On May 2, 2023, the US District Court for the Southern District of Indiana reversed a bankruptcy court’s ruling that read limitations into the application of Bankruptcy Code Section 546(e)’s safe harbor to a stock purchase transaction. Specifically, the District Court relied on the plain language of Section 546 in determining that a chapter 7 trustee could not avoid the transfer of $24.9 million by the debtor to repay a bridge loan in connection with a financed acquisition of the debtor’s stock two years prior to its bankruptcy filing. In so ruling, the District Court determined that the bankruptcy court erred in applying certain limitations to Section 546(e)’s safe harbor, including a temporal requirement and a requirement that the transaction involve public (and not private) securities. The District Court found neither requirement in the plain language of Section 546. The District Court further concluded that the Trustee could not set aside Section 546(e)’s safe harbor simply by asserting a state law claim through Bankruptcy Code Section 544, and that even if the Trustee somehow could assert standalone claims under state law, Section 546(e) would preempt them.  

Since the US Supreme Court’s decision in Merit Management Group, LP v. FTI Consulting, 138 S. Ct. 883 (2018), several decisions (mostly in the Second Circuit or in Delaware) have refused to narrowly construe Bankruptcy Code Section 546(e)’s safe harbor. The District Court’s decision here is noteworthy because it comes from a court in the Seventh Circuit, and the US Court of Appeals for the Seventh Circuit has not yet addressed application of Section 546(e) to a securities transaction post-Merit. Thus, it appears that courts in the Seventh Circuit may join the Second Circuit and Delaware in preserving broad application of Section 546(e)’s safe harbor, despite market fears to the contrary in the aftermath of Merit.    

Factual Background

BWGS, LLC (“BWGS”), originally formed as an Indiana corporation called Worm’s Way, Inc., distributed wholesale organic and hydroponic garden products. In 2015, BWGS began experiencing a downward trend in its gross profit margin. In 2016, it began incurring millions in net losses. Sun Capital Partners, VI, L.P. (“Sun Capital”), subsequently took interest in acquiring BWGS. At that time, all of BWGS’s outstanding stock was held in an Employee Stock Ownership Plan Trust (“ESOP Trust”). 

By late 2016, BWGS Intermediate Holding, LLC (“Intermediate Holding”), an affiliate of Sun Capital, entered into a stock purchase agreement (the “Stock Purchase Agreement”) to acquire all of BWGS’s stock from the ESOP Trust. In order to fund a portion of the stock purchase, on December 30, 2016, Intermediate Holding and BMO Harris Bank, N.A. (“BMO”) entered into an agreement whereby BMO provided a bridge loan to Intermediate Holding for $25.8 million (the “Bridge Loan”). Sun Capital or one of its affiliates either guaranteed the Bridge Loan or was otherwise obligated to ensure that the Bridge Loan was repaid (the “Sun Capital Guaranty”).

Shortly after the Stock Purchase Agreement closed, BWGS and Intermediate Holding, as co-borrowers, entered into agreements with LBC Credit Agency Services, LLC (“LBC”), as administrative agent, for a $20 million term loan and with JPMorgan Chase Bank (“JPMorgan”), as administrative agent, for a revolving credit facility of up to $20 million. Each of the loans was secured by a lien on substantially all of BWGS’s assets. A total of $25,887,303—the majority of which was funded with proceeds of the loans from LBC and JPMorgan—was transferred to BMO in full payment of the Bridge Loan. 

BWGS’s sales continued to decline following the transaction with Sun Capital, resulting in defaults on the two credit agreements in December 2017 and other obligations in May 2018. The two credit agreements were subsequently amended, and Sun Capital was required to inject $3 million into BWGS to reduce the principal amount owed on the term loan. The business did not successfully turnaround, however, and BWGS found itself in default again shortly thereafter. On March 13, 2019, three creditors filed an involuntary petition against BWGS under chapter 7 of the Bankruptcy Code. 

The chapter 7 trustee subsequently filed an adversary proceeding against BMO and Sun Capital, seeking to avoid as a constructively fraudulent transfer the $25.9 million transferred to BMO in repayment of the Bridge Loan. The trustee asserted causes of action under Section 544(b) of the Bankruptcy Code and Sections 14(a)(2), 17(a), and 18(b)(1) of the Indiana Uniform Voidable Transactions Act (“IUVTA”). BMO and Sun Capital moved to dismiss the lawsuit based on Bankruptcy Code Section 546(e)’s safe harbor, arguing that the trustee cannot avoid the transfer because it was made in connection with several securities contracts, including the Stock Purchase Agreement, the Bridge Loan and the Sun Capital Guaranty. BMO and Sun Capital also argued that the IUVTA claims were preempted by Section 546(e).

The Bankruptcy Court Determines That the Safe Harbor Does Not Apply

The Bankruptcy Court found that Section 546(e)’s safe harbor provision did not apply. The court first examined the legislative history and read into Section 546(e) a requirement that the securities at issue must be publicly held. The bankruptcy court then concluded that the transfer did not satisfy this requirement because it did not “implicate the national System for trades of publicly-held securities or pose a systemic risk to the financial marketplace.”  

The bankruptcy court next considered whether the transfer at issue was actually made “in connection with” a securities contract, as required by Section 546(e). The bankruptcy court determined that it was not by observing that the transfer occurred one month after the Stock Purchase Agreement closed and there lacked a “sufficient material nexus” between the Stock Purchase Agreement and the transfer. 

