For those still wondering if the outcome of a court case can depend entirely on the specific court adjudicating that case, a recent ruling from the Chicago-based U.S. Court of Appeals for the Seventh Circuit should dispel all doubt. Those advising defendants sued by U.S. bankruptcy trustees for recovery of securities settlement payments, and those evaluating the implications of such a suit, should take special note of the Seventh Circuit’s announced disagreement with virtually every other Circuit to address the issue.
The three-step scenario in the case is one familiar to hedge fund investors and about which this column has reported in the past. In step one, a leveraged buyer purchases the shares of a target company, paying a substantial amount of money to the target’s shareholders, but after a short time (four years or less), the buyer finds that it cannot support the burden of the leverage taken on and thus declares bankruptcy. In step two, a trustee or other control party invokes the bankruptcy law’s provisions on fraudulent conveyances to demand that a former target shareholder return the buyout money to the buyer’s estate for redistribution to creditors. This shareholder, the trustee’s argument goes, received property from a soon-to-be-insolvent entity and did not offer equivalent value in return, as evidenced by the buyer’s collapse after the leveraged buyout (the argument is more powerful in a true LBO, in which the target company itself is the buyer, and it receives nothing of meaningful value in exchange for buying its own shares from its own former shareholders).
Step three is the crucial and disputed one. The former shareholder-cum-defendant invokes a “safe harbor” provision in section 546(e) of the Bankruptcy Code. In specified cases, this provision shuts down any attempt to use any of the Code’s claw-back provisions to recover fraudulent conveyances or preferential transfers. In cases not involving actual fraud, the safe harbor provision prevents the recovery of any “settlement payment” or any other payment “in connection with a securities contract” made either “by or to” a “financial institution” or a series of enumerated financial industry actors. This provision was designed to avoid a domino chain of failures by other financial market intermediaries if any one financial market intermediary were to fail and a trustee starts selectively recovering value from the recipients of the interconnected web of payments made to settle that intermediary’s securities transactions.
If the debtor-leveraged buyer and the former shareholder were the only parties involved in the buyout transaction, the safe harbor provision would generally not apply. While the buyout payment is clearly connected to a securities contract, in most cases, neither buyer nor seller is a protected financial markets participant, i.e., a commodity broker, forward contract merchant, stockbroker, securities clearing agency, or financial institution. But clever lawyers for former shareholder-sellers have seized on the contorted language of the law, noting that the safe harbor protects any securities-related payment “by or to” a financial institution. In the ordinary course, the trade is cleared not by a hand-to-hand transfer of millions of dollars in cash, but by a payment to a bank-intermediary, a financial institution! Thus, in all but the most extraordinary securities deals, the debtor-buyer will have made the challenged payment to a financial institution, and the former shareholder-seller will have received the challenged payment made by a financial institution. The payment transfer is thus insulated in multiple directions.
This expansive interpretation of the safe harbor has prevailed before the appeals courts in the two most prominent U.S. bankruptcy jurisdictions, the Second Circuit in New York and the Third Circuit in Delaware, as well as the appeals courts in the more provincial Sixth, Eighth, and Tenth Circuits. While this is good news for former shareholders, it is less positive for the creditors of failed leveraged buyers.
So where would these creditors prefer to see lawsuits filed against their debtors’ securities sellers? The Seventh Circuit, with jurisdiction over Illinois, Indiana, and Wisconsin, including the major commercial center of Chicago. In its ruling at the end of July 2016, the Seventh Circuit concluded that the language of the safe harbor provision is facially ambiguous, so it must be interpreted in light of its purpose and history. It applies, the court held, only where the economic substance of the transaction directly involves a financial industry participant; that is, when the financial intermediary is a counterparty to the securities contract, not a mere payment conduit.
In so ruling, the Seventh Circuit did not reveal any fundamental flaw in the reasoning of the phalanx of prominent appeals courts who construed the safe harbor broadly. The Seventh Circuit simply disagreed with its sister courts, perhaps for policy-driven reasons even more so than for jurisprudential differences as to proper statutory interpretation.
Note that it is difficult to impossible to manipulate the location of the governing forum in cases like this. The proper venue for claw-back recovery cases is generally the location of the defendant (the former shareholder, in the case discussed here). While the debtor or perhaps its creditors can control where the bankruptcy case is filed, they have precious little influence over where potential settlement payment recipients are located throughout the country. Indeed, the bankruptcy case discussed here was filed in Delaware. The Seventh Circuit became involved only because the former shareholder was located in Chicago and was therefore sued by the trustee there. In any event, the case demonstrates that in law, as in real estate, the most important value factor is often location, location, location.