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A "Settlement Payment" Is a Settlement Payment, Don't Settle for Less!

June 30, 2011

Enron seems like ancient history but the Second Circuit has just issued an important decision in an Enron appeal confirming that the redemption of commercial paper made through DTC is entitled to the Bankruptcy Code § 546(e) exemption for “settlement payments” and, therefore, exempt from attack as preferential transfers. The Second Circuit held that this is so even though the Enron redemption payments were made prior to stated maturity, becoming the first Circuit Court of Appeal to address this issue. Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), __ F.3d __ (2nd Cir., June 28, 2011). A copy of the decision can be found HERE

Just before Enron’s storied collapse, the company drew down its $3 billion bank revolver to redeem more than $1.1 billion of its commercial paper prior to their maturity at prices well above market value. Shortly thereafter, Enron filed for bankruptcy. As all good bankruptcy professionals know, the prepayment of antecedent debt within 90 days prior to a bankruptcy filing generally constitutes a preference subject to avoidance actions under sections 547 and 550 of the Bankruptcy Code. As in other full contact sports, bankruptcy law prevents unfair play by calling penalties and enforcing the rules of the game. Like an ineligible receiver catching a touchdown pass, the recipient of a preferential transfer has its transaction unwound and returns to the original line of scrimmage—plus a five yard penalty for fees and expenses. 

However, section 546(e) of the Bankruptcy Code shields certain transactions from avoidance, including any “settlement payment . . . made by or to (or for the benefit of) a . . . stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract.” Only where such settlement payment was made with actual intent to defraud creditors may the transaction be avoided under the Bankruptcy Code. Section 546(e) represents an attempt to align divergent legislative policies concerning bankruptcy and securities law by preventing the market failure that might result from requiring firms to repay amounts received in settled securities transactions, thereby reducing the firms’ liquidity and endangering current securities trading obligations. 

Resolving an issue of first impression in the federal courts of appeal, the Second Circuit by majority opinion affirmed the District Court holding that the section 546(e) “safe harbor” extends to an issuer’s redemption of commercial paper prior to maturity through means of the Depository Trust Company, regardless of the nature of, the motivations behind, or the circumstances surrounding such redemption. The Second Circuit found that case law and the plain language of the Bankruptcy Code did not support Enron’s proposed limitation of the safe harbor. Specifically, the Second Circuit rejected Enron’s arguments that the early redemption did not constitute “settlement payments” because the redemption (1) involved the retirement of debt and not the acquisition of title to the commercial paper and (2) did not involve a financial intermediary that took a beneficial interest in the securities during the course of the transaction. 

With respect to the first argument, the majority rejected the argument espoused by the Bankruptcy Court, namely that SEC v. Sterling Precision Corp., in which the Second Circuit held that an issuer’s redemption of bonds and preferred stock was not a “purchase” within the meaning of the Investment Company Act of 1940, because the issuer did not acquire title but merely discharged the obligations. The Court found no equivalent purchase or sale requirement under the Bankruptcy Code and only scant support for such requirement in the securities case law and the context of the securities industry generally. The Court likewise eschewed Enron’s argument for curtailing the scope of the safe harbor on the basis that the systemic risk that the legislature intended to prevent through section 546(e) did not exist under the circumstances because the financial intermediary never acquired a beneficial interest in the securities. The majority found (perhaps for the first time ever) that the language of the Bankruptcy Code is plain and unambiguous, given the lack of any explicit requirement in the Bankruptcy Code that the intermediary take a beneficial interest and the precedent of other Circuit Courts decisions affirming application of the safe harbor in cases involving leveraged buyouts in which an intermediary served merely as a conduit. 

The dissent threw a flag, lamenting the majority’s capacious definition of “settlement payment” as a threat to decades of routine avoidance proceedings in bankruptcy court. Judge Keltl’s dissent acknowledged that the plain language of the Bankruptcy Code, including the circular definition of “settlement payment” in section 741(8), fails to indicates that the redemption of commercial paper is beyond the scope of the safe harbor; however, he argued that the complete lack of clarity in the Bankruptcy Code makes the statute ambiguous, requiring a closer look at legislative intent. No matter. The referees have made their call and, unless the instant replay officials grant a writ of certiorari and overturn the Second Circuit, the call on the field stands. 

So the referee just put additional time on the clock, giving bondholders an opportunity to score under pressure. A borrower in financial difficulty may be able to raise cash through asset sales or obtain new money by offering security in an attempt to prove its viability and increase investor confidence. Provided such pre-maturity redemption is effected through the DTC, security holders are likely immune from preference actions under the Bankruptcy Code.