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Bankruptcy Avoidance Actions: Navigating the Evolving Standards

Pursuing and Defending Preference and Fraudulent Transfer Actionspresents

Today's panel features:

Steven M. Yoder, Partner, Potter Anderson & Corroon, Wilmington, Del.

Frederick B. Rosner, Partner, Messana Rosner & Stern, Wilmington, Del.

Brian E. Greer, Counsel, Dechert, New York

Wednesday, June 10, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 90-Minute Audio Conference with Interactive Q&A

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I. PURSUING AVOIDANCE ACTIONS A. CHAPTER 5 ACTIONS Avoiding powers are granted to a bankruptcy trustee in order to ensure equality of distribution of assets among non-priority creditors. The Bankruptcy Code grants a trustee broad avoiding powers to avoid, or otherwise set aside, certain transactions, i.e., various statutory liens, preferential transfers and/or fraudulent conveyances. These avoiding powers enable the trustee to recover property (or an interest in such property) that was transferred by the debtor in order to provide a more equitable distribution to creditors. The powers granted pursuant to these sections enable a trustee to avoid (1) transfers and liens on the debtor's property that could have been avoided by a creditor under the applicable local law (11 U.S.C. § 544); (2) liens arising by statute (11 U.S.C. § 545); (3) certain preferential transfers within a specified time before the bankruptcy filing (11 U.S.C. § 547); (4) certain fraudulent conveyances (11 U.S.C. § 548); and (5) and certain transfers made after the bankruptcy filing. (11 U.S.C. § 549). The Bankruptcy Code expressly grants these avoiding powers to the trustee but each is exercisable by the debtor-in-possession (debtor) pursuant to section 1107 of the Bankruptcy Code.

Avoidance actions provide a means of recovery as well as act as a deterrent for those who would strong-arm payment in anticipation of bankruptcy. 1. Strong-Arm Powers Under State Law, 11 U.S.C. § 544. Section 544 grants the debtor certain rights and powers to avoid any transfer or obligation of the debtor that might be avoidable under non-bankruptcy law as of the petition date. These rights and powers are often referred to as the trustee's ''strong arm powers.''1 Although federal bankruptcy law provides the trustee with the rights of an actual unsecured creditor, the extent of the trustee's rights is determined entirely by applicable non-bankruptcy law.

(a) Powers as a judicial lien creditor under section 544(a)(1)

Upon commencement of the case, section 544(a)(1) grants a debtor the status of a lien creditor with a judicial lien on all property on which a creditor could have obtained a judicial lien, whether or not such a creditor actually exists.2 1 In re LMJ, Inc., 159 B.R. 926 (D. Nev. 1993)(stating that the ''strong arm'' provision of section 544 is designed to aid in recovering assets for the benefit of all creditors); In re Tri-State Mechanical Servs., Inc., 141 B.R. 488 (Bankr. W.D. Pa. 1992) (section 544 was designed to eliminate the race between creditors under state law). 2 A "judicial lien" means lien obtained by judgment, levy, sequestration, or other legal or equitable process or proceeding.'' 11 U.S.C. § 101.

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(b) Powers as a creditor with an unsatisfied judgment under section 544(a)(2) Section 544(a)(2) provides the trustee the rights of a creditor with a lien returned unsatisfied, which vests the debtor with the equitable rights of a hypothetical creditor that has exhausted its legal rights. Potential benefits of this status include a presumption that the debtor is insolvent or the ability to invoke the equitable doctrine of marshaling. (c) Rights as bona fide purchaser of real property under section 544(a)(3) Pursuant to section 544(a)(3), the debtor is given the rights and powers of a bona fide purchaser of real property from the debtor, in order to avoid any liens or conveyances that such a bona fide purchaser could avoid. The debtor's rights as a bona fide purchaser are subject to state recording statutes and cannot avoid any interest of which a trustee would have had constructive notice under state law. 2. Avoidance of Statutory Liens, 11 U.S.C. § 545. Section 545 of the Bankruptcy Code permits the debtor-in-possession to avoid certain liens created by statute. Statutory liens arise automatically and do not include consensual liens and judgment liens.3 Section 545 is an overriding federal avoiding power over statutory liens granted by nonbankruptcy law, without regard to hypothetical or actual third party rights. 3. Preferences, 11 U.S.C. § 547 Section 547 allows avoidance of transfers, whether voluntary or involuntary, that provide creditors with more than their proportional share in a hypothetical chapter 7 liquidation of the debtor. A preference requires all of the following elements: (1) a transfer to or for the benefit of a creditor; (2) for an antecedent debt (a debt that existed before the transfer); (3) made while the debtor was insolvent (a rebuttable presumption of insolvency exists for the 90-day period prior to the bankruptcy filing); (4) and within 90 days before bankruptcy (or one year if the recipient is an insider as defined by the Bankruptcy Code); and (5) if it permits the creditor to get more than it would have received if the transfer had not been made and the debtor were liquidated under chapter 7.

(a) Transfer to or for the benefit of a creditor

To constitute preference under section 547(b), it is not necessary that a transfer be made directly to preferred creditor. The term "transfer" for purposes of section 547(b) includes indirect transfers made by third parties on behalf of the debtor for the benefit of creditors.4

3 Examples of statutory liens include: (1) contractor's lien; (2) attorney's lien; (3) artisan's lien; (4) hospital lien; (5) automotive repairman's lien; (6) materialmen's lien; (7) maritime lien; and (8) warehouseman's lien. 4 11 U.S.C. § 101. In re Compton Corp., 831 F.2d 586 (5th Cir. 1987) (permitting trustee may recover from creditor beneficiary of letter of credit issued by bank with security interest in Chapter 7 debtor's property value of property upon which bank foreclosed); In re Kirk, 38 B.R. 257 (Bankr. D. Kan. 1984).

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The creation of a perfected security interest can constitute a preferential purpose, and the timing of the "transfer" depends upon the time upon which the transfer is perfected.5

(b) On account of an antecedent debt For purposes of section 547(b), the term "debt" is construed broadly and the determination of when an antecedent debt arises is based upon when the debtor first becomes legally bound to pay.6 The obligation to pay is incurred for purposes of determining an "antecedent debt" even if the debt is at first unmatured or contingent.7

(c) Made while the debtor was insolvent Section 547 provides a presumption of insolvency for the 90-day period immediately preceding the bankruptcy filing, and this presumption requires the defendant to put forth evidence of insolvency to rebut the presumption.8 Insolvency is a factual determination which is essentially a balance sheet test, i.e., debtor is insolvent when its liabilities exceed its assets, excluding the value of preferences, fraudulent conveyances, and exemptions.9

(d) Within 90 days or 1-year insider-period before bankruptcy

The avoidance period under section 547(b) is calculated by counting backward from the bankruptcy filing rather than measuring forward from the date of preferential transfer,10 and it is a prerequisite that the property transferred within the preference period was also acquired in the preference period.11

(e) Creditor receives more than would have been received in chapter 7 liquidation Since section 547 is directed at transfers which discriminate among creditors, no preference exists where the disputed transfer does not diminish the estate to the detriment of other creditors. A transfer is avoidable only if it improves a creditor's position as compared to other creditors in the same class, such that the court applies the "greater amount" test in order to construct a hypothetical Chapter 7 case and determine what the creditor would have received if the case had proceeded under Chapter 7. As a general rule payments to fully secured creditors during the preference period are not preferential because no other creditors are prejudiced,12 but where a transfer effectively changes a creditor's status from undersecured to fully secured, it may be avoided where the creditor would not have received full payment in a liquidation.

5 In re Hensley, 70 BR 237 (Bankr. D. Kan. 1987). 6 Alfa Mut. Fire Ins. Co. v Memory (In re Martin), 184 B.R. 985 (M.D. Ala. 1995); In re Wathen's Elevators, Inc., 37 B.R. 870 (Bankr. W.D. Ky. 1984). 7 In re Western World Funding, Inc., 54 B.R. 470 (Bankr D. Nev. 1985). 8 In re National Buy-Rite, Inc., 7 B.R. 407 (Bankr. N.D. Ga. 1980). 9 In re A. Fassnacht & Sons, Inc., 826 F.2d 458 (6th Cir. 1986). 10 In re Nelson, 959 F.2d 1260 3d Cir. 1992). 11 In re Conner, 21 B.R. 616 (Bankr. N.D. Ga. 1982). 12 In re Hale, 15 B.R. 565 (Bankr. S.D. Ohio 1981); In re Lackow Bros., Inc., 19 B.R. 601 (Bankr. S.D. Fla. 1982).

