On August 18, 2022, the United States Bankruptcy Court for the Southern District of Indiana, in In re BWGS, LLC, No. 19-01487-JMC-7A, 2022 WL 3568045 (Bankr. S.D. Ind. Aug. 18, 2022), narrowly interpreted the safe harbor provision in section 546(e) of the Bankruptcy Code by refusing to dismiss a lawsuit against a guarantor whose liability was eliminated by the debtor’s payment to the bank that held the guarantee.

Overview on Section 546(e) of the Bankruptcy Code

Congress re-designated section 546(d) as § 546(e) in 1984,^[1] and further amended the provision in December 2006 to clarify that the safe harbor applies to all transfers (other than actual fraudulent transfers) made to designated financial intermediaries in connection with their facilitation of trades executed through the Securities Clearance and Settlement System or the commodities clearance system.^[2] As explained by the House Committee on Financial Services, the 2006 amendment operates to “reduce systemic risk in the financial markets by clarifying” the application of the safe harbor to transactions similar to those already covered by existing law. H.R. Rep. No. 109-648, at 1-2. “The common thread of these transactions [covered by the safe harbor] is that they involve financial intermediaries – stockbrokers, financial institutions, financial participants or securities clearing agencies – that often hedge their risk on these transactions through other market transactions, repledge securities collateral received under these transactions, or both.” Id. at 5 and 8.

Facts of BWGS, LLC

A company was owned by an employee stock ownership plan trust (“ESOP”). A private equity investor negotiated a deal to purchase the company by acquiring the stock from the ESOP. The stock owned by the ESOP was not traded publicly.  To complete the acquisition, the buyer obtained a $24.9 million bridge loan from a bank. The buyer was obligated to the bank, but the company being acquired was not liable on the loan. One month after the acquisition was completed, the debtor obtained loans from another bank and paid off the $24.9 million bridge loan for which the buyer had been liable but the debtor was not.  To secure the loan, the debtor pledged all its assets as collateral.

The debtor’s business began to deteriorate after the acquisition. Approximately two years after the closing, the company’s creditors filed an involuntary petition under chapter 7 of the Bankruptcy Code.

Because the transfer occurred more than two years before filing, the chapter 7 trustee brought an adversary proceeding to avoid the transfer by invoking the power under section 544(b) to step into the shoes of an actual creditor and sue the buyer for a constructive fraudulent transfer under Indiana law. The chapter 7 trustee alleged that the transfer paying off the bridge loan was “to or for the benefit” of the buyer and that the debtor received no consideration for encumbering its property.

BWGS, LLC’s Ruling

Noting that the new loan paid off a financial institution and was used to buy stock from the ESOP, the buyer filed a motion to dismiss based on the Section 546(e) safe harbor. The subsection provides: “the trustee may not avoid a transfer . . . made by or to (or for the benefit of) a . . . financial institution . . . or that is a transfer made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract, as defined in section 741(7), . . . except under section 548(a)(1)(A) of this title [for a transfer made with actual intent to hinder, delay or defraud].”

After ruling that the chapter 7 trustee had made a plausible claim for a constructive fraudulent transfer, the Court then turned to the buyer’s safe harbor defense.

Examining the 1984 amendments giving rise to section 546(e), the Court said that Congress intended “to clarify that the safe harbor applies to all transfers (other than actual fraudulent transfers) made to designated financial intermediaries in connection with their facilitation of trades executed through the Securities Clearance and Settlement System or the commodities clearance system.” BWGS, LLC, 2022 WL 3568045, at *5.  The court further opined:

Even with this clear legislative intent, courts have no clear mandate in the language of  § 546(e) to apply the safe harbor to shield transfers that do not implicate the Securities Clearance and Settlement System. Courts should be particularly reluctant to do so where, as here, the transfer under attack does not implicate the national System for trades of publicly-held securities or pose a systemic risk to the financial marketplace. Nonetheless, under such circumstances, no conflict exists between (1) enforcing the Bankruptcy Code's policy of maximizing the bankruptcy estate by protecting “the Trustee's well established and important avoidance powers”; and (2) the purpose § 546(e) was enacted to serve.

Id.

The buyer had advocated a “a liberal interpretation of the broadly defined terms of the safe harbor[.]” Id. In rejecting this interpretation, the Court ruled that “the underlying purchase of stock was a private transaction that did not in any sense involve the System that § 546(e) was intended to protect.”  Id.

The Court went on to explain what must be shown in order to invoke the safe harbor provision: “[t]he Court must determine whether a sufficient nexus exists between the Transfer and a ‘securities contract’ that would lead to the conclusion that the Transfer was made ‘in connection with’ such a ‘securities contract’.  Id.at *6.

For definition of “in connection with,” the court cited Chadbourne & Parke LLP v. Troice, 571 U.S. 377, 387 (2014), where the Supreme Court said in a suit under SLUSA that “in connection with” “suggests a connection that matters.” The Court went on to eschew an overly broad construction to avoid interfering “with state efforts to provide remedies for victims of ordinary state-law frauds.” Id. at 391.

As a result, the Court ruled: “an overly expansive interpretation of ‘in connection with’ would not advance any purpose underlying Congress’ enactment of the safe harbor of § 546(e) or the policies underlying the avoidance provisions of the Bankruptcy Code’s chapter 5 or the [state fraudulent transfer law].”  The Court saw “no material nexus” between the buyer’s contract to purchase stock from the ESOP and the payoff of the loan to the bridge lender. According to the Court, nothing in the stock purchase agreement “indicates that [it] was executed or performed ‘in connection with’” paying off the bridge loan.

“Instead,” the Court said the stock purchase and the loan payoff were “two separate transactions” that occurred “one month apart.” The Court noted that the trustee was not aiming to avoid the payment to the ESOP that effected the stock purchase.

The Court denied the motion to dismiss under the safe harbor because the new loan one month after closing had “nothing to do with the purchase or sale of any securities or any ‘securities contract’” and there was no “sufficient nexus between the [stock purchase agreement] and the [loan payoff] to bring the ‘safe harbor’ of Section 546(e) into play.”

FOOTNOTES

^[1] Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, 98 Stat. 333.

^[2] Financial Netting Improvements Act of 2006, Pub. L. No. 109-390, 120 Stat. 2692.