Section 546(e): Fifteen Years After Kaiser Steel, Still Open To Interpretation
Proving that everything old eventually becomes new again, the leveraged buyout (“LBO”) — a widely popular investment structure in the 1980s and early 1990s — appears to be on the verge of a renaissance. LBOs — transactions in which a controlling interest in a company is acquired using debt secured by the target company’s assets — flourished when easy access to credit, the growth of the high yield bond market, and the promise of lucrative returns combined to attract institutional investors, buyout firms and high net-worth individuals. When the high yield market tightened in the late 1990s, LBOs fell out of favor. Today’s“cheap money” environment and a decline in acquisition valuations have sparked a revival in LBO transactions.
When structuring an LBO, a fundamental issue is determining the level of debt the acquiring company (typically created specifically to effectuate the LBO, with cash as its only asset) and the target company can assume to finance the cash-out of existing shareholders without leaving the resulting combined company (“Newco”) vulnerable to economic downturns. In a successful LBO, Newco is able to repay this debt either with cash flow from Newco’s operations or from the sale of certain of its assets. When the LBO is unsuccessful, Newco may find it necessary to file for bankruptcy protection under the United States Bankruptcy Code (the “Code”).
Although a bankruptcy filing is not an optimal business outcome, it may provide the company with a “second chance” through a restructuring and delevering of the balance sheet. On the other hand, the filing may result in litigation by the bankruptcy estate or its creditors to avoid the LBO altogether and recover (from the former shareholders of the company, the financial parties that facilitated the LBO, or both) the consideration that was given in the LBO to the former shareholders in exchange for their shares.
The Code provides a bankruptcy trustee (or a debtor-in-possession in a Chapter 11 case — see 11 U.S.C. §1107) with the power to avoid certain pre-petition transfers. However, §546 of the Code limits the trustee’s avoidance power. In bankruptcy litigation to avoid transfers under an LBO transaction (“LBO Avoidance Litigation”), the most important exception to the trustee’s avoidance powers is likely to be §546(e), which provides that a “settlement payment” made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency, is exempt from most forms of avoidance.
The $64,000 question is what constitutes a “settlement payment.” For a number of reasons, a uniform meaning and application of “settlement payment” has proven to be elusive. This article looks at the use of §546(e) to exempt LBO payments from avoidance, examines the interplay of LBOs and fraudulent conveyance law, and reviews the Kaiser Steel cases (two decisions of the Tenth Circuit Court of Appeals in the Kaiser Steel bankruptcy that are the leading early cases on whether payments made pursuant to a LBO are “settlement payments” for purposes of §546(e)) and their progeny.