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Second Circuit Exempts Commercial Paper Redemptions from Bankruptcy Avoidance

By Jonathan B. Stepanian, Litigation News Associate Editor – August 31, 2011

A divided U.S. Court of Appeals for the Second Circuit recently issued a decision that, depending on which judge is correct, either “imperil[s] decades of cases that allow avoidance of debt-related payments,” or represents a straightforward application of a safe harbor. Thus, while Enron's historic collapse may be old news, the legal consequences of the company's bankruptcy continue to reverberate.

In Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., the appellate court held that early redemptions of commercial paper are "settlement payments." Accordingly, they may not be avoided as preferential transfers under the U.S. Bankruptcy Code (the Code).

The appeal presented “an issue of first impression in the courts of appeals: whether 11 U.S.C. § 546(e), which shields ‘settlement payments’ from avoidance actions in bankruptcy, extends to an issuer’s payments to redeem its commercial paper.” Its decision may have far reaching implications limiting bankruptcy trustees' powers to avoid preferential transfers in other bankruptcy cases, and at least one lower court has already permit $376 million of similar transfers to stand.

Enron Seeks Return of $1.1 Billion in Allegedly Preferential Transfers
One month before filing for bankruptcy, Enron paid out more than $1.1 billion in early commercial paper redemptions to approximately 200 financial institutions, including Alfa and ING. Enron made redemptions to those institutions through the Depository Trust Company. According to the Court, Enron's early redemption payments were "considerably higher than the paper's market value."

After Enron filed for bankruptcy, these pre-petition transfers ultimately came under scrutiny. The Code provides the bankruptcy trustee with the ability to avoid most debt payments made within 90 days of the bankruptcy filing.

Enron Creditors Recovery Corp.—the reorganized entity—filed suit in 2003 against the financial institutions to which its predecessor made early redemption payments, including Alfa and ING. It sought to avoid and recover the payments as preferential transfers under section 547 of the Code. Combined, Enron made $53.6 million in early redemption payments to Alfa and ING.

Most of the other defendants settled prior to appeal and Enron reportedly has recovered more than $172 million in cash settlements arising from its commercial paper litigation. Alfa and ING, however, maintained that the redemption payments were "settlement payments" protected from avoidance by section 546(e) of the Code.

The Safe Harbor for “Settlement Payments” of Securities Transactions
The Code, in section 741, defines "settlement payments" as "a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities trade." Section 546(e) provides a safe harbor that protects settlement payments made to certain individuals and institutions, such as stockbrokers, financial institutions, or securities clearing agencies.

The safe harbor extended to settlement payments limits the market risk associated with requiring commodities and securities firms to repay settled securities transactions. Having to repay on settled transactions potentially leaves those firms without sufficient capital or liquidity to meet trading obligations.

The appellate court held that Enron's early commercial paper redemption payments constitute "settlement payments" as defined by the Code. Therefore, according to the appellate court, the payments are protected from avoidance actions by operation of the statutory safe harbor provision.

Enron's Attempted Avoidance of Redemption Payments
Enron sought to avoid the early redemption payments because the payments did not constitute a purchase or sale where title to securities changed hands. Instead, according to Enron, the payments involved the retirement of existing debt.

The appellate court rejected Enron's argument, however, because in the securities industry a settlement refers only to the "completion of a securities transaction." The appellate court found no basis in the Code to impose a purchase or sale requirement to qualify a "settlement payment" exempt from avoidance.

Enron also argued that the redemption payments did not implicate the policy considerations underlying enactment of the safe harbor because a financial intermediary was not involved. Again, the appellate court disagreed.

The appellate court stated that the safe harbor was not limited to financial intermediaries. Instead, the broad market concerns that gave rise to the safe harbor equally exist in transactions without intermediaries. Enron's redemption payments, for example, amounted to over one billion dollars and involved approximately 200 noteholders. Unwinding those payments could "also have a substantial and similarly negative effect on the financial markets" regardless of the lack of a financial intermediary's involvement, according to the Court.

Potential Breadth of Second Circuit's Opinion
District Judge John G. Koeltl, sitting by designation, authored a sharply worded dissent. Judge Koeltl warned that applying the safe harbor to Enron's redemptions contradicts "uniform case law spanning two decades" that allows "avoidance of debt-related payments."

Judge Koeltl also observed that the majority's opinion "would seem to bring virtually every transaction involving a debt instrument within the safe harbor . . . allowing the settlement payment exception to swallow up . . . the avoidance provision."

"I think that's overstating it," says John R. Burns, III, Ft. Wayne, Indiana, cochair of the ABA Section of Litigation's Bankruptcy and Insolvency Committee. “I think the presence of an intermediary was a primary factor for the majority in the case,” he adds.

The presence or absence of an intermediary, however, may be "irrelevant" according to Deborah D. Williamson, San Antonio, Texas, cochair of the Section of Litigation's Bankruptcy and Insolvency Committee. "The argument will be that I could have a private transaction as long as I use a financial institution and, as long as the transaction qualifies as a security," the safe harbor applies under the majority's broad definition, says Williamson.

Decision Is Already Having an Impact
Judge Koeltl's dire predictions may be materializing. The U.S. Bankruptcy Court for the Southern District of New York recent decision, In re Quebecor World (USA) Inc. [PDF], relies on Enron to exempt the prepetition repurchase of $376 million in private notes from avoidance under 546(e).

In Quebecor, the bankruptcy court sympathized that, “Purely from an equitable perspective, the disparity in relative recoveries between the Noteholders and Quebecor’s other creditors almost cries out for a remedy.” It observed, however, that the Second Circuit in Enron broadened the safe harbor provisions to “cover such a long list of debt and equity instruments [that] the impact of the decision on avoidance actions may be quite far reaching,” and noted the Second Circuit’s ruling “agreed with several recent decisions by Courts of Appeal that addressed the issue” of whether an unusual or atypical delivery process removes a transaction from the definition of “settlement payment.”

Keywords: litigation, bankruptcy, commercial paper redemptions, Second Circuit, Section 546 of Bankruptcy Code

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