On October 10, 2013, the Bankruptcy Court for the Northern District of New York, in Woodard v. PSEG Energy Technologies Asset Management Co., LLC (In re Tougher Industries, Inc.), ruled that wire transfers made from a debtor's bank account to another party in a prepetition, guaranteed leveraged buyout (LBO) qualified for protection under the section 546(e) safe harbor and therefore could not be avoided by the bankruptcy trustee.

In August 2003, PSEG Energy Technologies, Inc., predecessor in interest to PSEG Energy Technologies Asset Management Company, LLC (collectively, PSEG) and Jacob George Associates (JGA) entered into a stock purchase and sale agreement (Agreement). Under the Agreement, JGA acquired from PSEG all of the stock in Tougher Industries, Inc. and Tougher Mechanical, Inc. (collectively, Debtor) for $4.1 million. The stock purchase, which was structured as an LBO, called for $500,000 to paid at closing and the remaining $3.6 million to be accounted for by a promissory note. The note was secured by an unconditional guarantee from the Debtor (Corporate Guaranty), a security interest in all of the Debtor's assets and a personal guaranty from a principal of JGA.

Although the Agreement required $4.1 million to be paid by JGA, PSEG received about $3.6 million in the following installments:

In November 2006, Tougher Industries, Inc. filed for Chapter 11 bankruptcy in the US Bankruptcy Court for the Northern District of New York. In 2007, the court-appointed bankruptcy trustee (Trustee) caused Tougher Mechanical Inc. to file for bankruptcy. The cases were jointly administered under Federal Rule of Bankruptcy Procedure 1015(b).

In October 2008, the Trustee filed a complaint to avoid and recover the transfers made to PSEG based upon claims of fraudulent transfer. In March 2013, after protracted litigation, PSEG filed for a motion for summary judgment after which both PSEG and the Trustee engaged in oral argument and submitted additional memoranda of law in support of their positions.

PSEG argued that the Trustee's action should be dismissed because:

The Trustee countered by arguing that:

The Bankruptcy Court granted PSEG's motion for summary judgment and dismissed the Trustee's Second Amended Complaint. It concluded that all of the payments to PSEG were shielded from avoidance.

First, the Bankruptcy Court examined the initial $500,000 transfer by analyzing Bankruptcy Code provisions. According to section 544, a trustee can only avoid a transfer of the debtor's property or a transfer of the debtor's interest in property. Similarly, according to section 548, a trustee can only pursue causes of action to avoid transfers of an interest of the debtor's. Because JGA or its shareholders contributed the initial $500,000 payment to PSEG, the Bankruptcy Court concluded that the $500,000 was not the Debtor's property. Further, the Bankruptcy Court found nothing in the record indicating that the advance was meant to be a loan to the Debtor. Therefore, this transfer could not be the proper subject of a fraudulent transfer claim.

Second, the Bankruptcy Court asked whether the Debtor's remaining wire payments "were made by or to. . . [a] financial institution," which would qualify them for protection under the section 546(e) safe harbor. The Bankruptcy Court considered Second Circuit precedent, including:

The Bankruptcy Court also examined the case AP Services LLP v. Silva. In Silva, the bankruptcy trustee of a liquidated purchasing company attempted to recover LBO payments made to a family who owned a pharmacy. While the family claimed they qualified for protection under section 546(e), the trustee argued that the safe harbor was inapplicable because the funds for the payments had been wired directly to the family's account without the use of an intermediary. After analyzing the plain language of section 546(e), the statutory definition of the term "financial institution," and construing the term "settlement payment" extremely broadly, the US District Court for the Southern District of New York held that nothing in the language of section 546(e) or post-Enron case law indicates that an intermediary is necessary to trigger safe harbor protection. The Silva court also relied on a case from the US Court of Appeals for the Third Circuit, Brandt v. B.A. Capital Co., LP (In re Plassein Int'l Corp.), in which the Third Circuit held that settlement payments did not need to travel through the system of intermediaries and guarantees usually used in securities transactions and that financial institutions were implicated in transfers where a bank transferred LBO funds to shareholders' banks .

After finding Silva and Plassein to be persuasive, the Bankruptcy Court held that the plain language of section 546(e) does not require that a financial intermediary act as a conduit or take a beneficial interest in the transfer of settlement payments. Furthermore, because the Bankruptcy Code defines a "financial institution" to include a Federal reserve bank or a commercial or savings bank, the Bankruptcy Court concluded that the three wire transfers from the Debtor's bank account directly to PSEG's bank account were settlement payments "made to a financial institution." Finally, the Bankruptcy Court also rejected the Trustee's argument that the safe harbor should not be applied in this case because given the relatively small amount of money involved in the transaction, avoidance of the transfers would not substantially impact the financial markets. The Bankruptcy Court explained that the plain language of section 546(e) does not contain a threshold amount below which the safe harbor is unavailable and like the courts in Silva and Enron, it refused to base the application of the safe harbor on a factual determination as to whether a transaction's dollar amount would impact financial markets.

This case is one of several recent cases that have clarified the meaning and scope of the section 546(e) safe harbor. As a result of this decision, it may be more difficult for trustees to avoid settlement payments made in connection with LBOs simply because of the manner in which the payments are made.

The Bankruptcy Court's ruling continues the trend of courts broadly interpreting the section 546(e) safe harbor to bar avoidance actions in a variety of cases involving securities and the securities markets. For example, see the following Legal Updates:

For more information on the section 546(e) safe harbor, see Practice Note, Bankruptcy Code Avoidance Action Safe Harbors: Section 546(e) Safe Harbor: Stockholder's Defense and on the Bankruptcy Code's safe harbors generally, see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist.