On July 26, 2016, a three-judge panel of the U.S. Court of Appeals for the Seventh Circuit ruled that the Bankruptcy Code section 546(e) "safe harbor" applicable to constructive fraudulent transfers that are settlement payments made in connection with securities contracts does not protect "transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit." FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677.

Section 546(e) provides that pre-bankruptcy transfers made by or to, among other entities, a "financial institution" may not be avoided as a fraudulent transfer, unless the transfer was made with the actual intent to hinder, delay, or defraud creditors. Five circuit courts of appeal have ruled that the section 546(e) safe harbor applies where the only financial institution involved is merely a "conduit" for the transfer of funds from the debtor to another party. See In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); In re Resorts Int'l, Inc., 181 F.3d 505, 516 (3d Cir. 1999); In re Kaiser Steel Corp., 952 F.2d 1230, 1240 (10th Cir. 1991).

The Eleventh Circuit ruled to the contrary in In re Munford, Inc., 98 F.3d 604 (11th Cir. 1996), concluding that section 546(e) does not shield from avoidance payments made by a debtor to shareholders through financial institutions where the financial institution acts only as a conduit for the transfer of funds. The Seventh Circuit has now sided with the Eleventh Circuit, creating a greater possibility that the U.S. Supreme Court will resolve the split among the circuits.

In FTI Consulting, Valley View Downs, LP ("Valley View"), the owner of a Pennsylvania racetrack, acquired all of the stock of a competitor, Bedford Downs ("Bedford"), in a $55 million LBO transaction. Citizens Bank of Pennsylvania ("Citizens") acted as escrow agent for the exchange. After the LBO, Valley View filed for chapter 11 protection. The chapter 11 trustee for Valley View sued a 30 percent shareholder in Bedford, alleging that the transfer to the shareholder of approximately $16.5 million in the transaction was constructively fraudulent and therefore avoidable under sections 544 and 548(a)(1)(B) of the Bankruptcy Code. The bankruptcy court and the district court ruled that the transfer to the shareholder—not a financial institution—was protected by the section 546(e) safe harbor because the funds flowed through Citizens Bank—a financial institution.

The Seventh Circuit reversed. "Although we have said that section 546(e) is to be understood broadly," the court wrote, "that does not mean that there are no limits." Here, the court explained, although the transaction resembled an LBO, and "in that way touched on the securities market," neither Valley View nor the shareholder were "parties in the securities industry" but simply "corporations that wanted to exchange money for privately held stock." Citizens, the "financial institution" involved as escrow agent, was merely a conduit. Accordingly, the Seventh Circuit ruled, section 546(e) did not apply to the transaction.