Second Circuit Decision in Enron Affirms That Bankruptcy Code Safe Harbor Applies to Pre-Maturity Commercial Paper Payments

On June 28, 2011, the Second Circuit Court of Appeals decided Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., ING VP Balanced Portfolio, Inc., and ING VP Bond Portfolio, Inc., providing further assurance to investors in commercial paper that their secondary market transactions in the paper of a distressed issuer will not be unwound. The court held that Bankruptcy Code § 546(e), which protects a “Settlement Payment” from a bankruptcy trustee’s avoidance powers, applied to three holders of Enron Corporation’s commercial paper which, in the weeks leading up to the Enron bankruptcy filing, and before the paper had matured, sold it through a securities clearing agency to a broker-dealer, who then transferred the paper back to Enron.¹ Enron had sought to avoid the payments made to these holders as fraudulent conveyances and preferential transfers. The Second Circuit’s decision thus upholds an important ruling by the Southern District of New York concerning the immunity from later bankruptcy attack of securities settlements made with distressed borrowers through securities clearing houses. 

The decision represents a second straight appellate victory in the case for Bingham. Partners Sabin Willett, Harold Horwich, Mark Elliott and Joshua Dorchak led the successful defense of two ING fund defendants, from which Enron had sought approximately $49 million.

Prior to its December 2001 bankruptcy filing, Enron paid approximately $1.2 billion to redeem and retire a portion of its commercial paper prior to the paper’s maturity. In 2003, two years after its bankruptcy filing, Enron brought a $1.2 billion “clawback” suit in the Bankruptcy Court for the Southern District of New York against more than 200 former investors and financial institutions who had participated in that redemption. 

The noteholder defendants asserted that they were entitled to keep the money received in exchange for Enron’s commercial paper, among other reasons, because of the “settlement payment” safe harbor of Bankruptcy Code § 546(e). The trades had settled on the Depository Trust Company’s same-day settlement system.

Enron prevailed in the Bankruptcy Court on preliminary motions. Following the Bankruptcy Court’s denial of defendants’ motions to dismiss, and after approximately two years of voluminous expert and fact discovery, all but three defendants settled. When the Bankruptcy Court then denied those three defendants’ motions for summary judgment in 2009, the defendants sought an interlocutory ruling. The Southern District of New York accepted the appeal, reversed and directed the Bankruptcy Court to enter summary judgment for the defendants. Enron appealed that decision, and oral arguments were held at the Second Circuit in the Fall of 2010.  

Prior to these decisions, few decisions within the Second Circuit provided guidance as to the scope of the “safe harbor” under Bankruptcy Code § 546(e) for the millions of “settlement payments” that settle on New York’s clearing agencies each day, and so the new decision provides much-needed guidance.

The court held that the plain language of the Bankruptcy Code safe harbor provision extends to commercial paper, as the payments made to noteholders were “settlement payments” under the applicable legal definition of that term. In a matter of first impression, the court followed its sister circuits in defining a “settlement payment” as “the transfer of cash or securities made to complete [a] securities transaction,” citing, e.g., Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 985 (8th Cir.2009).² It noted that the securities industry considered the payments here to be transfers of cash or securities made to complete a securities transaction, as evidenced by various industry definitions,³ terminology appearing on trade confirmations and other contemporaneous documents,⁴ and the use in the transactions of “the customary mechanism of the Depository Trust Company.”⁵

The court rejected Enron’s statutory interpretation, according to which the applicability of the safe harbor must in “every case depend on a factual determination regarding the commonness of a given transaction,” including, perhaps, details such as the economic motivations for the transaction and the frequency of such transactions in the marketplace.⁶ The court explained: “This reading of the statute would result in commercial uncertainty and unpredictability at odds with the safe harbor’s purpose and in an area of law where certainty and predictability are at a premium.”⁷

The court also refused to credit Enron’s argument “that redemption payments are not settlement payments” because they retired debt “and were not [made] to acquire title to the commercial paper.” The court concluded that the Bankruptcy Code imposed no “purchase or sale” requirement, and held that Enron’s “proposed exclusions from the reach of § 546(e) have no basis in the Bankruptcy Code.”⁸ 

The court similarly rejected Enron’s contention that commercial paper is not a security, relying upon the Bankruptcy Code’s own definition of “security” at 11 U.S.C. § 101(49)(A)(i), according to which the term applies to a “note,” such as that evidencing commercial paper.⁹

Finally, the court declined to consider an argument by Enron regarding the safe harbor’s legislative history, reiterating that “the sole function of the courts — at least where the disposition required by the [statutory] text is not absurd — is to enforce it according to its terms.”¹⁰

In a lengthy dissent, District Judge Koeltl agreed with the Bankruptcy Court below that the definition of “settlement payment” should include a requirement that there be a purchase or sale of a security.¹¹ According to Judge Koeltl, the statute itself is ambiguous, and the Second Circuit’s decision not to require a purchase and sale requirement extends the concept of settlement payment “to every transaction in which commercial paper is redeemed by an issuer prior to maturity using the customary mechanism of the Depository Trust Company.” This, Judge Koeltl thought, is too broad an interpretation, especially where the central issue in the case “has never been decided previously by any court of appeals,” and where the result is to exempt this now broad category of “settlement payments” from a bankruptcy trustee’s avoidance powers, potentially threatening “routine avoidance proceedings in bankruptcy courts.”¹²

The holders were supported at the Second Circuit by the Securities and Exchange Commission and the Securities Industry and Financial Markets Association, which filed amicus curiae briefs arguing, in part, that the applicability of the safe harbor to the transfers here is critical to the predictability and smooth functioning of the commercial paper markets. 

This latest decision is a win for investors who sell the commercial paper of insolvent companies in the secondary market. It is expected to provide much-needed certainty regarding the scope of what constitute “settlement payments” for bankruptcy avoidance purposes within the Second Circuit, and thus to help instill market confidence in the finality of settled transactions in commercial paper.

Sabin Willett, Partner, Financial Restructuring Group
sabin.willett@bingham.com, 617.951.8775

Harold S. Horwich, Partner, Insurance Group
harold.horwich@bingham.com, 860.240.2722

Mark Michael Elliott, Partner, Securities and Financial Institutions Litigation
mark.elliott@bingham.com, 212.705.7796