Boston Generating: Second Circuit Triples Down on Its Holding that Transfers Made Under Securities Contracts Are Safe Harbored in Bankruptcy if the Debtor-Transferee is a Customer of a Financial Institution

Section 546(e) of the Bankruptcy Code's "safe harbor" provision (which shields transactions from avoidance claims in bankruptcy of certain securities, commodity, or forward-contract payments) has long been a magnet for controversy. Several noteworthy court rulings have been issued in bankruptcy cases addressing the scope of the provision, including its limitation to transactions involving "financial institutions" as transferors or transferees, its preemption of avoidance litigation that could have been commenced by or on behalf of creditors under applicable non-bankruptcy law, and its application to non-public transactions. The U.S. Court of Appeals for the Second Circuit contributed the latest chapter in the continuing debate concerning the breadth of the safe harbor in In re Boston Generating, LLC, 2024 WL 4234886 (2nd Cir. Sept. 19, 2024). In an unpublished decision, the court of appeals affirmed lower court rulings that payments made as part of a pre-bankruptcy recapitalization transaction were shielded from avoidance under the safe harbor because they were made through an agent bank that qualified as a "financial institution," meaning that its customers, including the debtor-transferee, were also financial institutions. 

The Section 546(e) Safe Harbor

Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, which include the power to avoid certain preferential and fraudulent transfers. Section 546(e) provides that the trustee may not avoid, among other things, a pre-bankruptcy transfer that is a settlement payment "made by or to (or for the benefit of) a … financial institution [or a] financial participant …, or that is a transfer made by or to (or for the benefit of)" any such entity "in connection with a securities contract," except under section 548(a)(1)(A) of the Bankruptcy Code. Thus, the section 546(e) "safe harbor" bars avoidance claims challenging a qualifying transfer unless the transfer was made with actual intent to hinder, delay, or defraud creditors under section 548(a)(1)(A), as distinguished from constructively fraudulent transfers under section 548(A)(1)(B) where the debtor is insolvent at the time of the transfer (or becomes insolvent as a consequence) and receives less than reasonably equivalent value in exchange. 

Section 101(22) of the Bankruptcy Code defines the term "financial institution" to include, in relevant part: 

[A] Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity and, when any such Federal reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer (whether or not a "customer", as defined in section 741) in connection with a securities contract (as defined in section 741) such customer ….  

11 U.S.C. § 101(22). "Customer" is defined broadly in section 741(2) of the Bankruptcy Code to include any "entity with whom a person deals as principal or agent and that has a claim against such person on account of a security received, acquired, or held by such person in the ordinary course of such person's business as a stockbroker, from or for the securities account or accounts of such entity …." 11 U.S.C. § 741(2). The term "securities contract" is defined in section 741(7) of the Bankruptcy Code, and sections 101(51A) and 741(8) define the term "settlement payment."

According to the legislative history of section 546(e), the purpose of the safe harbor is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982). The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id. 

Notable Court Rulings 

Many notable court rulings have addressed whether: (i) section 546(e) preempts fraudulent transfer claims that can be asserted by or on behalf of creditors by a bankruptcy trustee under state law; (ii) the section 546(e) safe harbor insulates from avoidance only transactions involving publicly traded securities; and (iii) a "financial institution" must be the transferor or ultimate transferee, as distinguished from an intermediary or conduit, for a transaction to be insulated from avoidance under the safe harbor. 

Preemption. For example, in Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 818 F.3d 98 (2d Cir. 2016) ("Tribune 1"), the Second Circuit affirmed lower court decisions dismissing creditors' state law constructive fraudulent transfer claims arising from the 2007 leveraged buyout ("LBO") of Tribune Company ("Tribune"). According to the Second Circuit, even though section 546(e) expressly provides that "the trustee" may not avoid certain payments under securities contracts unless such payments were made with the actual intent to defraud, section 546(e)'s language, its history, its purposes, and the policies embedded in the securities laws and elsewhere lead to the conclusion that the safe harbor was intended to preempt constructive fraudulent transfer claims asserted by creditors under state law. 

The Second Circuit reaffirmed this approach in In re Nine W. LBO Sec. Litig., 87 F.4th 130 (2d Cir. 2023), cert. denied, 144 S.Ct. 2551 (2024) ("Nine West"), where the court adopted a "transfer-by-transfer" rather than a "contract-by-contract" approach to the safe harbor in affirming in part and reversing in part a district court ruling that section 546(e) preempted a litigation trustee's fraudulent transfer and unjust enrichment claims seeking avoidance of payments made to public and non-public shareholders as part of an LBO because only the public shareholder payments involved a "financial institution."

