Turbulence Continues in Safe Harbors

The bankruptcy court denied the motion to dismiss as to grounds 1 and 2, rejecting the defendants' arguments that such claims are immunized by the safe harbor provision contained in Section 546(e) of the Bankruptcy Code or are preempted by the Bankruptcy Code, granted the motion to dismiss as to grounds 3 and 4 and as to 5, granted the creditor trust leave to replead.

Background

In 2007, Lyondell Chemical Company (Lyondell) was acquired by means of an LBO that was completely financed by debt secured by Lyondell's assets. Pursuant to the LBO, Lyondell took on approximately $21 billion of secured indebtedness, of which $12.5 billion was paid out to Lyondell's shareholders. Less than 13 months after the LBO, Lyondell filed for Chapter 11. Lyondell's unsecured creditors found themselves behind $21 billion in secured debt, with Lyondell's assets effectively having been depleted by payments of $12.5 billion in loan proceeds to its shareholders. Under Lyondell's plan of reorganization, certain creditor trusts were created for the benefit of unsecured creditors, certain claims were assigned to such trusts. Subsequently, actions were commenced against certain
Lyondell shareholders by the creditor trusts regarding the LBO and related transactions.

Many of the institutional shareholders that had received LBO funds moved to dismiss. The bankruptcy court denied these motions, finding that the claims were not being asserted on behalf of the estate but on behalf of individual creditors, and concluded that: 1) the safe harbor provision contained in section 546(e) of the Bankruptcy Code did not apply to suits under state fraudulent transfer laws; and 2) such state law claims were not preempted by federal law.

The Bankruptcy Court's Ruling

The bankruptcy court relied on recent holdings in In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013) (Sullivan, J.) (Tribune) and Irving Tanning Company. See Transcript of Decision of Feb. 17, 2013, Development Specialists, Inc. v. Kaplan (In re Irving Tanning Co.), No. 12-01024 (Bankr. D. Me. Feb. 17, 2013), ECF No. 43 (Kornreich, J.) (Irving Tanning). Like the Tribune and Irving Tanning courts, the bankruptcy court stated that it could not conclude that section 546(e) covers individual creditors' fraudulent transfer claims. The court, again relying on Tribune, distinguished Whyte v. Barclays Bank PLC (Barclays), 494 B.R. 196 (S.D.N.Y. 2013) (Rakoff, J.) by noting that in the pending case, the creditor trust is not asserting claims on behalf of the Lyondell estate.

By way of background, Barclays was decided under section 546(g) of the Bankruptcy Code ' the safe harbor provisions relating to swap claims. In Barclays, Chapter 5 claims and creditors' claims under state law were assigned to a single litigation trust. The litigation trustee, however, only prosecuted fraudulent transfer claims under state law. The district court, however, granted the defendants' motion to dismiss, finding that section 546(g) expressly barred the litigation trustee from asserting claims as the assignee of the debtor-in-possession, and impliedly preempted the trustee's right to assert claims on behalf of creditors. The Barclays court found that 546(g) was intended to protect financial markets, noting earlier cases where courts had rejected attempts to repackage fraudulent transfer claims as state law claims.

However, the Barclays court sought to limit its ruling to a situation where both Chapter 5 and state-law clams are assigned to a single litigation trust. An appeal of the Barclays ruling is pending before the Second Circuit and will be heard together with an appeal in the Tribune case.

Preemption

The bankruptcy court also concluded that preemption fails because neither express or field preemption exists, noting that state and federal fraudulent transfer recovery schemes have coexisted, with the federal statute availing trustees of state remedies, for 75 years. The bankruptcy court also found that conflict preemption that occurs when state law actually conflicts with federal law, including where it is either: 1) impossible for a private party to comply with both state and federal requirements; or 2) where state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.

In connection with the impossibility branch of conflict preemption, the bankruptcy court noted that federal law does not require stockholders to sell their stock in LBOs or otherwise. State fraudulent transfer laws do not forbid a stockholder from receiving payment in exchange for its stock, even when payment comes pursuant to an LBO; they merely provide that if that stockholder effectively was unjustly enriched at the expense of creditors because the debtor was insolvent, the money must be paid back. In the LBO context, state fraudulent transfer laws do no more than attach consequences to past conduct, and grant rights of action to those unpaid creditors that have been injured thereby.

