Enron Bankruptcy Court Rejects Safe Harbor Defense When Underlying Transaction Was Against State Law.

By James Cain, Warren Davis, Erin Fenichel, Paul Turner and Tess Weil

Originally published September 28, 2005

A recent opinion in the Enron Corporation bankruptcy case provides some insight into a counterparty's eligibility for protections under the safe harbor provisions of the Bankruptcy Code. In an opinion issued May 3, 2005, the U.S. Bankruptcy Court for the Southern District of New York (the "Bankruptcy Court") ruled that Bear, Stearns International Ltd. ("Bear Stearns") was not immune from an avoidance action related to an equity swap transaction where the payment from Enron to Bear Stearns occurred several months before Enron's bankruptcy.

The Bankruptcy Court concluded that, because state law prevents a company from repurchasing its own stock when it is insolvent, payments associated with such transactions were not settlement payments under the Bankruptcy Code, and therefore are not exempt from avoidance actions. This case illustrates another example of a judicial interpretation narrowing the congressional protections for forward contract merchants and swap participants.

In May 2000, Enron and Bear Stearns entered into a transaction titled an "Equity Forward Confirmation" (the "Transaction"). The Transaction provided for Enron to purchase shares of its own common stock from Bear Stearns at a set price. To settle the Transaction, Enron had the option to either transfer shares of Enron common stock to Bear Stearns or to settle the transaction through cash payments. On August 22, 2001, Enron paid Bear Stearns approximately $30 million (the "Payment") in return for 323,000 shares of Enron. Enron opted to make the payment in cash.

Less than four months later, Enron filed its bankruptcy petition. Enron then sued Bear Stearns to recover the Payment, which Enron asserted was a constructively fraudulent transfer. The Bankruptcy Code allows a debtor-in-possession to avoid and recover a transfer made by the debtor within one year before the bankruptcy filing, if (a) the debtor received less than reasonably equivalent value in exchange, and (b) the debtor was insolvent at the time of the transfer.

Bear Stearns sought to dismiss Enron's action based on section 546 of the Bankruptcy Code, which Bear Stearns argued protected the Payment from avoidance. Section 546 provides that settlement payments may not be avoided when made by or to certain parties, including forward contract merchants. The Bankruptcy Court determined that Enron was a forward contract merchant; therefore, the primary issue was whether the Payment qualified as a settlement payment.

The Bankruptcy Code defines the term settlement payment (albeit in a circular fashion) as a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, or any other similar payment commonly used in the securities [or forward contract] trade." Although few courts addressed the meaning of settlement payment, those that have agree that the term should be broadly interpreted. In reaching that conclusion, courts have emphasized that Congress's intent in passing the statutes was to minimize the chances of a ripple-effect spreading through the entire commodity-trading industry if a major player files for bankruptcy. Giving settlement payment a broad interpretation serves the legislative objectives because it furthers the protections against market disruptions.

The Bankruptcy Court agreed with other courts that have held that a determination of whether a given transfer constitutes a settlement payment requires reference to the customs of the relevant industry practice. In order to qualify as a settlement payment, the Bankruptcy Court concluded, the payment "must be 'commonly used' within the industry."

Enron argued that the Payment could not be a settlement payment, however, because Oregon law prohibits a corporation organized in Oregon (like Enron) from repurchasing its own stock when the corporation is insolvent.

The Bankruptcy Court agreed with Enron. It noted that Oregon law provides that transactions that violate the prohibition against repurchases of stock by an insolvent corporation are considered void. Therefore, according to the court, the underlying Transaction was without any legal significance. The Bankruptcy Court noted, "A settlement payment is a payment made to discharge a settlement obligation. If the Oregon law was violated, the payment cannot be a settlement payment because the transaction is void and there is no settlement obligation to discharge nor any securities transaction to complete."

Thus, the Bankruptcy Court concluded that Bear Stearns was not eligible for the safe harbor protections of the Bankruptcy Code. The Court further determined that the Oregon law was not preempted by the Bankruptcy Code because it did not perceive any conflict between state law and federal law. The Bankruptcy Court has not yet determined whether Enron may avoid the Payment. Rather, in this opinion, the Bankruptcy Court only denied Bear Stearns's motion to dismiss. Other issues - such as whether Enron was insolvent at the time of the Payment - remain unresolved.

The ruling in this case is of particular concern to dealers who trade with counterparties in multiple jurisdictions; under this analysis, safe harbor protections could be affected by the individual laws of such jurisdictions. As a result, the International Swaps and Derivatives Association ("ISDA") and The Bond Market Association ("BMA"), two major trade associations that represent the views of dealers in the derivatives markets, have jointly filed an amicus brief supporting an effort by Bear Stearns to bring an interlocutory appeal of this ruling. Of course, all market participants should be concerned about developments that threaten to undermine the legal certainty afforded to OTC derivatives markets by Congress.

Sutherland Analysis

This opinion is instructive for derivatives traders (particularly commodity traders) in two ways. First, the ruling provides some guidance on the meaning of settlement payments by suggesting that courts must look to standard industry practice in determining what constitutes a settlement payment. However, such a requirement, potentially would make it more difficult for a counterparty to prevail on summary judgment on a section 546 defense because of the need for additional evidence. Moreover, the court's decision against preempting the Oregon statute provides similar guidance with regard to when the Bankruptcy Code will override state law.

Second, the opinion highlights the need for parties entering into transactions with counterparties that are experiencing financial stress to be cognizant of the applicable state insolvency laws, as these laws may undermine the federal protections afforded to swap participants and forward contract merchants in bankruptcy proceedings.

[c] 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.

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