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(f) Selected examples 1. Vendor threatens debtor who is delinquent in payment that it will stop shipping if the past-due balance is not paid and the debtor pays the outstanding account balance within the 90-day preference period. 2. The debtor owes unsecured debt to the lender and grants lender a security interest in its accounts receivable and inventory without the extension of additional debt within the 90-day preference period. 4. Fraudulent Transfers, 11 U.S.C. § 548. Section 548(a) provides for the avoidance of transfers either (1) made with the intent to hinder, delay or defraud creditors; or (2) made while the debtor was insolvent and not in exchange for reasonably equivalent value. The Uniform Fraudulent Transfer Act (UFTA) provides substantive law as to whether a fraudulent transfer has occurred.

(a) Actual fraud Section 548(a)(1) allows for avoidance of a transfer that was made with the actual intent

to "hinder, delay or defraud" creditors, i.e., an "actual fraud" fraudulent transfer. Section 4(b) of the UFTA provides that "in determining actual intent under subsection (a)(1), consideration may be given, among other factors, to whether: 1. the transfer or obligation was to an insider; 2. the debtor retained possession or control of the property transferred after the transfer; 3. the transfer or obligation was disclosed or concealed; 4. before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit; 5. the transfer was of substantially all the debtor's assets; 6. the debtor absconded; 7. the debtor removed or concealed assets; 8. the value of the consideration received by the debtor was reasonably equivalent to the value of the as-set transferred or the amount of the obligation incurred; 9. the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred; 10. the transfer occurred shortly before or shortly after a substantial debt was incurred; and 11. the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor. These factors are considered to be "badges of fraud" and no particular combination of these factors is necessary for a finding of intent. A finding of actual fraud can be inferred from any circumstances surrounding the transaction which preclude any reasonable conclusion other than that the purpose of the transfer was to defraud creditors.13

13 In re Missionary Baptist Foundation, Inc., 24 B.R. 973 (Bankr. N.D. Tex. 1982).

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(b) Constructive fraud

Section 548(a)(1)(B) authorizes the avoidance of a transfer made within two years of the bankruptcy filing for less than "reasonably equivalent value," ("constructive fraud") when one of the following exists: (1) the debtor was insolvent at the time of the transfer or rendered insolvent thereby; (2) the debtor engaged in a business or transaction for which his remaining property was "unreasonably small capital;" or (3) the debtor intended to incur debts beyond its capacity to repay. (i) Transfer The definition of "transfer" under section 548 is interpreted as broadly as section 547 and includes the granting of a release or waiving of claims, promising to transfer money or property, terminating a license, or making a tax election that results in a loss of valuable tax attributes. (ii) Reasonably equivalent value The question of "reasonably equivalent value" is one of fact based on the concept of determining if a debtor received a fair exchange in the marketplace for goods transferred or the obligation incurred.14 Indirect benefits must also be evaluated under this standard and the touchstone is whether the transaction conferred realizable commercial value on the debtor that was reasonably equivalent to the realizable commercial value of the assets transferred.15

(iii) Insolvency at time of transfer For purposes of section 548, a debtor is deemed insolvent when the sum of debts is greater than fair valuation, meaning the fair market value of the debtor's assets and liabilities within a reasonable time of the transfer.16

(iv) Remaining property constitutes "unreasonably small capital" Unreasonably small capitalization is not the equivalent of insolvency but constitutes financial difficulties that are short of insolvency but likely to lead to insolvency in the future.17 Relevant factors in this inquiry are debt-to-equity ratio, historical capital cushion, need for working capital in specific industry, and comparison of company's projected cash inflows with company's capital needs throughout reasonable period of time after challenged transfer.18

(v) Intending to incur debts beyond his capacity to repay

14 In re Ozark Restaurant Equipment Co., 850 F.2d 342 (8th Cir. 1988). 15 In re Coors of North Mississippi, Inc., 66 B.R. 845 (Bankr. N.D. Miss. 1986); Mellon Bank, N.A. v Metro Communications, Inc., 945 F.2d 635 (3d Cir. 1991) (addressing transfer in terms of leveraged buyout). 16 In re Ohio Corrugating Co., 91 B.R. 430 (Bankr. N.D. Ohio 1988). 17 In re Vadnais Lumber Supply, Inc., 100 B.R. 127 (Bankr. D. Mass. 1989). 18 Iridium IP LLC v Motorola, Inc. (In re Iridium Operating LLC), 373 B.R. 283 (Bankr. S.D.N.Y. 2007).

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This requirement generally dovetails with the insolvency requirement of the debtor, but where the balance sheet test of the debtor's insolvency is either speculative or inconclusive, independent evidence of a debtor's inability to repay debts as they mature is a relevant consideration.

(c) Good-faith transferees Section 548(c) protects good faith transferee's who are the recipient of a fraudulent transfer as the result of an arm's length transaction. Section 548(c) provides that a transferee, who takes for value and in good faith, has a lien on the property transferred (or may retain property transferred) to the extent of the value given for the transfer. The good faith element requires a showing that the transferee (1) had a belief in the propriety of the transfer, (2) did not intend to disadvantage other creditors, and (3) was not aware that the transfer would hinder, delay or defraud other creditors. Good faith is measured objectively according to whether the circumstances would place a reasonable person on inquiry of a debtor's fraudulent purpose and diligent inquiry would have discovered the fraudulent purpose.19 5. Post-Petition Transfers, 11 U.S.C. § 549

Section 549(a) provides a remedy for the avoidance of voluntary transfers that are not authorized under the Code or by the bankruptcy court.20 The debtor's avoiding powers under section 549 are limited by statute in three important ways. First, Section 549(c) protects transfers of realty to good faith purchasers of the estate's real property, without knowledge of the case, who have given less than ''present fair equivalent value.'' Second, this avoidance power is subject to any applicable law which permits perfection or continuation of a secured interest to be effective against an entity that acquires rights before the date of perfection or continuation. Third, section 549(d) specifies a separate statute of limitations of two years after the date of the transfer, or the time the case is closed or dismissed, whichever is earlier. 6. Limitations on Avoidance Powers, 11 U.S.C. § 546 The trustee's avoidance and recovery powers, as broad as they may be, are subject to numerous limitations.

(a) Time limitations on avoiding powers; 11 U.S.C. § 546(a)

Section 546(a) establishes a statute of limitations for avoidance actions brought under sections 544, 545, 547, and 548. Such actions may not be commenced after the earlier of (i) two years after the order for relief, (ii) one year after the appointment of a trustee; or (iii) the time the case is closed or dismissed.21 Section 546(a), however, only limits the commencement of the

19 Jobin v McKay (In re M & L Bus. Mach. Co.), 84 F.3d 1330 (10th Cir. 1996). 20 40235 Washington Street Corp. v. Lusardi, 329 F.3d 1076, 1081 (9th Cir. 2003) (''The general rule [in section 549 situations] is that the trustee is authorized to avoid the transfer in order to protect the creditors. Section 549(c) creates an exception to that rule to protect innocent purchasers whom the debtor has defrauded.'' (citations omitted) 21 11 U.S.C. §546(a).

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enumerated avoidance actions so a debtor is not time-barred from raising an avoidance action as a defense to claims or to the validity of liens asserted against the estate, but this defensive use is limited to disallowance of the amount of the claim or lien asserted by the creditor

(b) Limitation on avoiding powers based on right to perfect or continue perfection, 11 U.S.C. § 546(b)

Section 546(b)(1) limits a debtor's avoiding powers by preserving creditors' perfection rights pursuant to any applicable non-bankruptcy law. Under section 546(b)(1)(A), the bankruptcy filing does not prevent the holder of a security interest from post-petition perfection of that interest where the interest holder could have perfected its interest against an entity acquiring rights in the property before the date of perfection. Section 546(b)(1)(B) permits post-petition continuation of a perfected security interest if applicable non-bankruptcy law provides for the continuation of perfection to be effective against an entity that acquires rights in the property before the date on which action is taken to effect the continuation; for example, filing a statement to continue a security interest, is not subject to avoidance under sections 544, 545 or 549 of the Bankruptcy Code. B. PREFERENCES VS. FRAUDULENT TRANSFER Transfers may be both preferential and fraudulent in nature but significant differences exist between these avoidable transfers.22 Preference undermines the bankruptcy principle of equality of distribution among creditors,23 whereas fraudulent transfer involves dishonest motive in placing a debtor's assets beyond the reach of creditors.24 Preference law involves protecting the interests of creditors while fraudulent transfer law focuses on preserving estate assets against evaporating. While a fraudulent transfer requires some degree of dishonest intent, an objective standard is used under preference law such that a debtor's intent or motive is not relevant to an analysis under section 547(b). C. LIENS ON AVOIDANCE ACTIONS/RELEASE OF LIENS ON AVOIDANCE ACTIONS