The bankruptcy court also observed that the second branch of conflict preemption ' the obstacle analysis ' comes into play when state law is asserted to stand as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress. It precludes state law that poses an actual conflict with the overriding federal purpose and objective. However, this standard poses a high threshold such that federal law does not preempt state law under obstacle preemption analysis unless the repugnance or conflict is so direct and positive that the two acts cannot be reconciled or consistently stand together.

Congressional Intent

Finally, the bankruptcy court considered the totality of Congressional intent. Relying on Tribune, the court concluded that presumably Congress could, if it wanted, determine that its interest in protecting markets (or market participants, which is not the same thing), should trump the historical priority of creditors over stockholders. Congress then could provide for express preemption of state law constructive fraudulent transfer claims, just as it did with respect to charitable gifts. But Congress did not do so, even though its enactment of section 544(b)(2) makes clear that it was well aware of that option.

The bankruptcy court further noted that nothing in the legislative history of the existing law evidences a desire to protect individual investors who are beneficial recipients of insolvents' assets. The repeatedly expressed concern, by contrast, has been that of protecting market intermediaries and protecting the markets ' in each case to avoid problems of “ripple effects,” i.e., falling dominos. Thus, at least in the context of an action against cashed out beneficial holders of stock, at the end of the asset dissipation chain, state law fraudulent transfer laws do not “stand as an obstacle” to “purposes and objectives of Congress” ' even if one were to ignore the remainder of bankruptcy policy and focus solely on the protection against the “ripple effects” that caused section 546(e) to come into being.

Property of the Debtors

Turning to the third ground to dismiss, the bankruptcy court also rejected the contention that the creditor trust cannot recover by asserting that the transferred funds were not property of the debtors. It found that the creditor trust had satisfactorily alleged facts plausibly supporting a conclusion that the LBO (under which Lyondell incurred debt and its assets were pledged, with the intent that loan proceeds go to Lyondell shareholders) was a unitary transaction that should be collapsed, for analytical purposes, to correspond to its economic substance and to the intent of those who allegedly structured the LBO in that fashion. The court was unpersuaded by the contention that an “application of funds” provision ' requiring LBO loan proceeds to be used solely for the purpose of the LBO ' denied Lyondell control over the use of proceeds, precluding a finding of debtor control over the borrowed funds.

The bankruptcy court agreed, however, that nominees, non-beneficial holders of Lyondell stock, and conduits through which consideration passed cannot be held liable. To the extent any defendant was merely a conduit through which LBO proceeds passed to another, or otherwise was not an ultimate beneficial recipient of the LBO proceeds, the claims against it were dismissed.

The court further agreed with the contention that the LBO secured lenders (whose rights to avoid fraudulent transfers were also assigned to the creditor trust) must be deemed to have ratified the transfers. Creditors that authorized or sanctioned the transaction, or, indeed, participated in it themselves, can hardly claim to have been defrauded by it, or otherwise to be victims of it. To the extent that relief is sought on behalf of entities that were LBO lenders themselves, the motion to dismiss such claims was granted.

Though disagreeing on several points with respect to the allegations of intentional fraudulent transfer, the bankruptcy court agreed that the allegations were deficient, but dismissed the intentional fraudulent transfer claims with leave to replead. If the creditor trust cannot plead facts supporting intent to hinder, delay or defraud on the part of a critical mass of the directors who made the decisions in question, the creditor trust must then allege facts plausibly suggesting that the CEO (who was only one member of a multi-member Board) or others could nevertheless control the disposition of [Lyondell's] property ' by influence on the remaining Board members.

Conclusion

Lyondell makes it clear that in order to survive a motion to dismiss fraudulent transfer claims, a plan should at least provide that creditors holding state-law fraudulent transfer claims be assigned to a separate trust and that such trust only prosecute such claims. Another option to consider may be to have the bankrupt estate either waive or expressly agree not to simultaneously pursue Chapter 5 avoidance claims to the extent such claims are protected by safe harbor provisions contained in section 546 of the Bankruptcy Code.