More recently, in Petr v. BMO Harris Bank N.A., 95 F.4th 1090 (7th Cir. 2024), the U.S. Court of Appeals for the Seventh Circuit affirmed a district court ruling broadly construing the section 546(e) safe harbor to bar a chapter 7 trustee from suing under state law and section 544 of the Bankruptcy Code to avoid an alleged constructively fraudulent transfer made by the debtor shortly after it had been acquired in an LBO. Among other things, the Seventh Circuit agreed with the district court's conclusions that section 546(e) preempted the trustee's claim to recover the value of the transfer under section 544 and state law. 

Public v. Private Transactions. Because section 546(e) is silent as to whether it applies to both public and private transactions, some courts, finding the language of the provision to be ambiguous and looking to its legislative history for guidance, have concluded that the safe harbor is limited to transactions involving publicly traded securities. See, e.g., Kipperman v. Circle Trust F.B.O. (In re Grafton Partners, L.P.), 321 B.R. 527, 539 (B.A.P. 9th Cir. 2005) (finding that section 546(e) places a "line between public transactions that involve the clearance and settlement process and nonpublic transactions that do not involve that process"); Kapila v. Espirito Santo Bank (In re Bankest Capital Corp.), 374 B.R. 333, 346 (Bankr. S.D. Fla. 2007) (section 546(e) is inapplicable where the "case did not involve the utilization of public markets or publicly traded securities"). 

Other courts have disagreed, concluding that section 546(e) is not on its face limited to transactions involving publicly traded securities, and that resort to the provision's legislative history is therefore unwarranted. See, e.g., BMO Harris, 95 F.4th at 1098 (holding that the safe harbor extends to transactions involving private securities that do not implicate the national system for the clearance and settlement of publicly held securities); In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013) (ruling that the safe harbor applied to insulate from avoidance a repurchase transaction for private-placement notes that involved payments to a noteholder trustee that was a "financial institution"); overruled in part on other grounds by Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 583 U.S. 366 (2018) ("Merit"); Brandt v. B.A. Capital Co. L.P. (In re Plassein Int'l Corp.), 590 F.3d 252 (3d Cir. 2009) (finding that the plain meaning of section 546(e) is clear, and holding that the provision is not limited to publicly traded securities, but also extends to transactions involving privately held securities), cert. denied, 559 U.S. 1093 (2010); In re QSI Holdings, Inc., 571 F.3d 545, 550 (6th Cir. 2009) ("[W]e hold that nothing in the text of § 546(e) precludes its application to settlement payments involving privately held securities"), overruled in part on other grounds by Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 583 U.S. 366 (2018); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009) (section 546(e) is not limited to public securities transactions and protects from avoidance a debtor's payments deposited in a national bank in exchange for its shareholders' privately held stock during an LBO); In re Olympic Nat. Gas Co., 294 F.3d 737, 742 n.5 (5th Cir. 2002) (by including references to both the commodities and securities markets, lawmakers meant to exclude from the automatic stay and avoidance as a constructively fraudulent transfer "both on-market, and the corresponding off-market, transactions"); In re Taylor, Bean & Whitaker Mortgage Corp., 2017 WL 4736682, *9 (M.D. Fla. Mar. 14, 2017) ("[I]f Congress wanted § 546(e) to apply to only non-private transactions, it has the constitutional authority to rewrite the statute. The judiciary, however, does not."); In re Lancelot Investors Fund, L.P., 467 B.R. 643, 655 (N.D. Ill. 2012) (section 546(e) "does not limit its protection to transactions made on public exchanges."). 

Financial Institution as Transferor or Transferee. Prior to the Supreme Court's 2018 ruling in Merit, there was a split among the circuit courts concerning whether the section 546(e) safe harbor barred state law constructive fraud claims to avoid transactions in which the "financial institution" involved was merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. See generally Collier on Bankruptcy ¶ 546.06[2] n.16 (listing cases) (16th ed. 2024). The Supreme Court resolved the circuit split in Merit. 

In Merit, a unanimous Supreme Court held that section 546(e) did not protect a transfer made as part of a non-public stock sale transaction through a "financial institution," regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, the relevant inquiry is whether the transferor or the transferee in the transaction sought to be avoided overall is itself a financial institution. Because the selling shareholder in the LBO transaction that was challenged in Merit was not a financial institution (even though the conduit banks through which the payments were made met that definition), the Court ruled that the payments fell outside of the safe harbor. 

