Seventh Circuit rules that the Bankruptcy Code’s “safe harbor” provision shields private securities transactions from fraudulent transfer claims and preempts state law claims

On March 15, 2024, the US Court of Appeals for the Seventh Circuit issued a ruling that broadly applied the “safe harbor” provision of section 546(e) of the Bankruptcy Code to insulate from state and federal fraudulent transfer attack certain transactions involving private securities. Petr, Trustee for BWGS, LLC v. BMO Harris Bank, N.A. and Sun Capital Partners VI, L.P., No. 23-1931, 2024 WL 1132170 (7th Cir. 2024). The court addressed two questions of first impression in the Seventh Circuit:

1. “Whether §546(e), which shields from avoidance certain transactions made ‘in connection with a securities contract,’ extends to transactions involving private securities that do not implicate the national securities clearance market;” and, if so,
2. “[W]hether §546(e) also preempts state law claims seeking similar relief such that a bankruptcy trustee may not bring them under §544(a) of the Bankruptcy Code.”[1]

By affirming the US District Court for the Southern District of Indiana, the Seventh Circuit answered both questions in the affirmative.

In ruling on the first issue, the Seventh Circuit joined the Third, Fifth, Sixth, and Eighth Circuits, each of which has found that the safe harbor provision applies to private securities transactions.[2] As to the second issue of preemption, the Seventh Circuit joined the Second and Eighth Circuits in finding such state law claims preempted.[3]

The ruling has important implications within the Seventh Circuit as it provides protection against fraudulent transfer claims in bankruptcy cases to parties engaged in private transactions relating to redemptions, purchases, or other securities transactions that do not involve a national securities market.

Background

BWGS, LLC was a wholesale distributor of hydroponic and organic garden products. BWGS began to struggle financially, and, in 2016, Sun Capital Partners targeted BWGS for acquisition. At the time, an Employee Stock Ownership Plan (ESOP) owned all of BWGS’s outstanding stock. Importantly for the issues presented to the Seventh Circuit, BWGS was therefore a privately held company that never had publicly traded stock.

Sun Capital negotiated with the ESOP and ultimately executed a stock purchase agreement (SPA) pursuant to which a Sun Capital subsidiary called BWGS Intermediate Holding, LLC would acquire the stock of BWGS.

To finance the acquisition, Intermediate Holding entered into a loan authorization agreement with BMO Harris Bank N.A. Under the loan agreement, BMO extended a $25.8 million bridge loan to Intermediate Holding (BMO Bridge Loan), which Sun Capital guaranteed. Intermediate Holding then paid the funds to the ESOP as the purchase price for the BWGS stock. The acquisition and BMO Bridge Loan closed on December 30, 2016.

Approximately one month later, Intermediate Holding and BWGS entered into two credit agreements as joint borrowers and used the loan proceeds to satisfy the BMO Bridge Loan and terminate Sun Capital’s obligations under its guaranty. BWGS’s use of the proceeds shall hereafter be defined as the “transfers.” BWGS received no value in exchange for the transfers.

The transfers left BWGS in a dire financial position. Ultimately, following repeated defaults under the credit agreements, BWGS’s creditors filed an involuntary chapter 7 petition against BWGS in 2019. On April 24, 2019, the bankruptcy court entered an order for relief under chapter 7 of the Bankruptcy Code (BWGS Bankruptcy Case).

Procedural history

The chapter 7 trustee in the BWGS Bankruptcy Case commenced an action against BMO, Sun Capital, and other unidentified entities in the US Bankruptcy Court for the Southern District of Indiana, seeking to avoid and recover the transfers from either BMO or Sun Capital as fraudulent transfers. Specifically, the trustee moved under section 544(b)(1) of the Bankruptcy Code, which allows a trustee to step into a creditor’s shoes and avoid any transfers that creditor could have avoided under applicable law. The “applicable law” upon which the trustee relied was the Indiana Uniform Voidable Transactions Act (IUVTA), sections 14(a)(2) and 17(a), which allows a creditor to avoid constructively fraudulent transfers. The trustee further alleged that he could recover the value of the transfers under section 550 of the Bankruptcy Code and section 18(b)(1) of the IUVTA, which allows recovery of the value of an asset transferred to the extent such transfer is avoidable under IUVTA section 17(a)(1).

BMO and Sun Capital moved to dismiss the complaint on the grounds that the transfers were not avoidable because they were protected by the safe harbor provision of section 546(e). Under that provision, a trustee may not avoid certain transfers for the benefit of a financial institution made “in connection with” a “securities contract” (as defined in section 741(7) of the Bankruptcy Code), except for actual fraudulent transfers.

Findings

The bankruptcy court found that, although the SPA qualified as a “securities contract” under section 546(e), the parties did not make the transfers “in connection with the SPA,” because the transfers lacked “a sufficient material nexus” to the SPA.[4] The bankruptcy court also found that the trustee’s powers under section 544(b)(1) did not implicate the safe harbor because a creditor could recover the value of a transfer under the IUVTA “without actually avoiding the transfer.”[5]

The district court reversed, ruling that the underlying agreements (ie, the SPA, bridge loan agreement, and related guaranty) qualified as “securities contracts” and that the transfers were made “in connection with” those contracts. The district court therefore determined that the safe harbor of section 546(e) applied to prevent the avoidance action. It also held that the trustee waived his argument that the safe harbor does not apply to state law claims brought under section 544(a) of the Bankruptcy Code and that, even if he had brought such claims as freestanding claims under state law, the safe harbor would have preempted them.

Seventh Circuit ruling affirmed the district court and applied section 546(e) to reject the trustee’s avoidance action

In affirming the district court, the Seventh Circuit relied on the plain language of section 546(e), which provides:

Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title ... or that is a transfer made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract, as defined in section 741(7) ....

(emphasis added). In interpreting the statutory language, the court focused on the highlighted text above: whether private securities transactions fall within the term “securities contract” and what it means for a transfer to be made “in connection with a securities contract.”

“Securities contracts” include contracts for private and publicly held securities

On appeal, the trustee contended that the term “securities contracts” applied only to “transactions that implicate the national system for the clearance and settlement of publicly held securities.” The Seventh Circuit rejected that reading as too narrow and held that “securities contracts” also included private securities transactions. In so doing, the Seventh Circuit analyzed the plain language of section 546(e) and found that nothing in the text “excludes private contracts not implicating the national securities clearance system.” To the contrary:

Section 546(e) defines ‘securities contract” by reference to 11 U.S.C. § 741(7) of the Bankruptcy Code. As we have recognized, § 741(7) defines the term ‘very broadly.’ . . . . not one of [its] eleven sub-definitions contains any indication that it is limited to contracts implicating only publicly held securities.[6]

The Seventh Circuit also noted that the Third, Fifth, Sixth, and Eighth Circuits had all ruled similarly, finding that nothing in the definition of “securities contract” or section 546(e) limited the term to public securities. Accordingly, Seventh Circuit concluded that the term “securities contract” unambiguously includes contracts for private securities.

The court next considered whether the SPA, bridge loan agreement, and related guaranty qualified as “securities contracts” and concluded that each of them did. According to the Seventh Circuit:

1. The SPA was an agreement for the purchase of stock, so fell squarely within the definition of a securities contract under section 741(7)(A)(i), which includes contracts for the purchase or sale of a security
2. The bridge loan agreement was an extension of credit for clearance of the SPA, so fell squarely within the definition of a securities contract under section 741(7)(A)(v), which includes “any extension of credit for the clearance or settlement of securities transactions,”[7] and
3. The guaranty qualified as well under subsection 747(A)(xi) as a “credit enhancement” related to the bridge loan agreement.

The phrase “in connection with” should be broadly applied

As noted above, the safe harbor provisions of Section 546(e) apply only to transfers made “in connection with” a securities contract. The Seventh Circuit had no issue finding that the transfers occurred in connection with securities contracts. According to the Seventh Circuit, the transfer “fully satisfied the Bridge Loan – a securities contract – and extinguished Sun Capital’s obligations under the Guaranty – another securities contract.”

Last, the Bridge Loan and the Guaranty “effectuated the fulfillment of the SPA – yet another securities contract.”[8] The court acknowledged that the transfers occurred nearly a month after execution of the SPA but this did not change its conclusion that the transfers were made “in connection with” the SPA, as section 546(e) contains “no temporal requirement” and it saw “no reason to impose one.”[9]

The court concluded that the safe harbor provision was applicable to bar the trustee’s avoidance action.

Under the Supremacy Clause, section 546(e) of the Bankruptcy Code preempts state law avoidance claims

The Seventh Circuit then turned to whether the safe harbor provision of section 546(e) preempted the trustee’s state law claims under section 544(a) of the Bankruptcy Code. Under that section, “[t]he trustee shall have ... the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by” certain creditors.

The trustee argued that this provision gave him the right to pursue various causes of action under the IUVTA. Section 14(a)(2) of the IUVTA provides that a constructively fraudulent transfer is voidable “as to a creditor” and, under section 17(a)(1), a creditor may seek avoidance of a transfer to the extent of its claim. Under section 18(b)(1), to the extent a transfer is avoidable under 17(a)(1), the creditor may recover the value of the asset transferred.

Based on the above, the trustee argued that he could pursue a judgment for the value of an avoidable transfer under section 18(b)(1) without running afoul of section 546(e)’s prohibition on avoidance of a transfer, because he would not actually need to avoid the avoidable transfer in order to recover its value.

The court rejected this argument. In so doing, the court relied on opinions from the Second and Eighth Court of Appeals which found that “section 546(e) preempts state law claims seeking to recover the value of transfers that section 546(e) shields.”[10] It also cited its prior ruling in which it held that federal bankruptcy law preempted a trustee’s unjust enrichment claim, because to hold otherwise “would allow the trustee or a creditor to make an end run around the bankruptcy code’s allocation of assets and losses, frustrating the administration of the bankruptcy estate under federal bankruptcy law.”[11]

The court held that, if the trustee were permitted to recover the transfers, the safe harbor would be rendered meaningless, which was impermissible under the Supremacy Clause of the US Constitution. It further noted that section 550 of the Bankruptcy Code allows recovery of a transfer “to the extent that a transfer is avoided under section 544,” meaning the transfer must first be avoided in order to be recovered.[12]

The court concluded that the safe harbor of section 546(e) preempted the trustee’s state law claim to the extent it could otherwise be brought under section 544(a).

Outlook

In its BWGS ruling, the Seventh Circuit joined four of its sister circuits in finding that the safe harbor of section 546(e) shields private securities transactions from constructive fraudulent transfer litigation. Although the trustee has 90 days to appeal the ruling to the Supreme Court, a grant of certiorari may be unlikely given the unanimity among the Courts of Appeal with respect to the issues presented. As such, the ruling is likely to provide additional comfort to parties engaged in private securities transactions that those transactions should be protected from avoidance under 11 U.S.C. § 546(e).

DLA Piper’s Global Restructuring practice is highly experienced in developing solutions for distressed companies and their stakeholders in all manner of in- and out-of-court restructurings, liability management strategies, finance, and litigation matters.

If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors or your usual DLA Piper contact.


[1] BWGS, LLC, 2024 WL 1132170, at *1.
[2] See In re Plassein Int’l Corp., 590 F.3d 252 (3d Cir. 2009); In re Olympic Nat. Gas Co., 294 F.3d 737 (5th Cir. 2002); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009); Contemp. Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009).
[3] See In re Tribune Company Fraudulent Conveyance Litigation, 946 F.3d 66 (2d Cir 2019); Contemp. Indus. Corp., 564 F.3d at 981.
[4] Id, at *3.
[5] Id.
[6] Id. at *5
[7] Id. at 6*
[8] Id. at 7*
[9] Id.
[10] Id. at *9 (citing In re Tribune Co., 946 F.3d at 90-92; Contemp. Indus. Corp, 546 F.3d at 988 (emphasis added)).
[11] Id. (citing Grede v. FCStone, LLC, 746 F.3d 244, 259 (7th Cir. 2014)).
[12] Id.