In re Lyondell Chemical Co: SDNY Bankruptcy Court Holds that Section 546(e) Safe Harbor Does Not Bar State-law Fraudulent Transfer Claims | Practical Law

In re Lyondell Chemical Co: SDNY Bankruptcy Court Holds that Section 546(e) Safe Harbor Does Not Bar State-law Fraudulent Transfer Claims | Practical Law

The US Bankruptcy Court for the Southern District of New York in Weisfelner v. Fund 1 (In re Lyondell Chem. Co.) held that the safe harbor found in section 546(e) of the Bankruptcy Code does not bar or preempt individual creditors or their representatives from asserting state-law fraudulent conveyance claims against shareholders who received payments in connection with a leveraged buyout of the debtor.

In re Lyondell Chemical Co: SDNY Bankruptcy Court Holds that Section 546(e) Safe Harbor Does Not Bar State-law Fraudulent Transfer Claims

by Practical Law Finance
Published on 24 Feb 2014 • USA (National/Federal)
The US Bankruptcy Court for the Southern District of New York in Weisfelner v. Fund 1 (In re Lyondell Chem. Co.) held that the safe harbor found in section 546(e) of the Bankruptcy Code does not bar or preempt individual creditors or their representatives from asserting state-law fraudulent conveyance claims against shareholders who received payments in connection with a leveraged buyout of the debtor.
On January 16, 2014, the US Bankruptcy Court for the Southern District of New York in Weisfelner v. Fund 1 (In re Lyondell Chem. Co.) held that the safe harbor found in section 546(e) of the Bankruptcy Code does not bar or preempt individual creditors or their representatives from asserting state-law fraudulent conveyance claims against shareholders who received payments in connection with a leveraged buyout (LBO) of the debtor (503 B.R. 348 (Bankr. S.D.N.Y. 2014)). In doing so, it adopted the reasoning of the US District Court for the Southern District of New York in In re Tribune Co. Fraudulent Conveyance Litigation and expressly rejected that court's reasoning in Whyte v. Barclays Bank PLC (see Legal Updates, In re Tribune Co: Individual Creditors Lack Standing to Assert State-Law Fraudulent Transfer Claims, but Not Barred by Section 546(e) Safe Harbor and Whyte v. Barclays Bank: Court Rejects Attempt to Circumvent Section 546(g) Safe Harbor for Swap Transactions).

Background

In December 2007, Basell AF S.C.A. acquired Lyondell Chemical Corporation (Lyondell) through an LBO. The LBO was 100% financed by about $21 billion in secured debt, of which $12.5 billion was distributed to Lyondell shareholders. This "effectively depleted" Lyondell's assets and it filed for Chapter 11 relief in January 2009.
In April 2010, the Court confirmed Lyondell's plan of reorganization which, among other things:
  • Abandoned the estate's right to pursue, on behalf of individual creditors, state-law fraudulent transfer (SLFT) claims against several primarily institutional stockholders who had received proceeds from the LBO (Defendants), as section 546(e) of the Bankruptcy Code would likely have barred these claims had they been asserted by the estate.
  • Created a litigation trust (Creditor Trust), to which certain creditors assigned their SLFT claims, so that the Creditor Trust could pursue these claims on their behalf.
After Lyondell emerged from bankruptcy, the Creditor Trust sued the Defendants in New York Supreme Court for SLFT claims arising out of the LBO. The lawsuit sought to recover $6.3 billion of the $12.5 billion paid to shareholders in the LBO, but only from shareholders who received more than $100,000.
The Defendants removed the action to the US District Court for the Southern District of New York, which then referred the case to the Bankruptcy Court. The Defendants sought to dismiss the case on the following grounds:
  • The SLFT claims may not be brought because section 546(e) of the Bankruptcy Code:
    • bars these claims; and
    • preempts these claims.
  • The Creditor Trust could not recover because the transferred funds, which merely passed through the Debtors to the beneficial holders of Lyondell stock, were not property of the Debtors.
  • Many of the Defendants were merely nominees, non-beneficial holders or conduits who did not retain the proceeds of the LBO.
  • The Creditor Trust lacked standing to sue on behalf of the LBO lenders, whose SLFT claims were also assigned to the Creditor Trust, because they ratified the transfers by participating in the LBO.
  • The Creditor Trust failed to adequately plead its claims for intentional fraudulent transfer.