This strategy may be useful to counter the argument that segregation and separate prosecution of state law claims should be disregarded where either: 1) the right to pursue constructive fraudulent transfer Chapter 5 estate claims exists even though such claims are not being prosecuted; or 2) such claims are actually being separately pursued by the estate. A dual-track prosecution of constructive fraudulent transfer claims by a creditor trust and the estate raises a troublesome issue under section 362(a) with respect to the standing of a litigation trust to pursue state law claims. This is especially true where Chapter 5 constructive fraudulent transfer claims have either not been waived by, or are being pursued by or on behalf of the estate.

From the perspective of structuring LBO transactions, there are two takeaways. First, despite attempts to create conduits to isolate transferees from potential fraudulent transfer liability courts will still seek to collapse such transactions where the facts show that an insolvent or undercapitalized transferor incurred debt and pledged its assets with the intent that the proceeds of the transaction be paid to shareholders. To the extent that the LBO transaction uses a financial institution as an intermediary to receive payments, some protection from constructive fraudulent attack may remain although Lyondell and other cases discussed in this article seem to suggest otherwise.

Second, the expectation that the safe-harbor provision in section 546 of the Bankruptcy Code will protect such transactions from fraudulent transfer attack must be reevaluated, especially if the narrow reading of that provision in cases like Lyondell, Tribune and Irving Tanning continues. Further, any party with potential avoidance action liability should seek to limit exposure to state law fraudulent transfer actions by individual creditors with respect to any waivers and transfer and assignment of such claims to litigation trusts.

Next month, we discuss Lehman and the enforceability of contractual terms contained in a master agreement and accompanying schedule to liquidate and calculate amounts due under swap agreements.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at [email protected].

This two-part article highlights two recent decisions arising in the United States Bankruptcy Court for the Southern District of New York. The decisions in both Lyondell and Lehman demonstrate how courts are applying the so-called safe harbor provisions contained in the Bankruptcy Code to a variety of different factual circumstances and provide some valuable lessons and insights.

Lyondell Weisfelner v. Fund 1

(In re Lyondell Chemical Co.), 503 B.R. 348 (Bankr. S.D.N.Y. 2014) involved the transfer of funds to shareholders arising out of a leveraged buyout (LBO) transaction and the prosecution of state-court fraudulent transfer actions to recover those funds. Certain shareholder defendants sought to dismiss the actions on five grounds, namely that: 1) after a company files for bankruptcy, stockholder recipients of proceeds of leveraged buyouts are immunized from constructive fraudulent transfer claims by the Bankruptcy Code's section 546(e) safe harbor, even when the constructive fraudulent transfer claims are not brought by a trustee under the Bankruptcy Code, and instead are brought on behalf of individual creditors under state law; 2), the creditor trust cannot recover because the transferred funds were not property of the debtors; 3) many of the shareholder defendants were merely nominees, non-beneficial holders, or conduits; 4) the creditor trust lacked standing to sue on behalf of the lenders, who must be found to have ratified the transfers in question; and 5) the creditor trust failed to satisfactorily plead its claims for intentional fraudulent transfer.

The bankruptcy court denied the motion to dismiss as to grounds 1 and 2, rejecting the defendants' arguments that such claims are immunized by the safe harbor provision contained in Section 546(e) of the Bankruptcy Code or are preempted by the Bankruptcy Code, granted the motion to dismiss as to grounds 3 and 4 and as to 5, granted the creditor trust leave to replead.

Background

In 2007, Lyondell Chemical Company (Lyondell) was acquired by means of an LBO that was completely financed by debt secured by Lyondell's assets. Pursuant to the LBO, Lyondell took on approximately $21 billion of secured indebtedness, of which $12.5 billion was paid out to Lyondell's shareholders. Less than 13 months after the LBO, Lyondell filed for Chapter 11. Lyondell's unsecured creditors found themselves behind $21 billion in secured debt, with Lyondell's assets effectively having been depleted by payments of $12.5 billion in loan proceeds to its shareholders. Under Lyondell's plan of reorganization, certain creditor trusts were created for the benefit of unsecured creditors, certain claims were assigned to such trusts. Subsequently, actions were commenced against certain
Lyondell shareholders by the creditor trusts regarding the LBO and related transactions.

Many of the institutional shareholders that had received LBO funds moved to dismiss. The bankruptcy court denied these motions, finding that the claims were not being asserted on behalf of the estate but on behalf of individual creditors, and concluded that: 1) the safe harbor provision contained in section 546(e) of the Bankruptcy Code did not apply to suits under state fraudulent transfer laws; and 2) such state law claims were not preempted by federal law.

