Second Circuit Rules That Issuer’s Payments to Redeem Its Commercial Paper Are Protected From Avoidance in Bankruptcy

August 11, 2011

Second Circuit Rules That Issuer’s Payments to Redeem Its Commercial Paper Are Protected From Avoidance in Bankruptcy

In a case of first impression in the United States Courts of Appeals, the Second Circuit (“Second Circuit” or “Court”) in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. held in a 2-1 decision that payments made by an issuer to redeem its commercial paper prior to maturity were “settlement payments” within the plain language of 11 U.S.C. § 741(8) (“Section 741(8)”) and protected from avoidance actions in bankruptcy under the safe harbor provision of 11 U.S.C. § 546(e) (“Section 546(e)”). The Court determined that a “settlement payment” is a payment made to complete a securities transaction and an issuer’s payments to redeem its commercial paper, which the Bankruptcy Code defines as a security, were “settlement payments” that fell within Section 546(e)’s scope. The Court’s broad interpretation of “settlement payment” is good news for investors and other market participants who, in the course of buying and selling commercial paper, may receive payments from an issuer of commercial paper that later ends up in bankruptcy and seeks to avoid and recover amounts paid within 90 days of the bankruptcy filing. However, as Judge Koeltl points out in his well-reasoned Dissent, the Court’s broad reading of “settlement payment” “would seem to bring virtually every transaction involving a debt instrument within the safe harbor of Section 546(e), thus allowing the settlement payment exception to swallow up the Section 547(b) avoidance provision.” Following the Enron Creditors Recovery Corp. decision, many more payments that are made in connection with securities could be protected from avoidance actions under the safe harbor of Section 546(e), at least in the Second Circuit.

The Facts

Between October 25, 2001 and November 6, 2001, approximately one month before Enron Creditors Recovery Corp.’s (“Enron”) chapter 11 bankruptcy filing, Enron paid more than $1.1 billion to the holders (“Holders”) of some of its unsecured and uncertificated commercial paper (“Commercial Paper”) in order to redeem the Commercial Paper prior to maturity. The Holders delivered their respective beneficial ownership positions through The Depository Trust Company (“DTC”), as clearing agency for the subject Commercial Paper. DTC then forwarded the redemption payments for payment to the Holders and extinguished the Commercial Paper on its system. DTC did not take title to the Commercial Paper, but merely acted as a conduit to facilitate the redemption. Enron redeemed the Commercial Paper at the accrued par value (calculated as the price originally paid by the holders plus accrued interest), which was substantially higher than its market value. Roughly two years later, the reorganized Enron filed suit against approximately two-hundred investors seeking to recover the redemption payments as preferential transfers under 11 U.S.C. § 547(b) and as constructive fraudulent transfers under 11 U.S.C. § 548(1)(b).

The Rulings

The Bankruptcy Court for the Southern District of New York (“Bankruptcy Court”) denied the investor defendants’ motion to dismiss and held that (i) the definition of “settlement payment” in Section 741(8) is limited to payments that are “commonly used in the securities trade” and it needed evidence to determine whether Enron’s redemption payments were “commonly used in the securities trade” and (ii) factual issues existed as to whether the redemption payments were made to retire or purchase the Commercial Paper. Following the Bankruptcy Court’s ruling, most of the defendant investors settled with Enron; however, certain investors, Alfa, S.A.B. de C.V. (“Alfa”) and ING VP Bond Portfolio, Inc. and ING VP Bond Portfolio, Inc. (“ING” and together with Alfa, the “Investors”), continued with discovery and moved for summary judgment. The Bankruptcy Court denied the Investors’ motion for summary judgment and determined that “settlement payments” under Section 741(8) are limited to those payments made to buy or sell securities and do not include payments made to retire debt. On appeal, the District Court for the Southern District of New York (“District Court”) reversed the Bankruptcy Court and found in favor of the Investors that (i) “settlement payments” under Section 741(8) are not confined to payments which are “commonly used in the securities trade”, (ii) “settlement payments” include any transfer that completes securities transactions and (iii) Enron’s redemption was a securities transaction, irrespective of whether Enron acquired title to the Commercial Paper, because it included an exchange of funds and securities. The Second Circuit affirmed the District Court’s decision and held that Enron’s redemption payments were settlement payments pursuant to Section 741(8) and thus protected from avoidance as preferences or constructive fraudulent transfers under Section 546(e).

In reaching its decision, the Second Circuit focused on the plain language of the statute and case law to conclude that a protected “settlement payment” is a “transfer of cash… made to complete [a] securities transaction” and that no purchase or sale of the securities was necessary. The Court pointed out that this definition is consistent with existing case law because it would include payments made on “tradeable debt securities” yet exclude “payments made on ordinary loans.” In the course of addressing some of Enron’s other arguments, the Second Circuit also noted that “the absence of a financial intermediary that takes title to the transacted securities during the course of the transaction” was not a valid reason for denying the protection of the safe-harbor and a “settlement payment” does not necessarily need to be “commonly used in the securities trade” to warrant protection under Section 546(e).

The Analysis

The Second Circuit’s expansive interpretation of the Section 546(e) safe harbor provision in Enron Creditors Recovery Corp. may limit some of the risk that investors in commercial paper and other securities face with respect to the avoidance of payments made on securities transactions. Indeed, the Court recognized the value of “certainty and predictability” in the securities industry and the importance of a bright-line rule in this area of the law. In the course of crafting a clear rule of law, the Second Circuit took an all-encompassing view of the Section 546(e) safe harbor and established a Second Circuit precedent that is likely to protect most payments on securities transactions from avoidance.

In the aftermath of the Enron Creditors Recovery Corp. decision, it is unclear what types of payments, if any, in respect of securities issuances would remain subject to possible avoidance. For instance, payments made on ordinary loans, which the Court was careful to distinguish as not being protected under the safe harbor, are often securitized and thus could wind up being encompassed in the Court’s broad definition of Section 546(e). The Second Circuit’s interpretation of a “settlement payment” coupled with the Bankruptcy Code’s inclusive definition of security, would seem to shield from avoidance in bankruptcy a wide range of payments made in respect of securities transactions involving commercial paper and other securities. Additionally, as the Dissent warns, this decision appears to be inconsistent with the existing case law on Section 546(e) and “threaten… routine avoidance proceedings in bankruptcy court.” Accordingly, the decision, at least in the short-term, may have the unintended consequence of creating uncertainty for courts that are called upon to interpret the extent of the Section 546(e) safe harbor and reconcile Enron Creditors Recovery Corp. with the existing case law.

Enron has petitioned the Court for a rehearing before the entire Second Circuit en banc. Enron’s petition contends that the Court’s decision is a “sea –change in bankruptcy law” that “could dramatically alter the course of bankruptcy proceedings.” If Enron’s request for a rehearing is granted, the Second Circuit will have another opportunity to consider this issue.