Finally, the bankruptcy court held that because the trustee had adequately alleged a state law claim under IUVTA, he could avoid the transfers pursuant to his “strong-arm” powers under Section 544 notwithstanding Section 546(e). BMO and Sun Capital timely filed an appeal.

The District Court Rejects the “Public Securities” Requirement Imposed by the Bankruptcy Court

The District Court found that the bankruptcy court erred in imposing a requirement that the transfer at issue implicate publicly held securities. The District Court specifically rejected the bankruptcy court’s inquiry into the legislative history of Section 546(e), finding instead that the statute was clear and that principles of statutory construction prohibit considering the legislative history when the language of the statute itself is unambiguous. The District Court noted that the plain language of the statute does not distinguish between publicly traded securities versus privately held securities, and, therefore, nothing in the statute suggests that Congress intended to exclude transfers involving privately held securities from its purview. For support, the District Court looked to numerous other decisions from courts across the country that have applied Section 546(e)’s safe harbor to transactions that did not implicate publicly held securities.

The District Court Determines That Each of the Stock Purchase Agreement, the Bridge Loan and the Sun Capital Guaranty Were “Securities Contracts”

The District Court read the bankruptcy court’s decision to only consider whether the Stock Purchase Agreement was a securities contract, without considering whether the Bridge Loan and the Sun Capital Guaranty also were securities contracts. Because the bankruptcy court did not consider the applicability of Section 546(e)’s safe harbor to the other two contracts, the District Court reasoned that the bankruptcy court’s analysis of whether the transfer was made “in connection with a securities contract” was incomplete. 

The District Court then performed this analysis. In doing so, it found that the Bridge Loan was an “extension of credit for the clearance or settlement of a securities transaction” pursuant to Bankruptcy Code Section 741(7). Moreover, given that the Sun Capital Guaranty involved providing credit enhancement to BMO with respect to the Bridge Loan, the District Court found that the guaranty was an “arrangement or other credit enhancement related to any agreement or transaction.” Therefore, the District Court found that both the Bridge Loan and the Sun Capital Guaranty were securities contracts as defined by the Bankruptcy Code.

The District Court Holds That the Transfer Was “In Connection With” a Securities Contract

The District Court next addressed how to interpret the phrase “in connection with,” which the bankruptcy court interpreted to have a temporal requirement. The District Court rejected this interpretation, noting that the phrase should be interpreted broadly, following the logic of In re Lehman Bros. Holdings, Inc. 469 B.R. 415, 442 (S.D. N.Y. 2012). Similar to the bankruptcy court in Lehman, the District Court concluded that Section 546(e) does not explicitly impose a temporal requirement or a requirement that a transfer relate specifically to the securities contract in order for a transfer to be made “in connection with” a securities contract. Thus, the District Court held that the bankruptcy court erred in finding that the safe harbor did not apply due to the month-long gap between the transfer and the closing of the Stock Purchase Agreement. 

The District Court Determines That Section 546(e)’s Safe Harbor Preempts State Law Claims

The District Court reversed the bankruptcy court on this point as well, holding that the transfer fell within the plain language of Section 546(e), and, thus, the trustee could not avoid it by asserting a claim under Section 544(b) and the IUVTA. 

The IUVTA is Indiana’s set of laws that, among other things, allow a creditor to avoid certain constructively fraudulent transfers. Section 544(b) of the Bankruptcy Code allows a trustee to stand in the shoes of any unsecured creditor and avoid transfers that the unsecured creditor could have avoided outside of bankruptcy using applicable non-bankruptcy law. In this case, the trustee sought to stand in the shoes of an unsecured creditor under Section 544(b) and use the IUVTA to establish liability, then recover the value of the transfer under Section 550(a). 

The District Court found that the bankruptcy court did not consider that, without Section 544, the Trustee could not assert a claim using the IUVTA. Section 546(e) specifically states “[n]otwithstanding section 544 . . . the trustee may not avoid a transfer . . . .” In light of this language, the District Court reasoned that the trustee could not use Section 544 if a transfer falls within Section 546(e)’s safe harbor. As already noted above, the District Court concluded that the transfer fell within Section 546(e)’s safe harbor. 

The District Court further held that even if the trustee had asserted standalone claims under the IUVTA, Section 546(e) would have preempted them. In reaching this conclusion, the court noted that the US Court of Appeals for the Seventh Circuit had not addressed the issue, but followed the logic of other recent decisions. See In re Tribune Co. Fraudulent Conveyance Litigation, 946 F.3d 66, 96 (2d Cir. 2019); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 988 (8th Cir. 2009), abrogated on other grounds by Merit Mgmt. Grp., LP v. FTI Consulting, 138 S. Ct. 883 (2018) (“Allowing recovery on these claims would render the § 546(e) exemption meaningless, and would wholly frustrate the purpose behind that section.”); see also In re Quorum Health Corp., 2023 WL 2552399, at *11 (D. Del. Mar. 16, 2023). 

Key Takeaways

In the wake of the US Supreme Court’s 2018 decision in Merit, parties to commercial transactions expressed concern that the Supreme Court’s elimination of the “conduit” defense for fraudulent conveyance actions might have a chilling effect on the willingness of courts to apply Section 546(e) broadly to securities transactions. That simply has not been the case. And although the issue addressed in Merit was not directly implicated here, the District Court’s decision involving BWGS should give commercial parties further confidence when structuring financial transactions, including through the use of a bridge loan to fund a buyout where the permanent financing may not close for a period of time afterwards. Indeed, the decision demonstrates that Section 546(e) has vitality outside of the Second Circuit and Delaware, where many of the prior decisions have been issued post-Merit