In a footnote, the Court acknowledged that the Bankruptcy Code defines "financial institution" broadly to include not only entities traditionally viewed as financial institutions, but also the "customers" of those entities, when financial institutions act as agents or custodians in connection with a securities contract. Merit, 583 U.S. at 373 n.2. The selling shareholder in Merit was a customer of one of the conduit banks, yet never raised the argument that it therefore also qualified as a financial institution for purposes of section 546(e). For this reason, the Court did not address the possible impact of the selling shareholder's status on the scope of the safe harbor. 

The Second Circuit quickly filled that void. In In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), dismissing cert. in part, 141 S. Ct. 728 (2020), cert. denied, 141 S. Ct. 2552 (2021) ("Tribune 2"), the Second Circuit explained that, under Merit, the payments to Tribune's shareholders were shielded from avoidance under section 546(e) only if either Tribune, which made the payments, or the shareholders who received them, were "covered entities." It then concluded that Tribune was a "financial institution," as defined by section 101(22) of the Bankruptcy Code, and "therefore a covered entity." 

According to the Second Circuit, the entity Tribune retained to act as depository in connection with the LBO was a "financial institution" for purposes of section 546(e) because it was a trust company and a bank. Therefore, the court reasoned, Tribune was likewise a financial institution because, under the ordinary meaning of the term as defined by section 101(22), Tribune was the bank's "customer" with respect to the LBO payments, and the bank was Tribune's agent according to the common law definition of "agency." Tribune 2, 946 F.3d at 91; see also Kelley as Tr. of PCI Liquidating Tr. v. Safe Harbor Managed Acct. 101, Ltd., 31 F.4th 1058, 1065 (8th Cir. 2022) (noting that "we do not disagree" with Tribune 2's "basic assumption" that the customer of a financial institution may itself qualify as a financial institution for purposes of the section 546(e) safe harbor if it meets the definition of "financial institution" set forth in section 101(22)(A) of the Bankruptcy Code).  

Several bankruptcy and district courts in the Second Circuit picked up where the Second Circuit left off in Tribune 2, ruling that pre-bankruptcy recapitalization or LBO transactions were safe-harbored from avoidance as fraudulent transfers because they were effected through a bank or other qualifying financial institution. See, e.g., Holliday v. K Road Power Management, LLC (In re Boston Generating LLC), 617 B.R. 442 (Bankr. S.D.N.Y. 2020) (payments made to the members of LLC debtors as part of a pre-bankruptcy recapitalization transaction were protected from avoidance under section 546(e) because the debtors were "financial institutions," as customers of banks that acted as their depositories and agents in connection with the transaction), aff'd, 2021 WL 4150523 (S.D.N.Y. Sept. 13, 2021), aff'd, 2024 WL 4234886 (2nd Cir. Sept. 19, 2024); In re Nine W. LBO Sec. Litig., 482 F. Supp. 3d 187 (S.D.N.Y. 2020) (dismissing fraudulent transfer and unjust enrichment claims brought by a chapter 11 plan litigation trustee and an indenture trustee seeking to avoid payments made as part of an LBO, and ruling that the payments were protected by the safe harbor because they were made by a bank acting as the debtor's agent), aff'd in part, rev'd in part and remanded, 87 F.4th 130 (2d Cir. 2023), cert. denied, 144 S.Ct. 2551 (2024); SunEdison Litigation Trust v. Seller Note, LLC (In re SunEdison, Inc.), 620 B.R. 505, 515 (Bankr. S.D.N.Y. 2020) (noting that, under Merit, the "relevant transfer" was "the overarching transfer," and ruling that, because one step of an "integrated transaction" was effected through a qualified financial institution, section 546(e) shielded the "component steps" from avoidance as a constructive fraudulent transfer); see also In re Tops Holding II Corp., 646 B.R. 617 (Bankr. S.D.N.Y. 2022) (the safe harbor did not insulate a transaction whereby, after encumbering the assets of a privately held chapter 11 debtor with privately issued debt, certain private equity investors took massive dividends, because, although the proceeds of the private notes were intended to be deposited into the bank accounts of the debtors and the private equity investors, the parties' banks were not agents or custodians (as was the case in Tribune 2), and therefore were not qualifying recipients for purposes of section 546(e)), leave to appeal denied, 2023 WL 119445 (S.D.N.Y. Jan. 6, 2023). 

The Second Circuit revisited some of these issues in Boston Generating.  

