In FTI Consulting, Inc. v. Merit Management Group, LP,1 the Seventh Circuit recently held that transfers are not protected under the safe harbor of section 546(e) of the U.S. Bankruptcy Code from fraudulent transfer and other avoidance actions in bankruptcy when a financial institution or other statutorily-protected entity merely acts as a conduit for the transfers and is not either the debtor (as the entity actually making the transfer), or the real party in interest that ultimately received the payment from the financial institution conduit.
The decision revives a long-standing circuit split on the issue, siding with the minority view espoused by the Eleventh Circuit some 20 years ago in Munford v. Valuation Research Corp. and disagreeing with decisions since then by the Second, Third, Sixth, Eighth, and Tenth Circuits, representing every circuit-level decision on the issue between Munford and Merit. As discussed below, the decision has important implications for various counterparties in securities transactions, most notably selling stockholders in leveraged buyouts or “LBO” transactions, where years later a trustee or other estate fiduciary in bankruptcy may claim the buyout rendered the company insolvent and thus the transaction amounted to a constructive fraudulent transfer.
Merit involved a transaction similar to a leveraged buyout. Valley View Downs, LP, owner of a Pennsylvania racetrack, purchased 100% of the stock of another racetrack, Bedford Downs, in exchange for US$55 million in cash. To finance the acquisition, Valley View borrowed money from Credit Suisse and certain other lenders. Another bank, Citizens Bank of Pennsylvania, served as escrow agent, receiving the purchase price before passing it along to the selling stockholders.
After the transaction closed, Valley View filed for chapter 11 bankruptcy, largely due to its inability to secure a gambling license for the racetrack. FTI Consulting, Inc., as Trustee of the In re Centaur, LLC Litigation Trust, which included Valley View as one of the debtors, sued Merit Management Group, formerly a 30% stockholder of Bedford Downs. FTI alleged that Valley View’s transfer of cash to Bedford Downs in the transaction was avoidable as a constructive fraudulent transfer and thus Merit was liable for the amount it received in exchange for its Bedford Downs stock—approximately US$16.5 million (i.e., 30% of the US$55 million).
Merit asserted a defense under section 546(e) safe harbor. Section 546(e) of the Bankruptcy Code prohibits a trustee (or debtor-in-possession) from avoiding transfers that are “margin payment[s]” or “settlement payment[s]” “made by or to (or for the benefit of)” certain entities defined in the statute—namely commodity brokers, forward contract merchants, stockbrokers, financial participants, securities clearing agencies, and “financial institutions.” It also protects transfers “made by or to (or for the benefit of)” these statutorily-protected entities “in connection with a securities contract.”
While Merit admitted that it was not a statutorily-protected entity listed in section 546(e), Merit argued for safe harbor eligibility based on the involvement of Citizens Bank and Credit Suisse, i.e. the transfers sought to be avoided were made by, or to them. The district court agreed with Merit, holding that Valley View’s transfer of cash was “made by or to” a financial institution because the funds passed through Citizens Bank and Credit Suisse. FTI appealed.
On appeal, the Seventh Circuit reversed the judgment of the district court and held that the section 546(e) safe harbor does not protect “transfers that are simply conducted through a financial institution (or other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit.” In doing so, the Seventh Circuit extended its reasoning from an earlier decision, Bonded Financial Services, Inc. v. European American Bank, to the section 546(e) safe harbor, finding that the safe harbor requires the statutorily-protected entity to have “dominion over the money” or the “right to put the money to one’s own purposes.”
The Seventh Circuit began its decision by noting that section 546(e) is ambiguous and required the court to “search beyond the statute’s plain language” and “consider its purpose and context for further guidance.” The decision then analyzes various other sections of the Bankruptcy Code relating to the trustee’s avoidance powers and how the section 546(e) safe harbor fits within this overall statutory framework. While the Seventh Circuit provides a variety of technical reasons to support its holding, the decision focuses on the economic substance of the transaction over its form, with an analysis largely driven by concerns that “Merit’s preferred interpretation [of the safe harbor] would be so broad as to render any transfer non-avoidable unless it were done in cold hard cash….”
The Seventh Circuit’s decision also reasons that the legislative history supports the holding, noting that section 546(e) is intended to reduce “systematic risk in the financial marketplace” and there was “no evidence that [Valley View’s bankruptcy] would have any impact on Credit Suisse, Citizens Bank, or any other bank or entity named in section 546(e).”
Unless overturned through en banc review by the Seventh Circuit or on certiorari review by the Supreme Court, Merit is the law of the Seventh Circuit. Thus, parties other than the entities listed in section 546(e) will not receive the safe harbor’s protection in cases filed there. This is probably most significant for selling stockholders in the leveraged buyout context, where there is risk that years later a trustee or debtor-in-possession will argue that the consideration provided to the stockholders rendered the company insolvent and thus the buyout effectuated a constructive fraudulent transfer.
Notably, in such a scenario, sellers of identical securities and in the same transaction face drastically different outcomes in the Seventh Circuit: private stockholders that do not qualify for safe harbor treatment,i.e. are not financial institutions, stockbrokers and the like, are open to liability, while beneficial holders who qualify as safe harbor protected parties are not.
Finally, while Merit and the Eleventh Circuit’s Munford decision remain the minority view, Merit could prove persuasive to courts in which there is no circuit-level precedent. Further, even in the majority of circuits with precedents contrary to Merit, there is a possibility that trustees and other estate fiduciaries will cite the decision in arguing for a good-faith reversal of that circuit’s law, whether for perceived settlement value or otherwise.