The Bankruptcy Court's Ruling

The bankruptcy court relied on recent holdings in In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310 (S.D.N.Y. 2013) (Sullivan, J.) (Tribune) and Irving Tanning Company. See Transcript of Decision of Feb. 17, 2013, Development Specialists, Inc. v. Kaplan (In re Irving Tanning Co.), No. 12-01024 (Bankr. D. Me. Feb. 17, 2013), ECF No. 43 (Kornreich, J.) (Irving Tanning). Like the Tribune and Irving Tanning courts, the bankruptcy court stated that it could not conclude that section 546(e) covers individual creditors' fraudulent transfer claims. The court, again relying on Tribune , distinguished Whyte v. Barclays Bank PLC ( Barclays ), 494 B.R. 196 (S.D.N.Y. 2013) (Rakoff, J.) by noting that in the pending case, the creditor trust is not asserting claims on behalf of the Lyondell estate.

By way of background, Barclays was decided under section 546(g) of the Bankruptcy Code ' the safe harbor provisions relating to swap claims. In Barclays, Chapter 5 claims and creditors' claims under state law were assigned to a single litigation trust. The litigation trustee, however, only prosecuted fraudulent transfer claims under state law. The district court, however, granted the defendants' motion to dismiss, finding that section 546(g) expressly barred the litigation trustee from asserting claims as the assignee of the debtor-in-possession, and impliedly preempted the trustee's right to assert claims on behalf of creditors. The Barclays court found that 546(g) was intended to protect financial markets, noting earlier cases where courts had rejected attempts to repackage fraudulent transfer claims as state law claims.

However, the Barclays court sought to limit its ruling to a situation where both Chapter 5 and state-law clams are assigned to a single litigation trust. An appeal of the Barclays ruling is pending before the Second Circuit and will be heard together with an appeal in the Tribune case.

Preemption

The bankruptcy court also concluded that preemption fails because neither express or field preemption exists, noting that state and federal fraudulent transfer recovery schemes have coexisted, with the federal statute availing trustees of state remedies, for 75 years. The bankruptcy court also found that conflict preemption that occurs when state law actually conflicts with federal law, including where it is either: 1) impossible for a private party to comply with both state and federal requirements; or 2) where state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.

In connection with the impossibility branch of conflict preemption, the bankruptcy court noted that federal law does not require stockholders to sell their stock in LBOs or otherwise. State fraudulent transfer laws do not forbid a stockholder from receiving payment in exchange for its stock, even when payment comes pursuant to an LBO; they merely provide that if that stockholder effectively was unjustly enriched at the expense of creditors because the debtor was insolvent, the money must be paid back. In the LBO context, state fraudulent transfer laws do no more than attach consequences to past conduct, and grant rights of action to those unpaid creditors that have been injured thereby.

The bankruptcy court also observed that the second branch of conflict preemption ' the obstacle analysis ' comes into play when state law is asserted to stand as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress. It precludes state law that poses an actual conflict with the overriding federal purpose and objective. However, this standard poses a high threshold such that federal law does not preempt state law under obstacle preemption analysis unless the repugnance or conflict is so direct and positive that the two acts cannot be reconciled or consistently stand together.

Congressional Intent

Finally, the bankruptcy court considered the totality of Congressional intent. Relying on Tribune, the court concluded that presumably Congress could, if it wanted, determine that its interest in protecting markets (or market participants, which is not the same thing), should trump the historical priority of creditors over stockholders. Congress then could provide for express preemption of state law constructive fraudulent transfer claims, just as it did with respect to charitable gifts. But Congress did not do so, even though its enactment of section 544(b)(2) makes clear that it was well aware of that option.

The bankruptcy court further noted that nothing in the legislative history of the existing law evidences a desire to protect individual investors who are beneficial recipients of insolvents' assets. The repeatedly expressed concern, by contrast, has been that of protecting market intermediaries and protecting the markets ' in each case to avoid problems of “ripple effects,” i.e., falling dominos. Thus, at least in the context of an action against cashed out beneficial holders of stock, at the end of the asset dissipation chain, state law fraudulent transfer laws do not “stand as an obstacle” to “purposes and objectives of Congress” ' even if one were to ignore the remainder of bankruptcy policy and focus solely on the protection against the “ripple effects” that caused section 546(e) to come into being.