Outcome

The Court denied the motion to dismiss based on the first two grounds, holding that the Creditor Trust could pursue the SLFT claims because:
  • Section 546(e) did not apply to, nor preempt, these claims.
  • The transferred funds were the Debtors' property.
However, the Court narrowed the Creditor Trust's claims, dismissing them to the extent that they were:
  • Asserted against any conduits or non-beneficial owners of stock.
  • Asserted on behalf of LBO lenders.
  • For claims of intentional fraudulent transfer (dismissed without prejudice, with leave to replead).

Effect of Section 546(e)

The section 546(e) safe harbor provides that a trustee may not avoid prepetition:
  • Margin payments or settlement payments made by or to (or for the benefit of) certain protected parties.
  • Transfers made by or to (or for the benefit of) certain protected parties in connection with certain protected contracts.
(§ 546(e), Bankruptcy Code). For more information, see Bankruptcy Code Avoidance Action Safe Harbors: Section 546(e) Safe Harbor: Stockholder's Defense.
The Court ruled that section 546(e) does not:
  • Apply to individual creditors' SLFT claims.
  • Preempt constructive SLFT claims.

Section 546(e) Not Applicable to Individual Creditors' SLFT Claims

The Court, relying heavily on In re Tribune Co. Fraudulent Conveyance Litigation, held that the plain language of section 546(e) only prohibits a trustee from asserting SLFT claims and does not apply to SLFT claims brought by individual creditors or their representatives (see In re Tribune Co. Fraudulent Conveyance Litig., No. 11-MD-02296-RJS, (S.D.N.Y. Sept. 23, 2013) and Legal Update, In re Tribune Co: Individual Creditors Lack Standing to Assert State-Law Fraudulent Transfer Claims, but Not Barred by Section 546(e) Safe Harbor). Agreeing with Tribune, the Court noted that Congress did not make section 546(e) applicable to claims by or on behalf of individual creditors and that if Congress intended section 546(e) to be more broadly applicable, it could have simply said so. It found the statute's silence on this issue significant.
Therefore, the Defendants could not use section 546(e) to bar the Creditor Trust's claims.

Section 546(e) Does Not Preempt State Fraudulent Transfer Laws

The Court held that section 546(e) does not preempt state fraudulent transfer laws under the express, field or conflict preemption theories:
  • First, the Court held that express preemption does not apply because the plain language of section 546(e) does not prevent the enforcement of state fraudulent transfer laws. Further, Congress has demonstrated elsewhere in the Bankruptcy Code that it is able and willing to explicitly preempt individual creditor's state law claims, so had it intended to preempt SLFT claims, it would have done so explicitly. The Defendants did not even attempt to make this argument.
  • Second, the Court held that field preemption does not apply because Congress has not shown any intention to wholly "occupy the fields" of avoidance or recovery of fraudulent transfers or to preclude the enforcement of state laws on the same subject. In fact, as the Court noted, state fraudulent transfer laws predate federal fraudulent transfer law, and have a long history of coexistence with federal law.
  • Third, the Court held that conflict preemption does not apply because:
    • state fraudulent transfer law remedies do not make compliance with federal laws impossible; and
    • state fraudulent transfer laws do not stand as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress. Here, the Court relied heavily on Tribune, noting that there are many competing concerns addressed in bankruptcy policy, and that it is not entirely clear that the purpose of section 546(e) (protecting the stability of the nation's financial markets) trumps all of bankruptcy's other purposes. The Court also agreed with Tribune's finding that even after having been asked to do so, Congress failed to expressly preempt state fraudulent transfer law in other situations, and further that Congress demonstrated its ability and willingness to do so when it preempted state fraudulent transfer laws enabling individual creditors to recover certain charitable contributions.
The Court also rejected the Defendants' argument that state fraudulent transfer laws obstruct the purpose of section 546(e). It examined legislative history to determine that Congress enacted section 546(e) to protect the financial markets against the "ripple effects" caused by the insolvency of one commodity or security firm, not to protect "individual investors who are beneficial recipients of insolvents' assets." Therefore, the Court held that section 546(e) does not preempt "an action against cashed out beneficial holders of stock, at the end of the asset dissipation chain."
Finally, the Court rejected and distinguished the conflicting decision rendered by the District Court in Whyte v. Barclays Bank PLC (see 494 B.R. 196 (S.D.N.Y. 2013) and Legal Update, Whyte v. Barclays Bank: Court Rejects Attempt to Circumvent Section 546(g) Safe Harbor for Swap Transactions). First, in Barclays, the District Court dismissed SLFT claims asserted by a litigation trustee to whom the debtor and certain creditors assigned all of their federal and state law claims. The District Court held that section 546(g) of the Bankruptcy Code (the safe harbor for swap claims) expressly barred the litigation trustee from asserting claims as the debtor's assignee, and therefore also impliedly preempted it from asserting claims as the creditors' assignee. In contrast, here the Creditor Trust was only asserting creditor claims assigned to it by creditors after the estate abandoned its rights to pursue these claims. The Court then criticized Barclays for:
  • Declining to apply the "usual presumption against implied preemption" as directed by precedent set by the US Supreme Court and the US Court of Appeals for the Second Circuit.
  • Failing to consider Congressional objectives other than the protection of the financial markets.
  • Accepting, without any analysis, that voiding the payments at issue would disrupt the markets.

