The U.S. Supreme Court dealt leveraged buyouts and other stock sellers a blow when it held the safe harbor preventing recovery of securities settlement payments “by or to a financial institution” must be viewed in light of the entire chain from buyer to seller. This is likely to be a Pyrrhic victory for bankruptcy trustees. While neither the buyer nor the sellers in stock-sale transactions are usually financial institutions as one would ordinarily define this concept, the U.S. Bankruptcy Code takes a surprising approach to this key term.
The scenario is well known today and has been discussed in this column before. In cases involving the Tribune Company, LyondellBasell, and most recently an obscure horse racing operator called Valley View Downs, a shaky company agrees to buy out its (or another company’s) shareholders’ stock, but the buyer-company soon thereafter tips into U.S. bankruptcy proceedings. The bankruptcy trustee (or a litigation trust, often funded by litigation financiers) then pursues the seller-shareholders for a clawback of the buyout proceeds. It might contend that the buyout payment constituted a “constructively” fraudulent conveyance, involving no actual fraud, but nonetheless susceptible to reversal and recovery because the buyout transaction left the buyer-company insolvent and offered the buyer-company less than reasonably equivalent value for the buyout proceeds. Alternatively, if the buyout involved a promise to pay in the future, payment on that promise shortly before the buyer’s bankruptcy might be alleged to represent a preferential payment to the seller-shareholders, disadvantaging the buyer-company’s other unpaid creditors. In either event, U.S. bankruptcy law imposes two hurdles for pursuing such recoveries.
Not only must the buyer-company’s bankruptcy trustee (or litigation trustee) establish the requisites of a fraudulent conveyance or preferential transfer on the merits, it must avoid a safe harbor provision that might prevent pursuit of such payments entirely. To prevent disruption of the financial markets, the U.S. Congress decades ago adopted a provision prohibiting the pursuit under bankruptcy law of settlement payments and other payments under a securities contract if the payment was “made by or to … a … financial institution.”
Because large payments for purchases of securities are generally not made through in-person transfers of bags of cash, clever lawyers for the selling shareholders in the Valley View Downs case mentioned above, along with many other cases around the country, argued that any payment to them fell within this safe harbor, because the buyer-company’s money transfers were, of course, “made by or to” the parties’ respective banks; that is, financial institutions. This is the argument that the U.S. Supreme Court shot down this spring when it held that “the transfer” that is shielded has to be viewed holistically from beginning to end – buyer to seller – not disambiguated into its stages of (1) buyer to buyer’s bank, (2) buyer’s bank to seller’s bank, and (3) seller’s bank to seller. Because no one argued that either buyer or seller in that buyout was a financial institution, the safe harbor was held inapplicable.
The key words here, however, are “no one argued.” U.S. courts will generally not apply points of law, no matter how obvious or dispositive, that the parties fail to raise themselves. The court pointed out in a footnote that there might be a legitimate question as to whether the obviously non-financial horse racing company and the target’s individual shareholders were, in fact, “financial institutions.” That argument had been waived, however, when the parties failed to advance it, but what of future cases?
The selling shareholders’ lawyers in Merit Management likely failed to pursue such an argument because it is based on an extremely obscure and unexpected provision of law. Only in the Alice-in-Wonderland world of the U.S. Bankruptcy Code could a private individual shareholder be qualified as a “financial institution.” But buried in the long, ground-laying section at the head of the Code is a definition of a term few would think needs defining: “financial institution.” It begins with an entirely unsurprising enumeration of entities like commercial and savings banks, trust companies, and credit unions. It then takes an unexpected turn and expands the definition when any of these entities “is acting as agent … for a customer … in connection with a securities contract.” In such case, the definition of “financial institution” includes “such customer.”
That is, when a securities buyer’s and seller’s banks are, as they almost always are, acting as the payment agents of buyer and seller in an LBO or other securities contract-related deal, the U.S. Bankruptcy Code defines the seller and buyer themselves as being “financial institutions.” This counterintuitive conclusion is not absolute or unassailable, but one would have to engage in some serious semantic gymnastics to avoid this construction of the plain language of the statute. If Grandma Jones sells her stock in Tribune Company in an LBO, and if she and Tribune Company use their banks as payment agents to settle the payment for the stock sale (as would ordinarily be the case), granny is a financial institution. That being the case, the payment was thus “made by or to” a financial institution in the context of a securities contract deal and shielded from attack as a constructive fraudulent conveyance or preference.
This is not the only example of definitional sleight of hand in the Code. The definition of “corporation,” for example, “includes … unincorporated company or association.” That an unincorporated association could be considered a corporation is only mildly less surprising than the notion of considering Grandma Jones a financial institution. Many years ago, one of this author’s law professors published a book called “When Words Lose Their Meaning.” I have long thought that the subtitle of this book should have been: “When Lawyers Use Them.”
