Preventing the Exception from Swallowing the Rule — Why Congress Should Amend Section 546 of the Bankruptcy Code to Prevent the Underlying Policies of Fraudulent Conveyance Law and the Protection of Financial Markets from Colliding and to Prevent Participants in Fraud from Profiting
124 Pages Posted: 3 Jan 2018
Date Written: June 2, 2017
The Article discusses and analyzes recent developments regarding Section 546 of the Bankruptcy Code. Several important policies underpin the Bankruptcy Code, including, inter alia: (i) fostering the debtor’s reorganization of its financial affairs; and (ii) treating “similarly situated” creditors ratably in accordance with an established priority scheme. To reach these goals, the Bankruptcy Code contains provisions that allow the debtor to “clawback” transfers referred to as “preferential transfers” and “fraudulent transfers”. These clawback provisions are aimed at preventing certain creditors from: (i) “picking the debtor apart” within a close temporal proximity to the date of its bankruptcy filing; and (ii) receiving either actual or constructive fraudulent transfers from the debtor.
Over the past three decades, however, Congress has amended the Bankruptcy Code to reflect an additional policy — protection of the financial markets from systemic risk. To accomplish this goal, Congress enacted and expanded Section 546(e) of the Bankruptcy Code (the “Section 546(e) Safe Harbor”) to insulate various types of financial transactions from the Bankruptcy Code’s clawback provisions. Congress’s intent underlying the Section 546(e) Safe Harbor is to prevent a “ripple effect” of financial losses to financial institutions and clearinghouses that function as intermediaries in interconnected financial transactions.
Several recent cases of apparent first impression have demonstrated that the precise parameters of the Section 546(e) Safe Harbor are not clear. Indeed, there is a current split within the federal circuits on several crucial issues involving the Section 546(e) Safe Harbor. Several of these cases involve multi-billion dollar disputes connected to leverage buyouts (“LBO's”), Ponzi Schemes and derivative transactions. Several decisions applied the Section 546(e) Safe Harbor more broadly than Congress intended. Namely, there is a lack of clarity as to whether the Section 546(e) Safe Harbor: (i) insulates a settlement payment by a debtor to a holder of securities issued by the debtor from a constructive fraudulent transfer or a preferential transfer simply because a financial institution acted as a conduit (such as a transfer agent, escrow agent or bailee) between the debtor and the holder of the debtor’s securities; (ii) applies to settlement payments involving privately held securities; (iii) applies to payments to “net winners” in Ponzi schemes; and (iv) preempts: (a) fraudulent transfer actions based on state law; or (b) state law claims such as unjust enrichment. The Supreme Court has recently granted certiorari with respect to the conduit issue.
This Article argues that the Supreme Court should rule that the Section 546(e) Safe Harbor does not insulate a payment by a debtor to a holder of securities issued by the debtor from a constructive fraudulent transfer or a preferential transfer simply because a financial institution acted as a conduit (such as a transfer agent or escrow agent) between the debtor and the securities holder. The Article further argues that, even if the Supreme Court makes that ruling, that Congress should amend, clarify and narrow the scope of the Section 546(e) Safe Harbor so that it (i) never applies to shield Net Winners in Ponzi Schemes; (ii) never applies to insulate a financial institution from constructive fraudulent transfer liability or preferential transfer liability where that financial institution is engaged in proprietary trading and not acting purely as an intermediary in the commodities or securities clearing and settlement system; (iii) preempts constructive fraudulent transfer claims based on state law only against: (a) non-insider investors in publicly held securities that acted in good faith; (b) entities that act solely as intermediaries in the commodities and securities clearing and settlement system; (c) repo participants, and (d) swap participants; (iv) never preempts state law fraudulent transfer claims based on intentional fraud; and (v) does not preempt causes of action based on state law or federal law, such as breach of the covenant of good faith and fair dealing and unjust enrichment, so long as the underlying facts of such claims are not wholly identical to the elements of a preference action or constructive fraudulent transfer action.
Keywords: Bankruptcy, Section 546(E) of the Bankruptcy Code, Safe Harbor, Leveraged Buyout, Ponzi Scheme, Intermediaries in Securities Clearing & Settlement System, Preemption of Fraudulent Transfer Actions Based on State Law, Systemic Risk, FTI Consulting v. Merit Management, in Re Tribune
JEL Classification: G33, G32, G00, G01, G11, G14, G18, G20, G21, G23, G24, K10, K12, K22, K41, M21, M38, O1, O16, Z23
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