Transferred Funds Not Property of the Debtor

The Court rejected the Defendants' argument that the disputed funds were not the Debtors' property. It held that the Creditor Trust plausibly alleged facts that the two transactions comprising the LBO (the transfer of value to the LBO lenders in the form of liens securing the financing and the transfer of value to stockholders of the proceeds of the loans secured by Lyondell's assets) could be viewed as a single, "collapsed" transaction with the proceeds viewed as property of the Debtors.
For more information on the collapsing doctrine, see Practice Note, Fraudulent Conveyances: Issues and Strategies for Lenders and Private Equity Sponsors: "Collapsing" Transactions.

Mere Conduits Not Liable

In federal and state fraudulent transfer actions brought under federal law, recovery may only be obtained from an entity that is an "initial transferee" or for whose benefit the transfer was made. Because those who are not beneficial owners are not initial transferees, an alleged fraudulent transfer may not be recovered from "mere conduits" in the transfer. Therefore, the Court dismissed claims against Defendants who were either conduits that passed the LBO payments on to others, or who were "holders" of the stock (such as nominees or depositories) but not the beneficial owners.

Ratification by LBO Lender Creditors

The Court held that claims asserted by the Creditor Trust on behalf of the LBO lender creditors must be dismissed. By participating in the alleged fraudulent transfer, the LBO lenders must be deemed to have ratified the transfer and cannot seek to have it avoided.

Intentional Fraudulent Transfer Claims

The Court held that the Creditor Trust failed to adequately plead its intentional fraudulent transfer claims and dismissed those claims without prejudice, so that the Creditor Trust could replead them with more particularity.
For more information on intentional fraudulent transfer, see Practice Note, Fraudulent Conveyances in Bankruptcy: Overview: Actual Fraudulent Conveyance.

Practical Implications

Lyondell, like Tribune, highlights a loophole the effectiveness of the Bankruptcy Code's safe harbors from avoidance actions for financial transactions and could indicate a trend towards courts construing the section 546(e) safe harbor narrowly. Prior to these decisions, courts generally broadly applied the section 546(e) safe harbor (for example, see Legal Updates, In re Quebecor World (USA) Inc.: Second Circuit Broadly Applies Section 546(e) "Securities Contract" Safe Harbor, Second Circuit Holds that "Settlement Payment" Safe Harbor Insulates Early Redemptions of Enron Commercial Paper from Fraudulent Transfer and Preference Attack, In re Batavia Nursing Home: Section 546(e) Safe Harbor Covers Private LBOs Regardless of Size and In re Tougher Industries: LBO Wire Transfers without Financial Intermediary Qualify for Section 546(e) Safe Harbor).
The result in Lyondell may cause debtors and committees to consider abandoning fraudulent transfer claims that would otherwise be protected by the section 546(e) safe harbor, so that individual creditors would not be precluded from bringing these actions themselves. This leaves shareholders in failed LBOs vulnerable to fraudulent transfer actions brought by creditors under state law. Therefore, potential defendants in avoidance actions should carefully limit their exposure to SLFT actions by individual creditors when negotiating releases and assignments of claims to litigation trusts.
In following Tribune and rejecting Barclays, Lyondell also highlights a split within the Southern District of New York regarding the scope of the section 546(e) safe harbor, and creates uncertainty among market participants. However, the Second Circuit is scheduled later this year to hear the appeals of the Tribune and Barclays decision in tandem, which should provide more guidance and clarity in this area.
For more information on the section 546(e) safe harbor, see Practice Note, Bankruptcy Code Avoidance Action Safe Harbors and on the Bankruptcy Code's safe harbors generally, see Guide to Bankruptcy Code Safe Harbors for Financial Contracts: Checklist.