Avoidance Kept at Bay: Bank Customers as “Financial Institutions” Under the 546(e) Securities Safe Harbor

Analyzing the inner workings of the elements required for the securities contract “safe harbor” protection under Section 546(e) of the Bankruptcy Code, the Bankruptcy Court for the SDNY dismissed a complaint seeking to recover approximately $1 billion in allegedly fraudulent transfers brought against various transferees as part of the Boston Generating Chapter 11 case. The Court found that the transfers at issue, $925 million in tender offer payments made to equity holders and $35 million dividends in a leveraged recapitalization, were safe harbored under Section 546(e) and thus excepted from avoidance and recovery. In reaching this conclusion, the Court relied on the debtor-transferors’ status as “customers” of “financial institutions” and outlined the circumstances under which safe harbor protection would be available based on such status. See In re Boston Generating LLC, No. 10-14419 (SCC), 2020 WL 3286207 (Bankr. S.D.N.Y. June 18, 2020).

The Securities Safe Harbor—Brief Background

Pursuant to Section 546(e) of the Bankruptcy Code, certain securities-related transfers are shielded from fraudulent transfer attacks. To qualify for this safe harbor, the payments sought to be avoided must be (i) qualifying payments, such as “settlement payment[s]” or “transfer[s]...in connection with a securities contract,” and (ii) made by, or to (or for the benefit of) a “financial institution.”

The Bankruptcy Code’s definition of “financial institution” covers not only entities such as banks and loan associations, but also the “customers” for whom such entities are acting as agents or custodians “in connection with a securities contract.” In In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019), for example, the Second Circuit held that the transferor-debtor itself met the statutory definition of a “financial institution” because it was a “customer” of a trust company and bank that was acting as an agent for its customer (the debtor)  in connection with a securities contract.    

Boston Generating—The Transfer Meets Section 546(e) 

The fraudulent transfer complaint in Boston Generating was brought by a trustee of a liquidating trust created to pursue claims on behalf of the debtors’ unsecured creditors. Among other interesting issues, the Court focused on whether Section 546(e) applied to the transfers the trustee sought to avoid. The Court concluded that it did, finding the debtor-transferors—Boston Generating LLC and EBG Holdings LLC—qualified as “financial institutions” by virtue of their status as customers of “financial institutions”—in this case, banks—in connection with the challenged transfers.

The Court explained that “for the customer to qualify as a financial institution, the bank that sends or receives the relevant transfer must be acting as the customer’s agent or custodian in connection with a securities contract.” The Court found that this test was met because financial institutions—US Bank and BONY—sent the applicable funds, as the transferors’ agents, in connection with the securities transfer. BONY acted as the transferors’ depository in connection with the tender offer and the leveraged recapitalization, such that it was appointed to receive the tendered membership interests, hold them for the benefit of the transferors, and pay the tender price on behalf of the transferors to the tendering members. 

In reaching this conclusion, the Court analyzed the transferors’ relationships with the banks and found that an agency relationship existed. Such relationship, the Court explained, requires three elements, all of which were present: (1) a manifestation by the principal that the agent shall act for it; (2) acceptance of the undertaking by the agent; and (3) an understanding between the parties that the principal is to be in control of the undertaking. Of these elements, “the critical element is control of the agent by the principal.”

Finally, as required under Section 546(e), the Court concluded that the transfers themselves satisfied the statute’s conditions. While Section 546(e) requires that the transfer be either a “settlement payment” or made “in connection with a securities contract,” in this case both alternatives were met.

Takeaways

The Boston Generating decision follows in the footsteps of the Second Circuit’s Tribune precedent and reinforces the broad application of Section 546(e) to securities contracts among private parties, provided that the transfers were made by or to a financial institution that, while merely an intermediary, was acting as an agent or custodian for the transferor or transferee. 

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