The Supreme Court’s recent decision in Merit Management Group, LP v. FTI Consulting, Inc.[1] has the potential to dramatically change how the safe harbor contained in § 546(e) will be applied to avoidance actions brought under chapter 5 of the Bankruptcy Code.[2] In its unanimous ruling, the Court held that § 546(e) does not prohibit the avoidance of transfers made “by or to” a financial institution[3] when the financial institution served merely as a conduit, rejecting the rule previously followed by most federal courts. The import of the Merit decision is that categories of transfers that were once thought to be safe harbored may now be fair game, sharpening a tool for chapter 11 debtors, creditors’ committees, and trustees to increase stakeholder recoveries.

Background

In 2007, Valley View Downs, LP (“Valley View”) agreed to purchase the stock of Bedford Downs Management Corporation (“Bedford Downs”) for $55 million in order to reduce competition and obtain the last available “harness-racing” license in Pennsylvania. Credit Suisse financed the acquisition and paid $55 million into an escrow account at Citizens Bank, which eventually transferred $16.5 million to Merit Management Group, LP (“Merit”), the seller of 30% of Bedford Downs. After the acquisition, Valley View was unable to secure a second “gaming” license and subsequently filed for chapter 11.

FTI Consulting, Inc. (“FTI”), as trustee for Valley View’s post-confirmation litigation trust, sought to avoid the $16.5 million paid to Merit as constructively fraudulent. The parties agreed that the transfers were settlement payments made in connection with a securities contract, and that Credit Suisse and Citizens Bank were financial institutions. At issue was the meaning of the elemental phrase “by or to (or for the benefit of) a financial institution” as it applied to the roles of Credit Suisse and Citizens Bank in the transaction that FTI sought to avoid—that is, was the transfer to Merit “by or to (or for the benefit of) a financial institution” because it went through Credit Suisse or Citizens Bank?

The trial court answered in the affirmative based on the reasoning of most federal courts that had addressed the issue.[4] Specifically, the then-majority rule adhered to the notion that a transfer is safe harbored if it is made “by or to” a financial institution enumerated in § 546(e) (a “Covered Entity”),[5] even if the Covered Entity did not have a beneficial interest in the property transferred.[6] Accordingly, under this “conduit theory,” even if money was transferred through a Covered Entity (e.g., through a commercial bank via wire), the transaction is shielded from avoidance.[7]

The Seventh Circuit reversed and rejected the conduit theory. The Seventh Circuit held that “it is the economic substance of the transaction that matters” and not merely whether a transfer was made “by or to (or for the benefit of) a financial institution.”[8] The court concluded that the $16.5 million transfer could not be shielded by section 546(e) because “[i]f Congress had wanted to say that acting as a conduit for a transaction” between parties “is enough to qualify for the safe harbor, it would have been easy to do that.”[9] The Supreme Court granted certiorari to resolve a split among the circuits.

The Supreme Court’s Decision

The Court affirmed the Seventh Circuit and held that, for purposes of determining whether the § 546(e) safe harbor applies, the only relevant transfer is the one the trustee seeks to avoid, and not the component transfers that make up a larger transaction. Stated differently, if a transaction involves transfers A→B→C→D, and the trustee only seeks to avoid the ultimate transfer (A→D), then the safe harbor shall only be applied and analyzed with respect to A→D. The Court therefore framed the issue as to how the safe harbor should operate where a challenged transaction was executed by multiple transfers.

In argument, Merit had taken the position that courts should look to the entire transfer, including its component parts. FTI, on the other hand, had argued that the only relevant transfer is the transfer the trustee seeks to avoid (i.e., the end-to-end transfer). The Court sided with FTI and stated that the focus of the analysis is on identifying the relevant transfer at issue, and it puts the cart before the horse to start the analysis with defenses, including whether the transfer was made “by or to” a Covered Entity that had a beneficial interest in the property transferred under § 546(e). The Court ruled that the proper focus is on the end-to-end transfer, and not the transfer’s component parts.

The Court reached this conclusion by looking at the plain language of § 546(e). By its own terms, § 546(e) applies “notwithstanding” the avoidance powers contained in chapter 5 of the Bankruptcy Code. The Court concluded that the only transfers covered by § 546(e) are those subject to avoidance, not the component parts of a transaction. In other words, even when a challenged transaction involves multiple transfers that could be safe harbored if challenged separately, if the trustee challenges the end-to-end transfer (A→D) (and not the component parts (B→C)), § 546(e) only applies to the ultimate transfer (A→D).

The Court also relied on the structure of the Bankruptcy Code, noting that chapter 5 creates a system for avoiding certain transfers and also for protecting specified transfers from avoidance. The Court stated that where a trustee properly identifies a transfer for avoidance under the chapter 5 framework, courts have no reason to examine the intervening component parts of the transfer.

In sum, the Court held that § 546(e) protects transfers to a Covered Entity, not through a Covered Entity. Accordingly, the safe harbor will not shield transactions from avoidance where a Covered Entity acts as a mere conduit, but instead only protects those transfers where the end-to-end parties in the transaction subject to avoidance are Covered Entities.

Takeaways

Merit will likely result in a new wave of fraudulent transfer litigation as chapter 11 debtors, creditors’ committees, and trustees will have cause to attack transactions that historically have been shielded from avoidance. The decision also has the potential to dramatically shift leverage points in bankruptcy negotiations, particularly where trustees in the past have lacked leverage (e.g., in leveraged buyout transactions).

The Court in making what on the surface is a textual analysis has also made a sweeping policy determination. The class of transactions exposed to avoidance risk has grown, and a loophole has been closed that had been applied in unexpected ways to immunize transfers from recovery. This change in the law should greatly benefit creditors.

Of course, the market’s reaction remains to be seen.[10] While the Court’s decision may be interpreted as an invitation for estate representatives to seek the avoidance of certain prepetition transfers, it will foreseeably push parties to reconsider how transactions are structured with an eye towards a future bankruptcy filing.[11] It is notable, however, that Merit has altered the long-held belief that the safe harbors should be literally and strictly construed as written to protect the financial markets.

Importantly, the opinion has authoritatively established a principled basis for creditor representatives to challenge transactions that involve financial intermediaries, and this may lead to greater recoveries and more equitable outcomes for unsecured creditors in bankruptcy.