22 Faulkner v. Magri, 90 F.2d 808, 809 (4th Cir. 1937) (''The mere giving of a preference is not of itself sufficient to establish fraud ...''). But see Irving Trust Co. v. Chase Nat'l Bank, 65 F.2d 409, 410 (2d Cir. 1933) (''It is difficult to imagine a preferential transfer which does not incidentally hinder and delay creditors . . . ."). 23 See Kenan v. Fort Worth Pipe Co. (In re George Rodman, Inc.), 792 F.2d 125, 127 (10th Cir. 1986) (''In general, a 'preference' exists when a debtor makes payment or other transfer to a certain creditor or creditors, and not to others ... . Such favoritism is prohibited by 11 U.S.C. § 547(b) when a debtor is in bankruptcy.''); see also In re Cybermech, Inc., 13 F.3d 818 (4th Cir. 1994) (purpose of section 547 is to prevent favoritism among creditors who should stand on equal footing). 24 See Van Iderstine v. National Discount Co., 227 U.S. 575, (1913) ("A fraudulent conveyance is void regardless of its date; a preference is valid unless made within the prohibited period."); Rutter v. General Motors Acceptance Corp., 70 F.2d 479, 481-82 (10th Cir. 1934) (''There is a clear and broad distinction between a preferential transfer and a fraudulent transfer. The latter involves moral turpitude. The former does not.")

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Pre-petition secured creditors typically prefer replacement liens in seeking "adequate protection" for the debtor's use of cash collateral under the Bankruptcy Code. The granting of replacement liens, however, disadvantages unsecured creditors because such liens may reduce the availability of unencumbered assets. Despite the potential hazard to unsecured creditors, courts have allowed replacement liens on avoidance actions.

1. Pre-petition Liens on Avoidance Actions Most courts have held that a blanket pre-petition lien does not extend to avoidance actions because such actions come into existence only upon commencement of the bankruptcy case.25 This conclusion is based on section 552(a) of the Bankruptcy Code, which provides that "property acquired by the estate after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case." 2. Post-petition Liens on Avoidance Actions

Certain courts have also refused to grant a lien on avoidance actions because "neither a trustee in bankruptcy, nor a debtor-in-possession, can assign, sell or otherwise transfer the right to maintain a suit to avoid a preference."26

More recently, certain courts have allowed the lineal assignment of avoidance actions to creditors and paved the way for granting replacement liens thereon.27

D. ENTITIES OTHER THAN TRUSTEE EXERCISING AVOIDANCE POWERS 1. Post-confirmation authorization The Bankruptcy Code generally limits the avoiding powers to the trustee or debtor. Generally the avoiding powers are available only to the trustee or debtor. Section 1123(b)(3)(B), however, permits a debtor's plan of reorganization to provide for the retention and enforcement of causes of action by a "representative of the estate appointed for the purpose of pursing and enforcing such claims;" 28 thereby allowing a plan to transfer the authority to exercise one or more of the statutory avoidance powers a party other than the debtor.29

25 See In re Tek-Aids Industries Inc., 145 B.R. 253, 256 (Bankr. N.D. Ill. 1992); In re Pearson Industries Inc., 178 B.R. 753, 764-65 (Bankr. N.D. Ill. 1995); In re Ludford Fruit Productions Inc., 99 B.R. 18, 24-25 (Bankr. C.D. Ca. 1989); In re Integrated Testing Products Corp., 69 B.R. 901, 904-05 (D.N.J. 1987). 26 See In re Texas General Petroleum Corp. v. Evans (In re Texas General Petroleum Corp.), 58 B.R. 357, 358 (Bankr. S.D. Tex. 1986); United Capital Corp. v. Sapolin Paints Inc. (In re Sapolin Paints Inc.), 11 B.R. 930, 937 (Bankr. E.D.N.Y. 1981) (refusing to provide for assignment of avoidance action where contract negotiated at arm's length provided for valuable consideration). 27 See, e.g., Mellon Bank N.A. v. Dick Corp. (In re Qualitech Steel Corp.), 351 F.3d 290 (7th Cir. 2003) (court granted pre-petition secured creditors a replacement lien on avoidance actions because the pre-petition lenders were unsecured as of the bankruptcy filing and post-petition financing was necessary to conduct an orderly liquidation); In re Housecraft Industries USA Inc., 310 F.3d 64 (2d Cir. 2002) (where the court held that where a debtor consents, and/or relief is obtained from the court, a committee may bring avoidance actions). 28 See e.g., Citicorp Acceptance Co. v. Robinson (In re Sweetwater), 884 F.2d 1323, 1326-27 (10th Cir. 1989) (approving plan provision to pursue avoidance actions normally reserved for trustee or debtor-in-possession); In re

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Courts have adopted a case-by-case approach to determine whether an appointed party's authority under a plan qualifies them as a "representative of the estate." A two-part test is applied for parties seeking to enforce avoidance actions which requires that: (1) the party is appointed, meaning a court-approved plan of reorganization includes an appointment that is agreed to by the debtor-in-possession and administrative creditors; and (2) the party is a representative of the estate, meaning that a successful recovery by the representative would benefit the debtor's estate and unsecured creditors.30 A benefit to the unsecured creditors includes situations in which the successful prosecution of the avoidance action would increase the financial assets of the debtor's successor-in-interest, thereby increasing the interest held by unsecured creditors. 2. Authorization outside a plan of reorganization Courts have held that the committee of unsecured creditors has standing to pursue avoidance actions where the debtor-in-possession unjustifiably fails to do so. Creditors' committee are generally required to make a demand on the trustee to bring the avoidance action and then apply to the court for leave to bring the action on the basis that the debtor's unreasonable refusal to pursue an avoidance claim amounts to neglect of its fiduciary duty.31 Disagreement exists among the circuits as to whether avoidance powers of are assets of the debtor's estate that can be sold.32 E. STATE PREFERENCE STATUTES State statutes provide an alternative to bankruptcy which is styled as an assignment-for-the-benefit-of-creditors (ABC). ABC's largely mirror the structure of the Bankruptcy Code and typically arise by contract where a debtor (the assignor), transfers all of its property to an assignee to be held in trust. An ABC is designed to be a more expeditious, less-expensive type of liquidation proceeding than a chapter 7 bankruptcy case

Tennessee Wheel & Rubber Co., 64 B.R. 721 (Bankr. M.D. Tenn. 1986) (permitting actions under avoiding powers to be retained in plan and pursued and enforced post-confirmation). 29 Matter of Texas General Petroleum Corp., 52 F.3d 1330 (5th Cir. 1995); Duckor Spradling & Metzger v. Baum Trust (In re P.R.T.C., Inc.), 177 F.3d 774, 781, (9th Cir. 1999) (avoidance rights assigned for 50% of the proceeds collected). 30 In re Ameriserve Food Distribution, Inc., 315 B.R. 24 (Bankr. D. Del. 2004). 31 See, e.g., Coral Petroleum, Inc. v. Banque Paribas-London, 797 F.2d 1351, 1363 (5th Cir. 1986); Official Committee of Unsecured Creditors v. Chinery ( In re Cybergenics Corp.), 330 F.3d 548, 553 (3d Cir. 2003) (quotation omitted). 32 Compare Briggs v. Kent (In re Professional Inv. Properties of Am.), 955 F.2d 623, 626 (9th Cir.) , cert. denied, 506 U.S. 818, 113 S. Ct. 63, 121 L. Ed. 2d 31 (1992) (approving a chapter 7 trustee's sale of the avoidance power to a creditor) with Official Committee of Unsecured Creditors of Cybergenics Corp. v. Chinery (In re Cybergenics Corp.), 226 F.3d 237, 242 (3d Cir. 2000) (holding that fraudulent transfer claims arising from leveraged buyout were property of debtor's creditors and could be sold by debtor-in-possession). But see The Official Committee of Unsecured Creditors of Cybergenics Corporation v. Chinery, 330 F.3d 548, 580 (3d Cir. 2003)(Cybergenics II) (holding that under appropriate circumstances a bankruptcy court can authorize creditors committees to sue derivatively to avoid fraudulent transfers for the benefit of the estate).

