November 30, 2023

Fraudulent Transfers: 2nd Cir. Narrows Section 546(e) Safe Harbor

On Monday, the 2nd Circuit issued its decision in In Re: Nine West LBO SEC. Litig., 20-3257 (2d Cir.; 11/23), in which it overturned the SDNY’s prior decision dismissing creditors’ claims seeking to recoup merger consideration paid to the company’s former director, officer & employee stockholders in connection with 2016 LBO. In so doing, the Court adopted a narrower reading of the scope of the safe harbor established by Section 546(e) of the Bankruptcy Code for transactions made through a financial institution.

The creditors efforts to recover merger consideration paid to public and insider stockholders on the basis that the transaction involved a fraudulent transfer.  The defendants moved to dismiss the complaint, contending that the payments were protected by the Section 546(e) safe harbor. The Court affirmed the district court’s decision dismissing claims against the public stockholders but refused to dismiss claims against insiders.

Importantly, the manner in which payment of the merger consideration was paid differed between the two groups of stockholders.  The public stockholders who held certificated shares & shares held in electronic form by DTC were paid through Wells Fargo, which served as the company’s paying agent for the merger, while the insiders were paid by the company through its payroll system.

The Court’s conclusion boiled down to its views on which defendants could properly be regarded as a “financial institution” for purposes of the safe harbor. The district court held that a bank customer qualified as a financial institution for purposes of the safe harbor when a bank is acting as an agent for a customer in connection with a securities contract (i.e,. the merger agreement), and that all transactions made pursuant to that contract are within the safe harbor. The 2nd Circuit disagreed:

We hold that § 101(22)(A) must be interpreted using a “transfer-by-transfer” approach based on: (1) the language of the statute, (2) the statutory structure, and (3) the purpose of the safe-harbor provision. First, the Bankruptcy Code defines a “financial institution” to include a “customer” of a bank or other such entity “when” the bank or other such entity “is acting as agent” for the customer “in connection with a securities contract”. It does not provide that a customer is covered when a bank has ever acted as a customer’s agent in connection with a securities contract.

In other words, the text creates a link between a bank “acting as agent” and its customer with respect to a transaction. To satisfy that link, the plain language of § 101(22)(A) indicates that courts must look to each transfer and determine “when” a bank “is acting as agent” for its customer for a transfer, assuming, of course, the transfer is made in connection with a securities contract.

In holding that the safe harbor did not apply to payments made to the company’s insider stockholders, the Court noted that Wells Fargo had “nothing to do” with those transfers, and that if it extended the safe harbor to those transactions, it would essentially make it limitless in its application. In reaching that conclusion, the Court said that if it held that the safe harbor applied that broadly, “we cannot imagine a circumstance in which a debtor would choose to structure an LBO without involving a bank.”

The Court’s last statement strikes me as pretty odd, because it seems to me that the most likely outcome of this decision will be to increase the demand for banks to serve as paying agents in LBOs and to make sure that every last penny of merger consideration is paid through them. Paying agents aren’t always banks, but now it looks like there’s a good legal reason for them to be. In other words, this decision ultimately may turn out to be the “Full Employment for Bankers Act of 2023.”

John Jenkins