Leveraged Buyouts as Fraudulent Transfers: Battling the § 546(e) “Safe Harbor” Defense

Heavyweights (photo by Marilyn Swanson)

By Donald L. Swanson

Every now and then a battle shapes up between two heavyweights:

–Think Muhammed Ali v. George Forman; Magic Johnson v. Larry Bird; Bart Starr v. Roger Stauback.

It looks like such a battle is shaping up between two Federal court heavy-weights on bankruptcy issues:

–It’s between the Second Circuit Court of Appeals (which covers the Federal courts in New York) and the Third Circuit Court of Appeals (which covers the Federal courts in Delaware).

Initial salvos in the battle are heard out of Delaware in the ruling of PAH Litigation Trust v. Water Street Healthcare Partners L.P. (In re Physiotherapy Holdings, Inc.), Misc. No. 16-201, Doc. 22 (D. Del. Dec. 21, 2017).

The Case

The case involves a leveraged buyout and a fraudulent transfer lawsuit.


Here’s what happened, as alleged in the lawsuit:

Ownership. Physiotherapy Holdings, Inc., (“Debtor”) was owned and controlled by two equity investment funds (“Owners”).

Operations and Growth. Debtor provided physical therapy services to patients through hundreds of outpatient clinics. Debtor grew rapidly, as did its operational and financial difficulties.

Creative Accounting. Debtor used creative accounting to overstate its accounts receivable, net revenue and EBITDA “by at least 109%” in a “massive accounting fraud.”

Sale Price and Payment. The Owners fraudulently over-valued Debtor and sold it for approximately $528 million. The purchase price payment consisted of, (i) equity infusions of $218 million from purchasers, and (ii) loans of $310 million assumed by Debtor.

Fraudulent Transfer. As part of the sale, Debtor transferred $248.6 million in cash to the Owners in exchange for extinguishing their ownership interests; and Debtor received nothing of value in return. As a result, Debtor became instantaneously insolvent.

Lawsuit. Debtor ended up in bankruptcy, and its Trustee sued the Owners for recovery of the $248.6 million cash transfer. This lawsuit is Adv. Pro. No. 15-51238 in the Delaware Bankruptcy Court.

–Eight Count Complaint

The Trustee’s lawsuit asserts eight counts, seeking recovery under both § 544 and § 548 of the Bankruptcy Code: § 548 is the Bankruptcy Code’s own fraudulent transfer statute, and § 544 incorporates state laws on fraudulent transfers.

–Motion to Dismiss and Bankruptcy Court Ruling

The Owners then seek dismissal of all eight counts based on the “safe harbor” defense created by § 564(e) of the Bankruptcy Code. The critical language of § 546(e) is this:

“the trustee may not avoid a transfer that is a . . . settlement payment . . . made by or to . . . a financial institution . . . in connection with a securities contract . . . , except under section 548(a)(1)(A).”

The Bankruptcy Court denies dismissal as to five of the eight counts.

–Appeal to District Court

Owners ask the U.S. District Court in Delaware for leave to appeal the Bankruptcy Court’s ruling.

In its PAH Litigation Trust v. Water Street Healthcare Partners L.P. opinion linked above, the District Court approves the Bankruptcy Court’s no-dismissal ruling and denies the motion for leave to appeal.

Reasons provided by the District Court for approving the no-dismissal result, and denying appeal, are as follows.

1. Actual fraud claims under § 548(a)(1)(A) are an explicit exception to the § 546(e) safe harbor defense.

2. Creditors had previously assigned their fraudulent transfer claims to the Trustee, so the Trustee “had standing to assert claims in the capacity of both an estate representative and an assignee” of individual creditors.

3. The § 546(e) safe harbor defense:

–applies only against claims asserted by the Trustee on behalf of the bankruptcy estate under §§ 544 or 548; but

does not apply to state law claims asserted under § 544 by (or on behalf of) individual creditors.

 4. The Bankruptcy Court’s no-dismissal ruling:

–is “specific to the facts of this case” (e.g., the transfers were “to corporate insiders” who allegedly “acted in bad faith”; and the transfers “did not involve publicly-traded securities,” so any risk of a “ripple effect to the broader secondary market” is “eliminated”); and

–follows “well-established Third Circuit and Supreme Court law.”

–Current Status

The case is now back in the Bankruptcy Court and proceeding on the five fraudulent transfer counts that survive the § 546(e) motion to dismiss.  Discovery is progressing.

The Upshot

The U.S. Bankruptcy Court and the U.S. District Court in Delaware are setting up a mechanism for attacking leveraged buyouts as fraudulent transfers and skirting the § 546(e) safe harbor defense.

Such a mechanism applies only in limited circumstances:

–where transfers are made to corporate insiders who act in bad faith and where publicly-traded securities are not involved.

Since § 546(e) already excepts actual fraud claims under § 548, the effect of the new mechanism is twofold:

–it adds constructive fraud claims back into the mix; and

–it extends the reach-back period from two years under § 548 to the state law reach-back period (typically, four years) under § 544.

A Circuit Split

Both the Bankruptcy Court and the District Court acknowledge that their rulings in this case are directly counter to the Second Circuit’s ruling in ln re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 124 (2d Cir. 2016). In Tribune, the Second Circuit declared that the § 546(e) safe harbor defense “preempts state fraudulent transfer law” and prohibits the result being pursued in the Delaware case.

Assuming the Delaware Bankruptcy Court and District Court carry through on their analysis in this case, and assuming a fraudulent transfer judgment is ultimately granted, the Third Circuit Court of Appeals will then need to decide whether to follow suit . . . or to side with the Second Circuit.


It will be interesting to follow this PAH Litigation Trust case.

Here’s guessing the Bankruptcy and District courts in Delaware will follow-through on their initial position in this case and that the Third Circuit will affirm.  This guess is based on the District Court’s statement that its PAH Litigation Trust ruling follows “well-established Third Circuit” law.

Such a development would then leave it to the U.S. Supreme Court to decide whether the Second Circuit or the Third Circuit is right on the § 546(e) defense.

This should be interesting!!

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