On the heels of the New York District Court’s decision in the Tribune Company fraudulent conveyance litigation, the New York Bankruptcy Court has similarly held that section 546(e) of the Bankruptcy Code, which protects settlement payments from fraudulent transfer claims brought by a bankruptcy trustee under the Bankruptcy Code, does not preclude individual creditors, or their designees, from recovering a fraudulent transfer under state law.  See Weisfelner v. Fund 1, Case No. 10-4609 (Bankr. S.D.N.Y. Jan. 14, 2014).  Accordingly, former shareholders may be required to return payments received on account of their equity holdings to creditors under state law, notwithstanding the protections afforded them by the settlement payment defense in a bankruptcy case.

Case Background

Less than 13 months after its leveraged buy-out, Lyondell Chemical Company filed for chapter 11 protection in January 2009.  Pursuant to Lyondell’s chapter 11 plan, Lyondell’s creditors assigned their state law constructive fraudulent transfer claims with respect to the LBO to the LB Creditors Trust.  The LB Creditor Trust thereafter sought to recover approximately $6.3 billion from Lyondell’s former shareholders for payments that they received in exchange for their equity interests in the LBO.  According to the LB Creditor Trust, the LBO rendered Lyondell insolvent and undercapitalized and thus, the payments to the former shareholders, for which Lyondell receive no value, could be avoided as fraudulent transfers.  The LB Creditor Trust’s claims were based solely on state law and not the Bankruptcy Code.  In response to the LB Creditor Trust’s claims, certain former shareholders of Lyondell argued that the settlement payment defense under section 546(e) of the Bankruptcy Code immunized them.

Bankruptcy Court’s Analysis

Lyondell’s former shareholders argued that the settlement payment defense set forth in Bankruptcy Code section 546(e) protected the payments they received from state law fraudulent transfer claims asserted by the LB Creditor Trust.  Adopting the rationale of the Tribune court, the bankruptcy court disagreed.  The bankruptcy court noted that section 546(e) provides that “the trustee may not avoid a transfer.”  According to the bankruptcy court, the settlement payment defense thus, is applicable only to claims brought by a trustee on behalf of a debtor’s estate.  It does not apply to claims brought by individual creditors under state law.  “[T]here is no statutory text making section 546(e) applicable to claims brought on behalf of individual creditors, or displacing their state law rights, by plain meaning analysis or otherwise.”

The bankruptcy court also rejected the former shareholders contention that Bankruptcy Code section 546(e) preempts state constructive fraudulent transfer laws.  Under the Supremacy Clause of the Constitution, Congress may preempt state laws that conflict with federal law rendering such state laws ineffective.  Congress, however, did not expressly or implicitly preempt state fraudulent transfer laws by enacting Bankruptcy Code section 546(e).  Indeed, according to the bankruptcy court, Congress refused to preempt state law in this regard when it had the opportunity to do so, both at the time it enacted section 546(e) in 1977 and on the eight occasions thereafter when Congress amended section 546(e).

In reaching its conclusion, the bankruptcy court noted that it was somewhat at odds with the New York District Court’s decision in Whyte v. Barclays Bank, 494 B.R. 196 (S.D.N.Y. 2013) where the district court concluded that the Bankruptcy Code section 546(g) defense, which protects prepetition transfers made in connection with swap agreements from avoidance under the Bankruptcy Code, “preempts state-law fraudulent conveyance actions seeking to avoid ‘swap transactions’ as defined in the Code.”  According to the bankruptcy court, the Barclays case is distinguishable because the claims therein were being asserted by a single trust on behalf of both the bankruptcy trustee and individual creditors.  In the Lyondell case, the claims were being by the LB Creditor Trust asserting only the rights of individual creditors.  This “significant” difference in key facts justified the different outcomes.  Moreover, the bankruptcy court found the Barclays court’s preemption reasoning to be flawed in that it did not apply the appropriate standards for preemption, including “the usual presumption against implied preemption.”

Takeaway

A company’s payments to shareholders are, by definition, for less than reasonably equivalent value.  Therefore, if an LBO renders the target company insolvent or in severe financial distress, the shareholder payment may be subject to attack as a constructive fraudulent transfer under both the Bankruptcy Code and state law.  The settlement payment defense would protect shareholder payments against constructive fraudulent transfer claims brought by a bankruptcy trustee under the Bankruptcy Code.  While there is some support for the position that the settlement payment defense would apply to a state law constructive fraudulent transfer claim, former shareholders should be aware that based upon recent case law, including the Tribune and Lyondell decisions, they may be required to return their payments to a creditors trust (or other assignees of individual creditors’ claims) under state law.  This is one instance where what the Bankruptcy Code giveth, state law may taketh away.