Property of the Debtors

Turning to the third ground to dismiss, the bankruptcy court also rejected the contention that the creditor trust cannot recover by asserting that the transferred funds were not property of the debtors. It found that the creditor trust had satisfactorily alleged facts plausibly supporting a conclusion that the LBO (under which Lyondell incurred debt and its assets were pledged, with the intent that loan proceeds go to Lyondell shareholders) was a unitary transaction that should be collapsed, for analytical purposes, to correspond to its economic substance and to the intent of those who allegedly structured the LBO in that fashion. The court was unpersuaded by the contention that an “application of funds” provision ' requiring LBO loan proceeds to be used solely for the purpose of the LBO ' denied Lyondell control over the use of proceeds, precluding a finding of debtor control over the borrowed funds.

The bankruptcy court agreed, however, that nominees, non-beneficial holders of Lyondell stock, and conduits through which consideration passed cannot be held liable. To the extent any defendant was merely a conduit through which LBO proceeds passed to another, or otherwise was not an ultimate beneficial recipient of the LBO proceeds, the claims against it were dismissed.

The court further agreed with the contention that the LBO secured lenders (whose rights to avoid fraudulent transfers were also assigned to the creditor trust) must be deemed to have ratified the transfers. Creditors that authorized or sanctioned the transaction, or, indeed, participated in it themselves, can hardly claim to have been defrauded by it, or otherwise to be victims of it. To the extent that relief is sought on behalf of entities that were LBO lenders themselves, the motion to dismiss such claims was granted.

Though disagreeing on several points with respect to the allegations of intentional fraudulent transfer, the bankruptcy court agreed that the allegations were deficient, but dismissed the intentional fraudulent transfer claims with leave to replead. If the creditor trust cannot plead facts supporting intent to hinder, delay or defraud on the part of a critical mass of the directors who made the decisions in question, the creditor trust must then allege facts plausibly suggesting that the CEO (who was only one member of a multi-member Board) or others could nevertheless control the disposition of [Lyondell's] property ' by influence on the remaining Board members.

Conclusion

Lyondell makes it clear that in order to survive a motion to dismiss fraudulent transfer claims, a plan should at least provide that creditors holding state-law fraudulent transfer claims be assigned to a separate trust and that such trust only prosecute such claims. Another option to consider may be to have the bankrupt estate either waive or expressly agree not to simultaneously pursue Chapter 5 avoidance claims to the extent such claims are protected by safe harbor provisions contained in section 546 of the Bankruptcy Code.

This strategy may be useful to counter the argument that segregation and separate prosecution of state law claims should be disregarded where either: 1) the right to pursue constructive fraudulent transfer Chapter 5 estate claims exists even though such claims are not being prosecuted; or 2) such claims are actually being separately pursued by the estate. A dual-track prosecution of constructive fraudulent transfer claims by a creditor trust and the estate raises a troublesome issue under section 362(a) with respect to the standing of a litigation trust to pursue state law claims. This is especially true where Chapter 5 constructive fraudulent transfer claims have either not been waived by, or are being pursued by or on behalf of the estate.

From the perspective of structuring LBO transactions, there are two takeaways. First, despite attempts to create conduits to isolate transferees from potential fraudulent transfer liability courts will still seek to collapse such transactions where the facts show that an insolvent or undercapitalized transferor incurred debt and pledged its assets with the intent that the proceeds of the transaction be paid to shareholders. To the extent that the LBO transaction uses a financial institution as an intermediary to receive payments, some protection from constructive fraudulent attack may remain although Lyondell and other cases discussed in this article seem to suggest otherwise.

Second, the expectation that the safe-harbor provision in section 546 of the Bankruptcy Code will protect such transactions from fraudulent transfer attack must be reevaluated, especially if the narrow reading of that provision in cases like Lyondell, Tribune and Irving Tanning continues. Further, any party with potential avoidance action liability should seek to limit exposure to state law fraudulent transfer actions by individual creditors with respect to any waivers and transfer and assignment of such claims to litigation trusts.

Next month, we discuss Lehman and the enforceability of contractual terms contained in a master agreement and accompanying schedule to liquidate and calculate amounts due under swap agreements.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at [email protected].