High contrast image of magician hand with magic wandA bankruptcy court wrote that filing for bankruptcy is “powerful magic.”  By finding federal preemption of state law fraudulent transfer claims, the Second Circuit Court of Appeals’ decision in the long-running Tribune case showed just how powerful this magic can be.

The Tribune saga began in 2007 when, during steep changes in the publishing industry, the struggling Tribune Company was taken private in a leveraged buyout (“LBO”) led by investor Sam Zell.  Under the terms of the LBO, Tribune added approximately $8 billion of debt to its balance sheet to fund a cash tender offer for all of its outstanding common stock, paying $34.00 per share for the 224 million common shares that were tendered.  Within a year of the LBO, however, Tribune was forced to file bankruptcy under Chapter 11.

In 2010, the unsecured creditors’ committee (the “Committee”) filed suit against Tribune’s cashed-out shareholders seeking to avoid Tribune’s payments to shareholders in the LBO as fraudulent transfers. The Committee alleged that these payments were transfers made with actual fraud—with the intent to hinder, delay, or defraud creditors—under section 548(a)(1)(A) of the Bankruptcy Code.  The Committee did not allege that the payments were constructively fraudulent under section 548(a)(1)(B).  The omission of constructive fraud claims was not inadvertent, but took account of the fact that the “safe harbor” established by section 546(e) prohibits the trustee from avoiding most securities transactions except transfers made with actual fraud. Perhaps recognizing the heightened burden required to establish actual fraud, groups of unsecured creditors sought and obtained stay relief to file, in their individual capacities, actions to avoid the payments as constructively fraudulent transfers under state law. Eventually, these avoidance actions were consolidated in the U.S. District Court for the Southern District of New York.

The shareholders moved to dismiss the creditors’ claims on several grounds, including that the state law claims were preempted by section 546(e) and that under section 362, the automatic stay divested the creditors of standing to avoid transfers that were already the subject of avoidance actions. The district court dismissed the claims, agreeing that the automatic stay deprived the creditors of standing to avoid transfers while such transfers were the subject of the Committee’s avoidance action (even though the Committee was proceeding with actual fraud claims, as opposed to the creditors’ constructive fraud claims). However, the district court disagreed that the creditors’ state law claims were preempted by section 546(e), and instead concluded that section 546(e) applies only to the trustee, and therefore does not preempt the claims brought by creditors in their individual capacities.

On appeal, the Second Circuit affirmed the district court, but for different reasons. The Second Circuit found that even if the automatic stay would deprive the creditors of standing (which issue the Second Circuit did not decide), the bankruptcy court had lifted the stay.  Therefore, there was no stay in place to implicate the creditors’ standing. However, in a fatal blow to the creditor groups, the court held that the creditors’ state law claims for constructive fraud were preempted by section 546(e)’s safe harbor.

The Second Circuit examined the statute’s language, purpose, and legislative history and concluded that by enacting section 546(e), Congress sought to limit the effects of a bankruptcy filing on the financial markets. Section 546(e)’s safe harbor furthered Congress’s desire to protect the stability and finality of securities markets and thereby reduce the cost of capital. Given this clear Congressional purpose, the court held that it would be illogical to limit trustees to bringing suits based on intentional fraud without simultaneously extinguishing state law constructive fraud claims. Therefore, even in the absence of an express preemption clause, the Second Circuit held that preemption was implied and that section 546(e) precluded the creditors from bringing state law fraudulent transfer claims.

This interpretation of section 546(e) might seem to be at odds with the Bankruptcy Code’s purpose of maximizing returns to creditors. However, as the Second Circuit pointed out, enforcement of an intentional fraud claim by a trustee, committee or debtor-in-possession would be undermined if creditors could bring separate state law claims involving the same transfers.  For instance, a trustee (or Committee as in the Tribune case) would have difficulty negotiating more than a nominal settlement in an avoidance action if creditors could bring state law claims attacking the same transfers. Therefore, the concentration of authority in the trustee, to the exclusion of individual actors, such as the creditors, is not necessarily at odds with the goal of maximizing estate assets, rather, it is part of bankruptcy’s “powerful magic.”