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Twenty-two states 11 have adopted statutes that permit the assignee to recover preferences.33 Delaware's preference statute reads as follows:

Whenever any person, in contemplation of insolvency or in contemplation of taking the benefit of any of the insolvent laws of this State, makes an assignment of his or her estate or effects for the benefit of creditors, and by such assignment, either under its provisions or otherwise, prefers any creditor to others, or in or by such assignment, secures or pays to any creditor a greater proportion of his or her debt or demand than shall be secured or paid to all his or her creditors, every such assignment so giving a preference shall be deemed fraudulent and absolutely void, and the estate or effects contained therein shall be liable to be taken in execution, or attached, for the payment of such assignor's debts, as fully as if no such assignment had been made; and whoever makes such fraudulent assignment shall forever be deprived of the benefit of any insolvent law of this State.34

33 The states that have enacted preference avoidance provisions are: (1) California; (2) Colorado; (3) Delaware; (4) Georgia; (5) Indiana; (6) Iowa; (7) Kentucky; (8) Maryland; (9) Missouri; (10) Montana; (11) New Hampshire; (12) New Jersey; (13) New York; (14) North Carolina; (15) Ohio; (16) Oklahoma; (17) Pennsylvania; (18) South Carolina; (19) South Dakota; (20) Tennessee; (21) Washington; and (22) Wisconsin. 34 10. Del. Cod. Ann. § 7387.

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Strafford, Wednesday, June 10, 2009

BANKRUPTCY AVOIDANCE ACTIONS: NAVIGATING THE EVOLVING STANDARDS

Pursuing and Defending Preference and Fraudulent Transfer Actions

II. Defending avoidance actions

A. Defending Preference Actions

1. Attacking the Plaintiff’s Prima Facie Case

2. Ordinary Course of Business

3. New Value

4. Contemporaneous Exchanges

5. Other Defenses B. Defending Fraudulent Transfers

By: Frederick B. Rosner Messana Rosner & Stern LLP 1000 N. West Street, Suite 1200 Wilmington, Delaware 19801 Telephone: (302) 777-1111 frosner@mrs-law.com

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II. Defending avoidance actions

A. Preference Actions

1. Attacking the Plaintiff’s Prima Facie Case Section 547(b) provides that the trustee may avoid transfers of the debtor’s interest in property: 1. to or for the benefit of a creditor; 2. for or on account of an antecedent debt owed by the debtor before such

payment was made; 3. made while the debtor was insolvent; 4. made - (A) on or within 90 days before the date the petition was filed; or (B)

if the creditor is an insider, on or within one year before the date the petition was filed; and

5. that enabled the creditor to receive more that the creditor would have received if – (A) the case were a case under chapter 7 of the Bankruptcy Code; (B) the transfer had not been made; and (C) the creditor received payment of such debt to the extent provided by the provisions of chapter 7.

To recover a preference, the trustee must establish all five elements. See Waslow v. The Interpublic Group of Cos. (In re M Group, Inc.), 308 B.R. 697, 700 (Bankr. D. Del. 2004). In the event all five elements cannot be demonstrated by a preponderance of the evidence, a preference has not been established and no recovery can be made. However, if all five elements are established, creditors have a number of defenses that can be raised to eliminate liability. Before turning to the available defenses counsel might first consider whether plaintiff can make out its prima facie case.

Is the Transfer An Interest of Property of the Debtor?

In re Gruppo Antico, Inc., 359 B.R. 578 (Bankr. D. Del. 2007) (defendant was US-based company that provided sales and technical support, and acted as service arm for Taiwanese-based components parts manufacturer, from which debtor purchased components. Pre-petition debtor paid US company which, in turn, without cashing checks, remitted them to Taiwanese company. Defendant asserted that the transfers it received were not a “transfer of an interest of the debtor in property” and the “conduit defense.” Court agreed with defendant because checks were never deposited by US-company and it never exercised dominion or control over the alleged preferential transfers).

In re Bake-Line Group, LLC, 359 B.R. 566 (Bankr. D. Del. 2007), the debtor erroneously received and deposited a check from the defendant payable to an unrelated third party and on account of a debt owed to an entirely different entity. When notified of its error, the debtor promptly refunded the defendant’s money. The refund occurred during the preference period. In rejecting the trustee’s preference action, the bankruptcy court found that: (1) the debtor never acquired rights in those funds because those funds were rightfully property of an entirely

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different entity, and no legal or equitable interest in the funds ever vested in the debtor; (2) the debtor held the funds in constructive trust for the defendant under Illinois law; and (3) the defendant was never a creditor of the debtor and therefore could not be found to have incurred an antecedent debt.

In re Lenox Healthcare, Inc., 343 B.R. 96 (Bankr. D. Del. 2006 (Trustee sought to

recover pre-petition payments made by debtor-employer to insurance company administering its employee health and dental benefits. Defendant insurance company argued that transfers were not property of the estate and it was not an initial transferee but a mere conduit of any amounts received. Court noted that property in which debtor holds only bare title is not property of the estate. Court held that employee contributions, deducted from paychecks, are held in trust for employees and are not property of the estate. However, employer contributions to an employee benefit plan are not held in trust until they actually are transferred to the employee plan. In other words, at the time of the transfer, employer contributions are property of the estate, capable of being avoided. The insurance company failed to establish it was a mere conduit of the employer contribution payments. In fact, the insurance company was making advance payment of employee claims which, in turn, made it a creditor of the debtor.)

The Trustee also sought to amend his original complaint to add certain additional

transfers. Defendant opposed the amendment, arguing the additional transfers were time barred by the two year statute of limitations and they did not relate back to the original complaint. Defendant also argued, with respect to the additional transfers, that the Trustee had failed to satisfy his burden of proof under section 547(b)(5). Defendant relied on Trustee’s response to Defendant’s request for admissions wherein Trustee admitted that he did not perform any analysis or calculation to support the section 547(b)(5) allegation. The Court noted that if the moving party – here, the Defendant insurance company – does not bear the ultimate burden of proof on an issue – the section 547(b)(5) allegation – its burden under summary judgment standard is met by showing that there is an absence of evidence to support the non-moving party’s case. That shifts the burden to the non-moving party to come forward with persuasive evidence that its claim is not implausible. In Lenox, the Trustee presented no evidence to support its 547(b)(5) allegation, so the Court granted Defendant summary judgment as to the additional transfers. On motion for re-consideration, the Trustee argued that the Court’s failure to take judicial notice of the pleadings filed in the case (i.e. the Schedules and Statement of Financial Affairs) was clear error. The Court was not persuaded by the Trustee’s argument because the Trustee never requested that the Court take notice of any pleadings.

Challenge Solvency/Rebut the Presumption of Insolvency

In re American Classic Voyages, Co., 367 B.R. 500 (Bankr. D. Del. 2007) aff’d, 384 B.R.

62 (D. Del. 2008). (Plaintiff failed to prove insolvency) In re Iridium, 373 B.R. 283 (Bankr. S.D.N.Y. 2007)

2. Ordinary Course of Business. The ordinary course of business defense is

intended to leave normal financial transactions between a debtor and its creditors undisturbed by protecting those credit transactions that are made in the ordinary course of business of the parties or in the ordinary course of the industry. US Trustee v. First Jersey Sec., Inc. (In re First Jersey Sec., Inc.), 180 F.3d 504, 512 (3d Cir. 1999). Defendant must demonstrate the following

00000743. 3

elements: (1) the debtor incurred the underlying debt in the ordinary course of its business; (2) the debtor made the transfer to the transferee in the ordinary course of the parties’ business or financial affairs (the subjective inquiry, or (3) the transfer was made according to ordinary business terms (the objective inquiry).

Subjective Inquiry: if the parties have a brief or limited payment history, the industry

standard plays a more prominent role in the ordinary course analysis. See Morris & Butler v. Sampson Travel Agency, Inc. (In re US Interactive, Inc.), 321 B.R. 388, 392 (Bankr. D. Del. 2005). Courts examine a number of factors: (1) the length of time the parties engaged in the type of dealing of issues; (2) whether the subject transfer was in an amount more than usually paid; (3) whether the payments were tendered in a manner different than previous payments; (4) whether there appears to be any unusual action by the debtor or creditor to collect on the debt; and (5) whether the creditor did anything to gain an advantage in light of the debtor’s deteriorating financial condition. In re Global Tissue, 302 B.R. 808 (D. Del. 2003).

Range of Payments. In the Third Circuit, it is the industry range (as opposed to the

average) of payment terms in the industry that is relevant under section 547(c)(2)(c). See Molded Acoustical, 18 F.3d at 224 (referring to “range of terms”); Cherrydale, 2001 WL 1820323, at *3 (quoting Molded Acoustical); In re Color Tile, 239 B.R. 872, 874-876 (Bankr. D. Del. 1999) (concluding that the creditor had satisfied its burden under (c)(4) where the challenged payments were made within the range of three other companies in the industry).

Record-Keeping. The ordinary course of business defense requires some mechanism for identifying and illustrating the historical course of dealing between the parties – generally one to one and one-half years. Changes in technology result in frequent replacement of computers and record-keeping systems. Without that data, establishing an ordinary course of business defense becomes difficult. Accurate records often lead to a quick and cost-effective settlement. It is often worth the effort to analyze potential exposure when a debtor files for bankruptcy, and plan accordingly based upon that potential exposure. Also consider whether your client used third party carriers who might only keep records for up to 6 months (e.g. FedEx). Objective Inquiry: creditor – transferees may depart somewhat from the objective inquiry

with respect to industry standards depending on the length of their relationship with the debtors. See Fiber Lite Corp. v. Molded Acoustical Products, Inc. (In re Molded Acoustical Products, Inc.), 18 F.3d 217 (3d Cir. 1994) (largely adopting the Seventh Circuit’s Tolona Pizza decision.

In Universal Forest Products, Inc. v. Hechinger Investment Co. of Delaware Inc. (In re

Hechinger Investment Co. of Delaware Inc), 339 B.R. 332 (D. Del. 2006), the District Court for the District of Delaware explored the objective element of the ordinary course defense. In Hechinger, the defendant appealed an adverse judgment in the bankruptcy court, rejecting the defendant’s ordinary course claim. On appeal, the defendant argued that the debtor’s payment on eight-day terms prepetition was consistent with the industry norm of payment within thirty days. The district court rejected this argument and affirmed the bankruptcy court’s conclusion that “the transfers were not made according to ordinary business terms, because the combination of a credit limit and an eight-day repayment period were not normal practice in [the defendant’s] relationship with large retail customers like [the Debtor].” Id. at 337.

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Changing Business Terms. Be careful about modifying long standing credit practices

when the debtor is having financial trouble. The ordinary course may be destroyed or you will be left arguing that you had two ordinary course periods, which may be rejected by the courts. The downside if the credit terms are not altered is that the customer may refuse to purchase additional goods, resulting in lost sales. Forklift Liquidating Trust v. Spicer Clark-Hurth (In re Forklift LP Corp.), No. 00-1730,

2006 U.S. Dist. LEXIS 50264 (D. Del. July 20, 2006). In Clark-Hurth, the defendant invoked its extensive long-term relationship with the debtor to support an argument that major payments made during the preference period under a “payment plan” imposed within nine months of the debtor’s bankruptcy filing were ordinary course under both the subjective and objective test. The district court was unimpressed, and noted that under the subjective test as articulated in Molded Acoustical, the entirety of the parties’ long-term relationship, and not just an isolated portion of the period, was relevant. Accordingly, the court noted:

The payment plan implemented during the preference period was a first for the parties in their business relationships. Never before had Clark made consecutive weekly payments in such amounts. The method of payment changed and several unusual actions were taken by [the defendant] to collect the Clark debt, including increasing the pressure on Clark and getting higher management … involved in the collection.

Id. at *28. The court thus concluded that the defendant’s departure from a prior longstanding set of collection practices precluded a finding of ordinary course defense in the action.

Industry Standards. In re National Gas Distributors, LLC, 346 B.R. 394 (Bankr. E.D. NC 2006)

Standard Industry Codes.

3. Subsequent Exchange for New Value. The “new value” exception

encourages creditors to continue to do business with financially troubled debtors, with an eye toward avoiding bankruptcy altogether. See Mosser v. Ever Fresh Food Co. (In re IRFM, Inc.), F.2d 228 (9th Cir. 1995). A debtor or a trustee may not avoid or recover a transfer to or for the benefit of a creditor to the extent that such creditor subsequently provided new value (i.e., goods, services, etc.) to the debtor. The rationale behind this defense is that because the creditor transferred new value to the debtor, there was no depletion of the debtor’s estate. Remember that the key issue to this defense is timing – the creditor must have provided new value to the debtor after receipt of the allegedly preferential transfer.

Section 547(c)(4)(B) has caused much confusion and disagreement among the courts of appeals as to whether the “subsequent new value” defense requires the “new value” to remain unpaid. The position that “new value must remain unpaid” is followed by the Third, Seventh and Eleventh Circuits. See N.Y. City Shoes, Inc. v. Bentley Int’l. Inc. (In re N.Y. City Shoes, Inc.),

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880 F.2d 679 (3d Cir. 1989); In re Prescott, 805 F.2d 719 (7th Cir. 1986); Charisma Inv. Co. N.V. v. Airport Sys., Inc. (In re Jet Fla. Sys., Inc.), 841 F.2d 1082 (11th Cir. 1988).

4. Substantially Contemporaneous Exchange for New Value. This defense applies where the transfer was intended by the debtor and the creditor to be a substantially contemporaneous exchange for new value given to the debtor by the creditor, and there was in fact a contemporaneous exchange. Courts do not employ hard and fast rules as to what constitutes “contemporaneous.” The most common example of a contemporaneous exchange is a COD (cash on delivery) transaction.

Hechinger Liquidation Trust v. Universal Forest Products, Inc. (In re Hechinger

Investment Co. of Delaware, Inc.), 326 B.R. 282 (Bankr. D. Del. 2005), aff’d, 339 B.R. 332 (D. Del. 2006), aff’d in part, vacated in part and remanded by, 489 F.3d 568 (3rd Cir. 2007). The defendant argued that extensive prepetition transfers from the debtor to the defendant during the preference period were intended to be contemporaneous exchanges in support of ongoing shipments made by the defendant throughout the preference period. Although evidence at trial indicated that the defendant refused to make further shipments until the debtor made certain payments, that evidence also showed that when payments were made, the defendant applied these payments to the oldest invoices first. The court held that this fact contradicted the second element of the contemporaneous exchange defense and that “the nature of a credit relationship is inconsistent with the intent which is required in order to sustain the § 547(c)(1) defense.” Id. at 289.

5. Other Defenses

Mechanic’s Liens.

Preventive Maintenance

Demand C.O.D.

Require a Letter of Credit.

Require Payment from a Third Party.

Demand Prepayment.

Don’t ship new product to a financially troubled customer until you have actually received the customer’s check (not just after receiving a promise).

Take a security interest in the product sold or in other assets of the customer if possible. B. Defending Fraudulent Transfers

VFB LLC v. Campbell Soup Company, 482 F.3d 624 (3d Cir. 2007)

© 2008 Dechert LLP

Limitations on Avoiding Powers

Brian GreerAlessandra TebaldiDechert LLP1095 Avenue of the AmericasNew York, New York 10036(212) 698-3500

This presentation is provided by Dechert LLP for educational and informational purposes only and is not intended and should not be construed as legal advice. This presentation is considered attorney advertising in some jurisdictions.

© 2009 All Rights Reserved

1

TABLE OF CONTENTS

I. Mechanics Liens 2

II. Reclamation 6

III. Securities Contracts 10

IV. Repurchase Agreements 12

V. Swaps 14

VI. Setoff / Netting Agreements 17

VII. Prohibitions on Avoiding Certain Transfers 18

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I. Mechanics Liens

• Liens to secure the payment of those supplying material or labor used in the improvement of real property.

• In the United States, these liens have no common law basis, but are created by either statutes or constitutions.

• All states presently have some form of mechanic's lien laws.

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I. Mechanics Liens (cont’d)

• The filing of a bankruptcy petition by the owner or lessee of property that would be subject to a mechanic's lien triggers the application of section 362.

– Section 362(a) creates an automatic stay of various actions affecting the bankruptcy debtor or its property, subject to exceptions specified in subsection (b) of the statute.

– Section 362(a)(4) prohibits "any act to create, perfect, or enforce any lien against property of the estate."

– Section 362(a)(5) prohibits "any act to create, perfect or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title."

– Section 362(a)(5) extends the protection of the automatic stay to property acquired after the date on which the petition was filed, exempt property, abandoned property, and property that is defined as excluded from the estate under section 541, such as the debtor's beneficial interest in a spendthrift trust.

– In Lincoln Savings Bank, FSB v. Suffolk County Treasurer (In re Parr Meadows Racing Assoc., Inc.), the Second Circuit stated that tax liens may not arise post-petition "by operation of law." The court's comment was dictum because the tax liens did not arise passively, and required several affirmative acts by the taxing authority that had not been completed when the bankruptcy petition was filed.

– In Industrial Indemnity Co. v. Seattle-First Nat. Bank (In re North Side Lumber Co.), the Bankruptcy Appellate Panel for the Ninth Circuit stated that "post-petition perfection of a lien may be permissible, but the creation of a lien post-petition is not."

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I. Mechanics Liens (cont’d)

• Section 362(b) contains numerous exceptions to the automatic stay. Where these exceptions apply, there is no need for a creditor or lien claimant to obtain an order from the bankruptcy court terminating or modifying the bankruptcy stay.

– Section 362(b)(3), which provides that the filing of a bankruptcy petition does not operate as a stay: of any act to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee's rights and powers are subject to such perfection under section 546(b) of this title or to the extent that such act is accomplished within the period provided under section 547(e)(2)(A) of this title.

– The section 362(b)(3) exception allows two types of post-petition lien perfection. • The latter part of the exception allows acts of perfection during the thirty day period after the lien becomes

effective between the grantor and the recipient of the lien. The commencement of this period would usually correspond to the date when the lien attached.

• The first part of the exception under section 362(b)(3) allows the perfection of liens that, after perfection, would have a priority over the interest of the bankruptcy estate by virtue of section 546(b) of the Code.

– Section 546(b) is commonly relied on for the post-perfection of consensual security interests during the applicable grace period under Article 9 of the Uniform Commercial Code. It also applies, however, to the perfection of most forms of mechanic's liens, giving mechanic's lien claimants a favored status under bankruptcy law wherever the lien law meets the requirements of section 546(b).

5

I. Mechanics Liens (cont’d)

• The two tests of section 546(b):– Where a security interest qualifying under section 546(b) is perfected post-petition, its

perfection does not violate the bankruptcy stay and the perfected lien will survive challenge from the bankruptcy trustee under three avoidance power statutes.

– The focus then turns to the question whether a mechanic's lien qualifies under the two tests of section 546(b):

• whether the lien claimant has sufficient relation-back rights under the lien law, and

• whether the lien claimant had a sufficient pre-petition interest in the estate property when the bankruptcy case began.

– Both tests must be met for the lien claimant to be entitled to the stay exception and to the protection from lien avoidance that is afforded by section 546(b).

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II. Reclamation

• Outside Bankruptcy Law– Outside bankruptcy, the reclamation of goods is governed by Section 2-702 of the Uniform

Commercial Code.

– Section 2-702 provides that if a seller discovers that the buyer has received goods on credit while insolvent (and is thus unable to pay its bills when they become due), the seller may reclaim the goods upon written demand made within 10 days of the buyer’s receipt of the goods, or within 30 days if there has been a written misstatement of solvency.

– Section 2-702 further provides that the rights of a reclaiming seller are subordinate to the rights of a buyer in the ordinary course of business (including the rights of a lender which took a lien, charge or security interest in the buyer’s inventory) or a bona fide purchaser for value.

• Under Bankruptcy Law– Once the buyer files for bankruptcy the rules change.

– The reclaiming seller can choose between two distinctive remedies:• the new pre-petition administrative claim procedure under Section 503(b)(9) of Chapter 11 of the

US Code; and

• the traditional reclamation procedures under Section 546(c) of Chapter 11 of the US Code.

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• Section 503(b)(9)– Section 503(b)(9)of Chapter 11 is relatively new and applies to cases that were filed after October 17, 2005.

– This section provides that sellers which provided goods in the ordinary course of business to a distressed debtor in the 20 days before the date of commencement of a bankruptcy case are entitled to an administrative priority equal to the value of the goods sold.

– An administrative priority is the highest preference afforded to an unsecured claim in a Chapter 11 reorganization.

– Creditors with administrative claims receive 100 per cent of their claims upon confirmation of a Chapter 11 plan of reorganization and may even be paid earlier than confirmation, while other general unsecured creditors must wait and may receive little or nothing.

• However, there are still unresolved problems. – Must a Section 503(b)(9) creditor return an alleged preference before it can receive its administrative claim? The

answer is probably yes, but again there have been no definitive decisions.

– Can a creditor claim a credit for unpaid goods that are subject to a Section 503(b)(9) priority as a subsequent advance of credit for purposes of a preference defense under Section 547(c)(4) of Chapter 11? The answer should be no, but yet again no definitive answer has been given.

II. Reclamation (cont’d)

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II. Reclamation (cont’d)

• What, if any, effect will the administrative status for twenty-day claims have on the subsequent new value defense?

– Scenario 1 – All or a portion of the twenty-day claim invoices were unpaid at the petition date, and the creditor seeks to assert a subsequent new value defense based on the twenty-day claim invoices.

– Scenario 1 brings into play the intersection of 502(d) (the disallowance of claims filed by preference defendants) with 547(c)(4) (the new value defense).

– If a twenty-day claim is construed to be the equivalent of a properly perfected and enforceable reclamation claim, then it follows that so long as administrative claims are paid in full the twenty-day claim invoices no longer would qualify as allowed new value.

– As noted by the court in Arizona Fast Foods LLC, once a creditor is paid in full on its reclamation claim, “the ‘new value’ has become unavoidable…and does not replenish the estate to protect earlier transactions from constituting preferences.” In other words, whatever “new value” the debtor initially received was “restored” to the creditor via the granting of the administrative claim. Once that administrative claim is paid, the new value is on account of “an otherwise unavoidable transfer” as set forth in 547(c)(4)(B).

– Several courts deny the use of the new value defense for invoices paid post-petition regardless of whether the repayment was made by return of the goods or with an otherwise unavoidabe post-petition transfer.

– To ensure against the “double dipping” by defendants who have twenty-day claims, plaintiff’s counsel should include a cause of action to disallow all twenty-day claims of a creditor pursuant to 502(d) until the preferential transfers are returned. Counsel should also take care to preserve the right to object to twenty-day claims until avoidance litigation decisions have been made.

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II. Reclamation (cont’d)

– Scenario 2 – Invoices that are eligible for a twenty-day claim were paid by an avoidable transfer(s).

– Scenario 2 affects the prima facie case under 547(b)(5) of the Code.

– A creditor who would have had valid twenty-day claims but for the fact that the twenty-day claim invoices were paid, can now argue that those transfers are not avoidable due to 547(b)(5).

– Had the twenty-day claim invoices not been paid, in a hypothetical chapter 7 liquidation the creditor would have (1) timely filed an administrative claim and (2) its 503(b)(9) claim would have been satisfied in full.

– The analysis is similar to that used for mechanics liens that are satisfied by the alleged preferential payment. If the preferential transfer was on account of an invoice that would have qualified as a as secured by a lien, creditors will challenge this element. If a case was administratively solvent as of the petition date, they have a sound basis to defeat the prima facie case.

– The counter argument is that unlike certain liens that arise by operation of law, there is no guarantee that the twenty-day claim would have been timely filed under whatever proceduresthe court adopted for the filing of administrative claims.

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III. Securities Contracts

• Defined in § 741(7) (not part of the regular chapter 7; but the sub-chapter applicable to stockbroker liquidation):

– Contract;

– for purchase, sale or loan• (query-is redemption/prepayment in full of debt instruments qualifies as a purchase? Not clear. Enron, 325

B.R. 671, 686 (Bankr. S.D.N.Y. 2005);

– of a security, certificate of deposit, mortgage loan or any interest in a mortgage loan, group or index of securities, certificates of deposit, or mortgage loans, or interest therein(including any interest therein or based on value thereof), or any option to purchase or sell any of the foregoing and any repo or reverse repo on the foregoing (whether or not the repo or reversed repo comes within the definition of a “repurchase agreement”);

– option entered on a national securities exchange relating to foreign securities;– the guarantee, including by novation, by or to a securities clearing agency of a

settlement of cash, securities, certificates of deposit, mortgage loans or interests therein, group or index of securities, or mortgage loans or interests therein (including any interest therein or based on the value thereof), or option on any of the foregoing, including an option to purchase or sell any such security, certificate of deposit, mortgage loan, interest, group or index, or option (whether or not such settlement is in connection with any agreement or transaction referred to in the definition of a”securities contract”);

11

III. Securities Contracts (cont’d)

– any margin loan;– Extension of credit for the clearance or settlement of securities transactions;– Loan transaction coupled with securities collar transaction, any prepaid forward

securities transaction, or any total return swap transaction coupled with securities sale transaction;

– any other agreement or transaction that is similar to an agreement or transaction referred to in the section;

– Similarly to forwards and repos, the definition includes any combination of agreements or transactions, option to enter into these agreements or transactions, master agreements with all supplements and security and credit enhancement agreements, with damages subject to § 562.

– does not include purchase, sale or repurchase obligation under a participation in a commercial mortgage loan.

12

IV. Repurchase Agreements

• Defined in §101(47):– an agreement, including related terms

• provides for a transfer;

• of certificates of deposit, mortgage related securities (as defined in Section 3 of the Securities Exchange Act of 1934), mortgage loans, interests in mortgage related securities or mortgage loans;

• eligible bankers’ acceptances, qualified foreign government securities (representing a direct obligation of, or that is fully guaranteed by, the central government of a member of the organization for Economic Cooperation and Development);

• securities that are direct obligations of, or are fully guaranteed by the U.S. or U.S. agency;

• against transfer of funds by the transferee;

• with simultaneous agreement by transferee to transfer the instruments back;

• at a date certain not later than one year after the transfer, or on demand, against transfer of fund.

– any combination of agreements or transactions described in (i) and (iii);– an option to enter into an agreement or transaction described in (i) or (ii);– a master agreement that provides for an agreement or transaction referred to above,

together with all supplements to any such master agreement, without regard to whether such master agreement provides for an agreement or transaction that is not a repurchase agreement under this paragraph, except that such master agreement shall be considered to be a repurchase agreement under this paragraph only with respect to each agreement or transaction under the master agreement that is referred to above; or

13

IV. Repurchase Agreements (cont’d)

– any security agreement or arrangement or other credit enhancement related to any agreement or transaction referred to in clause (i), (ii), (iii), or (iv), including any guarantee or reimbursement obligation by or to a repo participant or financial participant in connection with any agreement or transaction referred to in any such clause, but not to exceed the damages in connection with any such agreement or transaction, measured in accordance with section 562;

• Does not include a repurchase obligation under a participation in a commercial mortgage loan.

• Applies to reverse repos: A Repo in which the broker-dealer rather than being the initial seller, is the initial buyer.

• Mortgage related securities: A security that is rated in one of the two highest rating categories by at least one nationally recognized statistical rating agency. American Home Mortgage v. Lehman Brothers, 388 B.R. 69 (Bankr. D. Del. 2008) (notes secured by mortgages rated BBB by S&P and Baa2 by Moody’s, do not meet the definition).

• Interest in mortgage loans: Notes secured by mortgage loans qualify. American Home Mortgage v. Lehman, supra.

• Eligible bankers’ acceptances: Probably refers to bankers’ acceptances authorized under § 13(7) of the Federal Reserve Act. Bankers’ acceptances are essentially third-party obligations which the bank committed to honor.

14

V. Swaps

• Swap agreement is defined in § 101(53B):

– Any agreement (including terms and conditions incorporated by reference in such agreement);

– an interest rate swap, option, future, or forward agreement (is the term different from the defined term forward contract? Nat’l Gas, 369 B.R. at 895), including a rate floor, rate cap, rate collar, cross-currency rate swap, and basis swap;

– a spot, same day-tomorrow, tomorrow-next, forward, or other foreign exchange, precious metals or other commodity agreement;

– a currency swap, option, future, or forward agreement;

– an equity index or equity swap, option, future, or forward agreement;

– a debt index or debt swap, option, future, or forward agreement;

– a total return, credit spread or credit swap, option, future, or forward agreement;

– a commodity index or a commodity swap, option, future, or forward agreement;

– a weather swap, weather derivative, or weather options;

– Emissions swap, option future, or forward agreement; or

– Inflation swap, option, or future agreement.

15

V. Swaps (cont’d)

– any agreement or transaction that is similar to any other agreement or transaction referred to in this paragraph and that

• is of a type that has been, is presently, or in the future becomes, the subject of recurrent dealings in the swap markets (including terms and conditions incorporated by reference therein); and

• is a forward, swap, future, option or spot transaction on one or more rates, currencies, commodities, equity securities, or other equity instruments, debt securities or other debt instruments, quantitative measures associated with an occurrence, extent of an occurrence, or contingency associated with a financial, commercial, or economic consequence, or economic or financial indices or measures of economic or financial risk or value.

• Similar to the other financial contracts, the definition includes any combination of these agreements or transactions, any option thereon, any master agreement and the supplements and any security or credit enhancement agreement, with damages subject to § 562.

• The definition applies only for Bankruptcy Code purposes and shall not be applied to challenge or affect the characterization or treatment of swaps under any other statute, regulation or rule.

• The 2005 amendments significantly expanded the definition to specifically cover, among other things, equity and credit derivatives. The legislative history notes that the original definition, which included “any other similar agreements,” was intended to provide sufficient flexibility to avoid the need to amend the definition as the nature and uses of swaps mature. The amended definition is designed to clarify such intent.

16

V. Swaps (cont’d)

• Legislative history to the 2005 amendments states that agreements are not protected just because they are documented as swaps. National Gas Distributors, LLC, 369 B.R. 884, 898 (Bankr. E.D.N.C. 2007) (refusing to treat a forward gas supply agreement as a swap agreement because it was a private supply agreement with no impact on financial markets), rev’d, Hutson v. E.I. Du Pont, No. 07-2105 (4th Cir., Feb. 11, 2009).

17

VI. Setoff / Netting Agreements

• Legislative Intent: Focus is on stability of financial markets:– "[T]he stay provisions of the Code are not construed to prevent brokers from closing out the

open accounts of insolvent customers or brokers. The prompt closing out or liquidation of such open accounts freezes the status quo and minimizes the potentially massive losses and chain reactions that could occur if the market were to move sharply in the wrong direction." H.R. Rep. No. 97-420, at 2 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 584; see also id. at 585 (specifically referring to forward contract merchants).

• Exercise of setoff rights and other secured creditor’s remedies are generally subject to the automatic stay. §§ 362(a)(4),(6),(7); 553

• Recoupment is generally held to be exempt from the stay. Holyoke Nursing, 372 F.3d 1, 3 (1st Cir. 2004).

– Setoff allows parties to setoff obligations arising from various transactions among them; recoupment is limited to the same transaction.

– Recoupment does not apply to claims arising from post rejection/termination of the contracts. Mirant, 310 B.R. 548, 560 (Bankr. N.D. Tex. 2004).

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VII. Prohibitions on Avoiding Certain Transfers

• Except for actual fraudulent transfers, § 546(e), (f), (g), protect from avoidance transfers that constitutes margin or settlement payments made by, to, or for the benefit of a protected party, or transfers made in connection with qualified contracts.

– While the 2006 amendments provide that § 546(e), dealing with margin or settlement payments to a commodity broker, forward contract merchant, stockbroker, financial institutions, financial participant or securities clearing agencies, apply to transfers made under qualified contracts, it is not clear that it requires that the margin or settlement payments referred to be made under a qualified contract.

– The 2006 amendments to § 546(f) dealing with repos, deleted the reference to margin and settlement payment and apply to any transfer made “in connection with a repurchase agreement.”

– Note that § 546(g) dealing with swaps, exempt a transfer under, or in connection with a swap agreement but does not reference margin or settlement payments.

– The 2005 amendments added § 546(j) protecting from avoidance a transfer made by, to or for the benefit of a master netting agreement participant (defined in § 101(38B) as an entity that any time before the petition is a party to an outstanding master netting agreement with the debtor), in connection with a master-netting agreement, except if such transfer is avoidable under a contract covered by the master netting agreement.

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VII. Prohibitions on Avoiding Certain Transfers (cont’d)• Protection is supplemented by § 548(d)(2)(B), (C), (D) providing that protected parties

that receive margin or settlement payments are deemed to have provided value.

– Legislative History: “[T]his provision exempts these types of customary setoff payments in the forward contract trade from scrutiny as to whether they are actually fair value for the amount used.” H.R. Rep. No. 101-484, at 7 (1990), reprinted in 1990 U.S.C.C.A.N. 223, 229.

• Margin Payments – Margin payment for forward contract purposes is defined in section 101(38) of the Bankruptcy

Code as a "payment or deposit of cash, a security or other property, that is commonly known in the forward contract trade as original margin, initial margin, maintenance margin, or variation margin, including mark-to-market payments, or variation payments."

• Sections 741(5) and 761(15) of the Bankruptcy Code contain similar definitions of margin payment for the securities trade and commodities trade, respectively. In re Stewart Finance Co., 367 B.R. 909 (Bankr. M.D. Ga. 2007) at *5 (“Margin payment is a broadly construed term and includes any payment by a debtor to pay for the purchase of securities or to reduce a deficiency in a margin account.”)

– At least two courts suggested that an initial payment made to open a margin account, at a time when no trades took place and no deficiency exists, is not a margin payment. Seitter v. Farmer's Commodities Corp. (In re Yeagley), 220 B.R. 402, 405 (Bankr. D. Kan. 1998) ("The term 'margin payment' is not broad enough, however, to encompass payment made to open a margin account before any trading is conducted or any deficiency incurred."); Biggs v. Smith Barney, Inc. (In re David), 193 B.R. 935, 940 (Bankr. C.D. Cal. 1996) ("[T]he terms 'margin payments and 'settlement payment' do not include all payments into a margin account. For example, the court would be hard-pressed to find that a payment made to open an account with a stockbroker, prior to any trading, constituted a margin payment.").

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VII. Prohibitions on Avoiding Certain Transfers (cont’d)

• Settlement Payments– Settlement payment is defined in § 101(51A) for forward contract purposes as "a preliminary

settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade." Section 741(8) of the Bankruptcy Code contains a substantially similar definition of settlement payment for the securities trade.

– In Contemporary Industries Corp. v. Frost , grant of summary judgment in favor of defendant is affirmed where: 1) the district court and bankruptcy court did not err in concluding that the payments defendants received in exchange for their privately-held stock were exempt settlement payments within the meaning of former Bankruptcy Code sec. 546(e); and 2) bankruptcy court properly granted summary judgment on plaintiff's state law claims for unjust enrichment and illegal and/or excessive shareholder distributions as the claims were preempted by former Bankruptcy Code sec. 546(e).

– Although the statutory definition is circular and not particularly illuminating, courts, in the securities context, have held that at a minimum the payment must involve the system of intermediaries and guarantees typical of the securities industry. Munford, 98 F.3d 604, 609-10 (11th Cir. 1996) (LBO is essentially a private transaction; no protection from avoidance); Norstan Apparel Shops, Inc., 367 B.R. 68 (Bankr. E.D.N.Y. 2007) (LBO of a private company); Grafton, 321 B.R. 527 (Bankr. 9th Cir. 2005) (redemption of equity in an LLC run as a ponzi scheme; not protected-not involving public markets and involving illegally unregistered securities).

21

VII. Prohibitions on Avoiding Certain Transfers (cont’d)– Zahn v. Yucaipa Capital Fund, 218 B.R. 656, 675-76 (D.R.I. 1998) (court held that, even if interpreted broadly, to

qualify as settlement payment for purposes of statute, payment must implicate the "system of intermediaries and guarantees" of the securities industry "wherein parties use intermediaries to make trades of public stock which are instantaneously credited, but in which the actual exchange of stock and consideration therefor take place at a later date"); Jewel Recovery, L.P. v. Gordon, 196 B.R. 348, 353 (N.D. Tex. 1996) (held, private stock sale not protected by the Bankruptcy Code because it "lack[s] the impact on the public market trading systems that Congress intended to protect"); Grand Eagle, 288 B.R. 484, 491-95 (Bankr. N.D. Ohio 2003) (private sale through financial intermediary); Integra Realty, 198 B.R. 352, 356-60 (Bankr. D. Colo. 1996) (spin-off); Healthco, 195 B.R. 971, 983 (Bankr. D. Mass. 1996) (LBO); Wieboldt Stores, 131 B.R. 655, 664-65 (N.D. Ill. 1991) (LBO).

– Other cases refuse to deny protection simply because the transaction does not impact the public markets or involve illegal securities law transactions. Resorts Int’l, 181 F.3d 505, 514-16 (3d Cir. 1999) (LBO); Kaiser Steel, 952 F.2d 1230, 1236-37 (10th Cir. 1991) (LBO); Bevill, Bresler, 878 F.2d 742, 750-53 (3d Cir. 1989) (Repo); Hechinger, 274 B.R. 71, 83-89 (D. Del. 2002) (LBO); QSI Holdings, 2007 WL 4557855 (W.D. Mich. 2007) (private LBO); Plassein Int’l Corp., 366 B.R. 318 (Bankr. D. Del. 2007), aff’d 388 B.R. 46 (D. Del.2008) (LBOs of privately held companies); Quality Stores, 355 B.R. 629 (Bankr. W.D. Mich. 2006), aff’d, W.D. Mich. Dec. 21, 2007 (private LBO); IT Group, 359 B.R. 97 2006 (Bankr. D. Del. 2006) (private stock sale transaction).

– Applies to “private” stock redemption, Loranger Mfg. Corp., 324 B.R. 575, 583-86 (Bankr. W.D. Pa. 2005), and to payments made under a contract for purchase of stock of non-publicly traded company. Elrod Holdings, 390 B.R. 760 (Bankr. D. Del. 2008).

– A CLO’s sponsor’s purchase of CLO notes to provide credit support and to prevent investors’ losses through financial institutions and stockbrokers, qualifies as a settlement payment. Enron Corp. v. Int'l Finance Corp., 341 B.R. 451 (Bankr. S.D.N.Y. 2006).

– Payment made contrary to the applicable contractual terms, does not qualify. Enron, 325 B.R. 671, 685-86 (Bankr. S.D.N.Y. 2005) (Prepayments made to retire short terms CP notes, where the notes were not redeemable or prepayable pursuant to their terms and the offering document (and also at significantly above market value) are not common and thus do not qualify).

22

VII. Prohibitions on Avoiding Certain Transfers (cont’d)

• These authorities are probably inapplicable to forwards and swaps as these transactions are typically private. But see National Gas Distrib., 369 B.R. at 898 (refusing to treat a forward gas supply agreement as a swap agreement because it was a private supply agreement with no impact on financial markets), rev’d, Hutson v. E.I. Du Pont, No. 07-2105 (4th Cir., Feb. 11, 2009).

– The Fifth Circuit expressed its agreement with precedents outside the securities area that the term should be interpreted broadly, and in the context of forward contracts does not require the payment to be made on a financial derivative, under on-market transaction or to be cleared or settled through a centralized system. Olympic Gas, 294 F.3d at 742, aff'g 258 B.R. at 165-66 (payments made under forward contracts were settlement payments for forward contract purposes although their avoidance "would have no impact on the securities system"); Borden Chemicals, 336 B.R. 214, 229 (Bankr. D. Del. 2006) (payments made under the contract following delivery of gas are settlement payments); Mirant, 310 B.R. 548, 563 (Bankr. N.D. Tex. 2004) (setoff of claims arising from termination of forward contract is a settlement payment).

• The legislative history to section 101(51A) as well as the section itself state that, as to forward contracts, a settlement payment includes a "similar payment commonly used in the forward contract trade." Olympic Gas, 258 B.R. at 166 (net payments exchanged monthly among the parties on account of forward contracts for natural gas, qualified as settlement payments under section 101(51A) as "a similar payment commonly used in the forward contract trade"), aff'd, 294 F.3d at 742.

23

VII. Prohibitions on Avoiding Certain Transfers (cont’d)

• Courts applied this definition to repos. Hamilton Taft, 114 F.3d 991, 993 (9th Cir. 1997) (reverse repo); Jonas v. Resolution Trust Corp. (In re Comark), 971 F.2d 322, 326 (9th Cir. 1992) (party's withdrawal from a repurchase transaction, and the return of additional margin posted in connection with the repo, is a settlement payment); Bevill, Bresler & Schulman Asset Management Corp. v. Spencer Sav. & Loan Ass'n, 878 F.2d 742, 751-53 (3d Cir. 1989) (interpreting the term settlement payment to fit the settlement process applicable to repurchase agreements).

• Payment obtained through attachment did not qualify as a protected payment under a swap under the pre-2005 amendments version of section 546(g), Interbulk, 240 B.R. 195, 201 n.8 (Bankr. S.D.N.Y. 1999), but does qualify post 2005 amendments. Casa de Cambio, 390 B.R. 595 (Bankr. N.D. Ill. 2008).

• Exercise of setoff to recover erroneous payments, may not qualify. GPR Holdings, 316 B.R. 477 (Bankr. N.D. Tex. 2004) (forward).

• Payment for gas purchased after initial failure to pay and collection activities by the seller, may not qualify. Aurora Natural Gas, 316 B.R. 481 (Bankr. N.D. Tex. 2004) (forward).

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