Boston Generating 

Boston Generating LLC ("BosGen"), its holding company EBG Holdings LLC ("EBG"), and their subsidiaries (collectively, the "debtors") owned and operated electric power generating facilities near Boston. In November 2006, BosGen and EBG launched a leveraged recapitalization transaction whereby they borrowed approximately $2.1 billion from lenders, in part to fund a $925 million tender offer for EBG's member units and warrants, and the distribution of $35 million in dividends to EBG's members. The Bank of New York ("BNY") acted as the depository and agent for both BosGen and EBG in connection with the tender offer.  

The $2.1 billion cash infusion from the credit facilities was deposited into BosGen and EBG bank accounts at U.S. Bank National Association ("US Bank"). US Bank then transferred approximately $708 million (the "BofA transfer") to EBG's account at Bank of America ("BofA") to fund the unit buyback, warrant redemption, and dividend distribution and approximately $50 million to pay fees and expenses incurred in connection with the closing of the credit facilities. Thereafter, EBG caused the funds to be transferred to its accounts at BNY (the "BNY transfer" and, together with the BofA transfer, the "BosGen transfer"). In December 2006, EBG directed BNY to pay the BosGen transfer funds as part of the $925 million unit and warrant redemption payment and the $35 million dividend payment (the "dividend transfer") to EBG's members. 

The debtors filed for chapter 11 protection in the Southern District of New York in August 2010. After authorizing the sale of substantially all of the debtors' assets, the bankruptcy court confirmed a liquidating chapter 11 plan for the debtors in August 2011. The plan created a liquidating trust to pursue claims on behalf of the debtors' general unsecured creditors. The liquidating trustee commenced an adversary proceeding seeking, among other things, to avoid and recover the BofA transfer and the dividend transfer as intentional and constructive fraudulent transfers under the New York Debtor & Creditor Law. The defendants moved to dismiss, arguing that the transfers were safe-harbored under section 546(e).

The bankruptcy court granted the motion to dismiss the liquidating trustee's fraudulent transfer claims. The court ruled that: (i) section 546(e) preempted the claims; and (ii) the payments were protected by the section 546(e) safe harbor because BosGen and EBG were "financial institutions," as customers of US Bank and/or BNY. See Boston Generating, 617 B.R. at 480–90. 

Initially, the court acknowledged that neither Tribune 1 nor Tribune 2 addressed whether section 546(e) preempts intentional (as distinguished from constructive) fraudulent transfer claims under state law. Nonetheless, the court saw "no reason why Tribune's reasoning does not extend to intentional state law fraudulent transfer claims." Examining the plain language of section 546(e), the court declined to extend section 546(e)'s exception for federal intentional fraudulent transfer claims under section 548(a)(1)(A) to include state law intentional fraudulent transfer claims. 

According to the bankruptcy court: 

Congress may have specifically excluded state law intentional fraudulent transfer claims from section 546(e)'s exception having determined the need for stability in the securities markets overrode the potential danger of creditors escaping claims for intentional fraud based on a fear that inconsistent application of fifty (50) states' fraudulent transfer statutes would result in instability in the securities markets. 

Id. at 480. Looking at the BosGen transfer as an "integrated transaction," the bankruptcy court determined that the transfer satisfied the requirements for the safe harbor because: (i) "a transfer of cash to a financial institution made to repurchase and cancel securities—in other words, to complete a securities transaction—qualifies for the safe harbor as a settlement payment"; (ii) the LLC member units and warrants qualified as "securities" under the Bankruptcy Code's broad definition; (iii) the payments were made "in connection with a securities contract"—the tender offer; (iv) BosGen qualified as a "financial institution" by virtue of its relationship with US Bank, which acted as the agent of its customers BosGen and EBG in connection with the tender offer; and (v) additionally, or in the alternative, both BosGen and EBG qualified as "financial institutions" as customers of BNY, which acted as their agent in connection with the tender offers. 

Finally, the court also ruled that section 546(e) preempted the liquidating trustee's constructive fraudulent transfer claims under state law—an issue that was conceded by the trustee. 

The liquidating trustee appealed the decision to the district court, which affirmed. 

On appeal, the liquidating trustee argued that the BofA transfer was the "relevant transfer" for the purposes of his avoidance complaint and, misapplying Merit, the bankruptcy court concluded that the relevant transfer also included the BNY transfer. The avoidance defendants countered that the "'overarching transfer' was the payment by the Debtors of nearly $1 billion … to their shareholders in satisfaction of their equity interests." 

