On June 10, 2013, the US Court of Appeals for the Second Circuit in Official Committee of Unsecured Creditors of Quebecor World (USA) Inc. v. American United Life Insurance Co. (In re Quebecor World (USA) Inc.) affirmed a broad interpretation of the "securities contract" safe harbor found in section 546(e) of the Bankruptcy Code by ruling that a debtor's $376 million prepetition purchase of private placement notes issued by its affiliate was not avoidable as a preference.

In 2000, Quebecor World Capital Corp. (QWCC), an affiliate of Quebecor World Inc. (QWI), raised $371 million by issuing a series of private placement notes under two Note Purchase Agreements (NPAs). These notes were guaranteed by Quebecor World (USA) Inc. (Debtor) and QWI. The NPAs permitted QWCC to prepay the notes if it paid the outstanding principal, accrued interest and a make-whole amount.

In 2008, the Debtor purchased the notes from the noteholders, wiring $376 million from its bank account at Bank of America to CIBC Mellon, the trustee for the notes. CIBC Mellon distributed the cash to the noteholders, who then returned the notes to QWI. CIBC Mellon never took title to the notes.

Less than 90 days after the purchase, the Debtor filed for Chapter 11 bankruptcy protection. The creditors' committee commenced an adversary proceeding to avoid and recover the $376 million payment as a preference under section 547(b) of the Bankruptcy Code.

The bankruptcy court ruled that the payment was shielded from avoidance under the safe harbors of section 546(e) of the Bankruptcy Code because the payment was both:

The bankruptcy court relied on the Second Circuit's decision in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.) in which it defined "settlement payment" as "a transfer of cash made to complete a securities transaction" (see Legal Update, Second Circuit Holds that "Settlement Payment" Safe Harbor Insulates Early Redemptions of Enron Commercial Paper from Fraudulent Transfer and Preference Attack). Alternatively, the bankruptcy court ruled that because Enron applied section 546(e) to redemptions of commercial paper, this payment also qualified as a transfer made "in connection with a securities contract," regardless of whether the Debtor redeemed or purchased the notes.

This district court affirmed the bankruptcy court's ruling that the Debtor's payment was a "settlement payment" under Enron. However, the district court did not agree that the securities contract safe harbor applied if the Debtor redeemed the notes. It reasoned that a transfer to redeem securities does not fit within the Bankruptcy Code's definition of "securities contract," which it defines as a contract "for the purchase, sale or loan of a security." Therefore, the district court affirmed the bankruptcy court's alternative holding that the "securities contract" safe harbor applied on the basis that the transfer was a purchase, not a redemption.

The creditors' committee appealed the district court's decision to the Second Circuit. The Second Circuit affirmed only on the grounds that transfer was protected from avoidance under the "securities contract" safe harbor of section 546(e) of the Bankruptcy Code. In doing so, the Second Circuit concluded that:

The Second Circuit agreed with the Third, Sixth and Eighth Circuits in holding that the plain language of section 546(e) of the Bankruptcy Code includes any transfer to a financial institution, even if it is merely a conduit or intermediary. The Second Circuit also noted that its ruling was consistent with the legislative purpose of the safe harbors to promote stability and minimize disruption in the commodities and securities markets in the event of a major bankruptcy affecting those industries.

The Second Circuit declined to address whether the result would be different if the Debtor had "redeemed" its own securities rather than purchased its affiliate's notes, agreeing with the district court that the transfer was a purchase of the notes, rather than a redemption.

The Second Circuit also declined to address whether the payments were also protected from avoidance by the settlement payment safe harbor because it already determined that they were protected under the "securities contract" safe harbor.

The Second Circuit's ruling continues the trend of the courts broadly interpreting the section 546(e) safe harbors to protect certain pre-bankruptcy financial contracts and payments from avoidance as preferences or constructive fraudulent transfers. Before this case, section 546(e) litigation focused primarily on the settlement payment defense, as the securities contract safe harbor was not added to the Bankruptcy Code until 2006. The ruling clarifies what types of transactions are protected from a trustee's avoidance powers under the securities contract safe harbor.

While this decision is beneficial for financial institutions, it may also have the unintended effect of expanding their exposure to preference and fraudulent transfer liability. The Second Circuit's interpretation of the securities contract safe harbor is somewhat inconsistent with the mere conduit defense to "initial transferee" liability under section 550(a)(1) of the Bankruptcy Code (see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors: Mere Conduit Defense). Its ruling that any transfer to a financial institution, even if it is a mere conduit, can be protected under the securities contract safe harbor begs the question why a financial institution acting as a mere conduit should not also be an initial transferee subject to preference and fraudulent transfer liability.

For more information of preferences, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors.