Article: August 2016: Bankruptcy & Restructuring Litigation Update

Delaware Bankruptcy Court Disagrees with Second Circuit on Implied Preemption of State-Law Fraudulent Transfer Claims Brought by Creditors. In recent years, several bankruptcy and district courts have addressed whether the safe harbor provision of the Bankruptcy Code, 11 U.S.C. § 546(e), bars constructive fraudulent transfer claims brought directly by unsecured creditors under state law. While courts have uniformly held that the plain language of the safe harbor extends to constructive fraudulent transfer claims brought by the trustee under the Bankruptcy Code, 11 U.S.C. § 548(a)(1)(B) or § 544, courts are split as to whether the statute also preempts constructive fraudulent transfer claims brought by creditors under state law. The safe harbor itself is silent regarding state-law avoidance claims brought by individual creditors. This preemption issue has arisen in several bankruptcy cases when creditors or their assignees assert constructive fraudulent transfer claims arising from failed leveraged buyouts (“LBOs”) involving securities transactions that potentially implicate the safe harbor.

In a controversial decision that is subject to a pending petition for panel and en banc rehearing, a panel of the Second Circuit recently ruled that the safe harbor impliedly preempts state-law fraudulent transfer claims of creditors to the same extent that a trustee would be barred from bringing such claims in bankruptcy. In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 105 (2d Cir. 2016) (“Tribune II”). By its express terms, the safe harbor limits fraudulent transfer claims brought by a bankruptcy “trustee” under certain federal avoidance statutes, not those brought by a debtor’s creditors under state law. 11 U.S.C. § 546(e). The crux of the Tribune II decision is that, nevertheless, there is “ambiguity” in § 546(e), 818 F.3d at 111-18, and that ambiguity should be resolved in favor of implied preemption of all state-law avoidance claims because the presumption against preemption does not apply in bankruptcy (id. at 109-12), and because the legislative history and federal policies that motivated the enactment of the safe harbor support broad preemption (id. at 119-24).

Although not entirely unprecedented, the Tribune II decision was contrary to the decisions of most lower courts that had previously considered the issue and rejected attempts to dismiss creditors’ state-law fraudulent transfer claims as barred by the safe harbor. See Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 503 B.R. 348, 358 (Bankr. S.D.N.Y. 2014) (“Lyondell”) (finding no implied preemption), In re Tribune Co. Fraudulent Conveyance Litig., 499 B.R. 310, 325 (S.D.N.Y. 2013) (“Tribune I”) (same), Development Specialists, Inc. v. Kaplan (In re Irving Tanning Co.), No. 12-01024, Doc. 43 at 7 (Bankr. D. Me. Feb. 7, 2013) (same), PHP Liquidating, LLC v. Robbins, 291 B.R. 603, 607 (D. Del. 2003) (same). But see Whyte v. Barclays Bank PLC, 494 B.R. 196, 200 (S.D.N.Y. 2013) (finding implied preemption).

Following Tribune II, the bankruptcy court for the District of Delaware specifically considered and rejected the preemption holding of Tribune II shortly after it was decided. PAH Litigation Trust v. Water Street Healthcare Partners, LP (In re Physiotherapy Holdings, Inc.), No. 15-51238, Doc. 250 at 16 (Bankr. D. Del. June 20, 2016) (“Physiotherapy”). In Physiotherapy, the bankruptcy court concluded that “[a]lthough Tribune II settled the split in the Second Circuit, it is nevertheless not binding on the Court. The Court finds the reasoning [of the Southern District bankruptcy court] in Lyondell more persuasive and therefore adopts its holding.” Id.

In concluding that the safe harbor does not preempt state-law fraudulent transfer claims brought by creditors, Physiotherapy found that (1) the presumption against preemption does apply because “[s]tates have traditionally occupied the field of fraudulent transfer law” (id. at 16); (2) the plain language of the safe harbor only limits a trustee’s ability to bring certain fraudulent transfer claims under the Bankruptcy Code (id. at 20); (3) Congress used express preemption language in related Code provisions when it intended to preempt similar state-law avoidance claims (id. at 20-21); (4) the legislative history of the safe harbor does not support broad preemption of all state-law avoidance claims (id. at 18); and (5) the federal policies that motivated the enactment of § 546(e) were focused on “systemic risk,” not “finality for individual investors,” and this narrow focus is inconsistent with broad preemption of state-law avoidance claims that have no “destabilizing effect on the financial markets” (id. at 16-20).

Given the significance of the issue in the context of bankruptcy-related litigation and interplay between federal and state law, we expect that the United States Supreme Court will be called upon to be the final arbiter of the implied preemption issue either on review of Tribune II or perhaps in the future after another Court of Appeals contributes an opinion.