The district court explained that, in accordance with Merit, the relevant transfer is defined by the governing substantive avoiding power—here, the N.Y. Debtor & Creditor Law—which requires that, "where a transfer is only a step in a general plan, the plan must be viewed as a whole with all its composite applications." Boston Generating, 2021 WL 4150523, at *3 (citation and internal quotation marks omitted). Thus, the court concluded, the liquidating trustee improperly sought to avoid only one component—the BofA transfer—of the "overarching" BosGen transfer, which was "an integral transfer" in the leveraged recapitalization transaction. Analyzing the BofA transfer in a vacuum, the district court wrote, "would permit the trustee to circumvent the safe harbor by carving up an integrated securities transaction consisting of multiple component parts … [, which] would unnecessarily restrict the safe harbor and 'seriously undermine … markets in which certainty, speed, finality, and stability are necessary to attract capital.'" Id. (quoting Tribune 2, 946 F.3d at 90). 

The district court found no fault with the bankruptcy court's finding that the BosGen transfer was a settlement payment made in connection with a securities contract, as required by section 546(e). According to the district court, the bankruptcy court also properly found that BosGen was covered by the safe harbor because, as the customer of a bank or trust company—US Bank—that acted as its agent in connection with a securities contract, it was a "financial institution." 

The district court rejected the liquidating trustee's argument that a customer is a financial institution only when a bank makes or receives the relevant transfer on behalf of the customer. According to the court, even if the court were to adopt this approach, BosGen would satisfy it, when the transaction was viewed as a whole, rather than piecemeal, as urged by the liquidating trustee. In addition, the district court rejected the liquidating trustee's contention that a financial institution must be specifically identified as such in a securities contract to serve as a customer's agent. 

The district court also held that the bankruptcy court did not err in ruling that the $35 million dividend payment was safe harbored because it was a settlement payment made in connection with the tender offer. 

Finally, the district court held that the bankruptcy court properly concluded, in accordance with Tribune 2, that the liquidating trustee's state law fraudulent transfer claims (both intentional and constructive) were preempted by section 546(e). 

The liquidating trustee appealed the ruling to the Second Circuit. 

The Second Circuit's Ruling 

A three-judge panel of the Second Circuit affirmed on appeal in an unpublished opinion. 

Initially, the Second Circuit agreed with the lower courts that the BosGen transfer was executed in connection with a securities contract because "BosGen's credit facility agreements … expressly contemplated that the proceeds from the loan would be used 'to fund the Distribution and Tender Offer of EBG' and that Bos Gen would transfer the proceeds to EBG for that express purpose." Boston Generating, 2024 WL 4234886, at *2 (citations omitted). In addition, consistent with Merit's directive that the section 546(e) safe harbor applies to the "overarching" transfer, rather than its individual components, the Second Circuit concluded that the bankruptcy court correctly rejected the liquidating trustee's argument that each "component part" of the recapitalization transaction should be examined independently. Id. The Second Circuit also found no fault with the bankruptcy court's determination that, even if section 546(e) requires that the debtor be a party to the securities contract in question, the evidence clearly established that the tender offer was a contract among BosGen, EBG, and EBG's members. 

Next, the Second Circuit held that the bankruptcy court correctly concluded that both BosGen and EBG were "financial institutions," as defined by section 101(22)(A) of the Bankruptcy Code, because they were customers of their agent bank BNY. Id. at *3. In so ruling, the court of appeals rejected the argument that its conclusion was somehow inconsistent with its previous holding in Nine West that each transaction must be examined transfer-by-transfer, as distinguished from contract-by-contract, to determine whether the transaction is safe harbored under section 546(e). According to the Second Circuit, "even under Nine West's transfer-by-transfer approach, we look to the end-to-end transaction to determine whether the safe harbor applies." Id.  

Outlook 

With Tribune 2, Nine West, and, most recently, Boston Generating, the Second Circuit has now tripled down on its broad construction of the Bankruptcy Code's safe harbor protecting payments made as part of securities‑contract transactions from avoidance as constructively fraudulent transfers. Consistent with the Supreme Court's decision in Merit, such transactions qualify for the safe harbor provided, among other things, they were made by or with the assistance of a "financial institution" acting as the agent of its transferee-customer in the context of larger, overarching transactions. Going forward, parties should carefully document the sequencing (i.e., clearly stating what the transfers are doing and how such transfers work in context) and structuring (e.g., rely on a bank as agent) of the interim transfers such that each individual transfer tracks out to the overarching transfer. In the absence of any circuit split on this important issue, the Supreme Court is unlikely to resolve any lingering disputes among the courts any time soon.