Although it might be risky to rely on the safe harbor ahead of time, once you are faced with avoidance claims in a bankruptcy, anyone who can shoehorn themselves into one of the listed classes of financial intermediaries should definitely consider Section 546(e) as a possible defense.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
