The United States Bankruptcy Court for the Southern District of New York (the “Court”) in Weisfelner v. Fund 1 (In Re Lyondell Chemical Co.), 2014 WL 118036 (Bankr. S.D.N.Y. Jan. 14, 2014) recently held that the safe harbor provision of 11 U.S.C. § 546(e) did not bar unsecured creditors from seeking, under state fraudulent transfer law, to recover payouts made to former shareholders of a company acquired in a leveraged buyout. This case highlights the limitations in section 546(e)’s so-called safe harbor provision, which protects settlement payments made to complete pre-bankruptcy securities contracts from later being attacked and avoided by the bankruptcy estate representative as fraudulent transfers.

In December of 2007, Bassell AF S.C.A. acquired Lyondell Chemical Company (“Lyondell”) through a leveraged buyout (“LBO”). Just over a year later, in January of 2009, Lyondell filed a petition for chapter 11 relief. The LBO had been financed 100% by debt secured by Lyondell’s assets, and as a result, Lyondell’s unsecured creditors found themselves in line behind $21 billion in secured debt—$12.5 billion of which had been used to cash out shareholders whose rights of repayment would have been junior to those of unsecured creditors in bankruptcy. To address this inequity, Lyondell’s confirmed chapter 11 plan created a trust for the benefit of Lyondell’s creditors (the “LB Creditor Trust”) to pursue state law fraudulent conveyance claims against Lyondell’s former shareholders who received proceeds from the LBO. The LB Creditor Trust commenced a lawsuit pursuant to state law alleging the LBO rendered Lyondell insolvent and Lyondell received nothing in return for the payments to former shareholders, and seeking to recover $6.9 billion in payments (limited to former shareholders who had received more than $100,000).

Several shareholder defendants (primarily investment banks, brokerage firms and other financial institutions) moved to dismiss the case pursuant to section 546(e), as well as several other theories not discussed here. The shareholder defendants asserted that section 546(e) bars avoidance and recovery of settlement payments under state fraudulent conveyance law, regardless of whether such a claim is brought by the trustee, debtor-in-possession or creditors. In the alternative, they argued section 546(e) preempts state law since section 546(e) would have precluded an estate representative from avoiding such payments under federal constructive fraudulent conveyance law.

Rejecting both arguments, the Court held that section 546(e) did not bar the LB Creditor Trust’s state law fraudulent transfer action. The Court relied on two recent cases in which creditors asserted fraudulent conveyance claims after failed LBOs—In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013) and Development Specialists, Inc. v. Kaplan (In re Irving Tanning Co.), No. 12–01024 (Bankr.D.Me. Feb. 17, 2013), ECF No. 43 (Kornreich, J.)—in holding that section 546(e) only bars a trustee acting on behalf of the estate from recovering settlement payments, and does not bar claims brought on behalf of individual creditors under state law. The Court distinguished its holding from a contrary district court decision, Whyte v. Barclays Bank PLC, 494 B.R. 196 (S.D.N.Y. 2013), because the litigation trust in that case had asserted fraudulent conveyance claims on behalf of both the estate and creditors.

The Court further explained that state law was not preempted by section 546(e) because (i) there was no express preemption, (ii) Congress did not manifest an intent to “occupy the field” since state fraudulent transfer law predates federal fraudulent transfer law and there is a long history of coexistence of the two, and (iii) conflict preemption did not exist because state law fraudulent transfer remedies do not make compliance with federal laws impossible. The Court noted that Congress enacted section 546(e) in order to protect the nation’s financial markets from instability and the ripple effects caused by reversal of settled securities transactions. Agreeing with the Tribune court, the Court held this LBO payout was not the kind of transaction Congress intended to protect, because undoing this transaction would only affect the individual investors at the very end of the asset dissipation chain and would not cause ripple effects in the markets.

Lyondell, Tribune and Irving Tanning could indicate a trend toward courts construing section 546(e) narrowly, such that shareholders may not be able to avail themselves of the safe harbor protections of section 546(e) if individual creditors regain their rights to pursue state law fraudulent conveyance claims.