Shareholders who received nearly $8 billion from the Tribune Company leveraged buyout (LBO) do not have to give back that money as a constructive fraudulent transfer. Although the possibility remains that the creditors can recover this money through the pending intentional fraudulent transfer claims, which are much more difficult to prove, the Second Circuit recently held that the Bankruptcy Code preempts creditors from recovering under state constructive fraud theories when shareholders receive distributions under securities contracts effectuated through financial institutions.

In 2007, Tribune decided to go private through an LBO transaction that paid almost $8 billion to holders of shares of Tribune common stock. Tribune soon found itself in bankruptcy because of the crushing debt used to finance the LBO – almost $11 billion.

Seeking a way to increase the recovery to unsecured creditors, the Creditors’ Committee sued former shareholders for the return of the LBO proceeds, alleging the transaction constituted an intentional fraudulent transfer. The Creditors’ Committee did not pursue a constructive fraudulent transfer claim because it is clear that the safe harbor provision of Bankruptcy Code section 546(e) bars such claims.

However, a group of creditors separately filed suit against shareholders seeking to avoid the LBO payments under theories of state law constructive fraudulent transfer, claiming section 546(e) did not bar such claims. The creditors filed almost two dozen lawsuits around the country, which were eventually consolidated with the pending intentional fraudulent transfer actions filed by the Creditors’ Committee.

The safe harbor prevents a trustee from avoiding transfers made pursuant to securities contracts and effectuated through financial institutions, except in the case of actual fraud. This prohibition is intended to promote securities market stability by recognizing the sanctity of the transaction notwithstanding bankruptcy of the transferor. An open question had been whether the safe harbor provided a bar to someone other than the trustee (e.g., a creditor) from bringing such claims; this is precisely the issue considered in Tribune.

In Tribune, the District Court dismissed the constructive fraud claims for lack of standing on the grounds that the automatic stay prohibited the creditors from pursuing the same recovery from the same shareholders, albeit under a different legal theory, as the Creditors’ Committee. The Court also held that the bankruptcy safe harbor did not prevent the creditors from bringing the state law constructive fraudulent transfer claims.

The Second Circuit reversed on both issues. First, the Court determined that the Bankruptcy Court had granted relief from the automatic stay for the express purpose of permitting the creditors to bring (but without any decision as to whether such claims were viable) the state law constructive fraudulent transfer actions. Second, the Court held that that the Bankruptcy Code preempts state law regarding creditor rights.  Thus, where state law might conflict with the purpose of the Bankruptcy Code’s safe harbor, state law must yield.  The Court also recognized that the important federal policy of protecting the securities markets required preemption as well.

The Second Circuit decided that the bankruptcy safe harbor will protect transfers that fall within its purview regardless of who is challenging the transfer; there will be no creative work-around.

This decision should inform ongoing activity in other pending LBO shareholder cases where creditors have tested the scope of the safe harbor provision by bringing avoidance actions through someone other than the trustee. It appears these creative attempts are no longer viable (at least in the Second Circuit) and recovery from shareholders that received LBO proceeds will be much more difficult.