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Delaware Bankruptcy Court Holds Section 546(e) Safe Harbor Does Not Bar a Litigation Trust, as a Creditor-Assignee, From Asserting State Law Constructive Fraudulent Transfer Claims

PAH Litig. Trust v. Water Street Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), No. 15-51238 (KG), 2016 WL 3611831 (Bankr. D. Del. June 20, 2016)

In rendering this Opinion and permitting a post-confirmation trust to pursue state law constructive fraudulent transfer claims against two former shareholders of debtor Physiotherapy Holdings, Inc. (“Physiotherapy”), the Honorable Kevin Gross of the Delaware Bankruptcy Court eschewed the recent holding of the Court of Appeals for the Second Circuit that section 546(e) of the Bankruptcy Code preempts not only state law fraudulent transfer claims brought by trustees in bankruptcy, but also those brought by creditors.

Prior to the commencement of its bankruptcy proceeding, Physiotherapy was the target of a leveraged transaction.  As a result, it assumed $210 million of senior secured note obligations while its equity holders received $248.6 million for selling their shares.  The problem, as alleged by plaintiff, PAH Litigation Trust (the “Trust”), was that the notes were knowingly and fraudulently marketed with overstated revenue streams and enterprise values.  Physiotherapy defaulted on the notes shortly after the closing and ultimately filed for bankruptcy.  During the course of the bankruptcy, the Trust was established pursuant to a confirmed plan of reorganization.  In addition, the defrauded noteholders assigned their individual claims to the Trust.  Acting as estate representative and creditor-assignee, the Trust asserted fraudulent transfer claims under state and federal law against multiple defendants, including two controlling shareholders who allegedly participated in the accounting fraud.

The defendants moved to dismiss the Trust’s claims under Bankruptcy Code section 546(e)’s safe harbor, relying on case law from the Second Circuit that prevents post-confirmation trustees as creditor-assignees from asserting state law constructive fraudulent transfer claims.  See Whyte v. Barclays Bank PLC, 494 B.R. 196 (S.D.N.Y. 2013).  While the plain language of section 546(e) prevents “trustees” from avoiding as state law constructive fraudulent transfers settlement payments made by or to a financial institution in connection with a securities contract, the Trust argued that it does not apply to its claims because they are asserted in the Trust’s capacity as a creditor-assignee and not as an estate representative.  In support, the Trust relied upon conflicting case law from the Second Circuit permitting a post-confirmation trust, acting as an assignee of creditors’ claims, to pursue state law fraudulent transfer claims.  See Weisfelner v. Fund 1 (In re Lyondell Chem. Co.), 503 B.R. 348 (Bankr. S.D.N.Y. 2014).  The Second Circuit recently resolved this intra-district split, agreeing with Barclaysand abrogating Lyondell.  See Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig.), 2016 WL 1226871 (2d Cir. Mar. 29, 2016).

While the decisions of the Second Circuit courts are non-binding on the Delaware Bankruptcy Court, Judge Gross nevertheless found the reasoning of Lyondell persuasive and adopted its holding.  According to the court in Lyondell, state law fraudulent transfer claims “have traditionally occupied the field of fraudulent transfer law” and accordingly, preemption is appropriate only if state law thwarts the purpose behind section 546(e).  Holding that it does not, the Southern District of New York noted that section 546(e) was enacted to shield markets and avoid systemic risk therein.  This policy concern is not implicated when a debtor’s creditors sue its shareholders to recover assets wrongfully dissipated.

Looking at the circumstances present in Physiotherapy through the lens of the Lyondell analysis, the Court examined whether the purpose of section 546(e) would be thwarted by allowing the Trust to pursue its state fraudulent transfer claims against the defendants.  It concluded that “the answer is clearly no.”  Op. at *20.  First, the action targeted two controlling shareholders of a non-public corporation so it was difficult for the Court to envision any ripple effect on the market.  Second, the Trust brought the actions as a creditor-assignee, not as an estate representative – a scenario not addressed by Congress in section 546(e) despite its ability to do so.  Third and finally, the defendants were alleged to have acted in bath faith and thus, dismissal of the action would undermine other overarching policy objectives of the Bankruptcy Code targeted at ensuring a fair distribution of assets and protecting creditors from shareholder wrongdoing.

Given that the plain language of section 546(e) specifically limits the scope of its safe harbor to “trustees” – a term used in the Bankruptcy Code to refer to a debtor-in-possession or a trustee appointed under the Bankruptcy Code as opposed to creditors or other parties-in-interest – one could envision a broad holding from the Physiotherapy Court that simply permits post-confirmation trustees, when acting as creditor-assignees, to pursue state law constructive fraudulent transfer claims.  However, the Court limited its holding, permitting litigation trustees to assert state law constructive fraudulent transfer claims in the capacity of a creditor-assignee when “(1) the transaction sought to be avoided poses no threat of ‘ripple effects’ in the relevant securities markets; (2) the transferees received payment for non-public securities, and (3) the transferees were corporate insiders that allegedly acted in bad faith.”  Op. at *22.