In a February 2018 ruling, the United States Supreme Court narrowed one of the safe harbors for fraudulent transfer and other avoidance actions. Merit Management Group, LP v. FTI Consulting Group, Inc., 138 S. Ct. 883 (2018). The question essentially boiled down to whether the existence of a “financial institution” intermediary in a series of transfers insulated a downstream recipient (that is not a financial institution or otherwise covered by the safe harbor) from fraudulent transfer or other avoidance action liability. Previously, the Second, Third, Sixth, Eighth and Tenth Circuits ruled that the safe harbor would apply to protect the downstream recipient. The Eleventh Circuit had held otherwise, and the matter ultimately reached the Supreme Court on an appeal from a decision of the Seventh Circuit that aligned with the Eleventh Circuit’s view that the safe harbor would not apply in that scenario.

In the case in front of the Supreme Court, Valley View Downs entered into a transaction with Bedford Downs Management pursuant to which Valley View purchased all of Bedford’s stock for $55 million. Valley View arranged for Credit Suisse to wire the funds to third-party escrow agent Citizens Bank of Pennsylvania. The Bedford shareholders deposited their stock certificates into escrow, and Citizens Bank disbursed the $55 million over two installments. Of that amount, Merit Management Group received $16.5 million. Ultimately, Valley View filed a chapter 11 bankruptcy case, and a litigation trustee sought to avoid the transfer from Valley View to Merit, arguing that it was constructively fraudulent under 11 U.S.C. § 548(a)(1)(B).

Section 548(a)(1)(B) authorizes a trustee to avoid a transfer of an interest of the debtor in property if, among other things, the debtor received less than a reasonably equivalent value in exchange for the transfer and was insolvent when the transfer occurred or became insolvent as a result of the transfer. Section 550(a) authorizes a trustee to recover from initial transferees or subsequent transferees, so the trustee was able to pursue Merit Management as subsequent transferee. Merit Management argued that the so-called “securities” safe harbor of § 546(e) applied to bar the trustee from avoiding the transfer. Section 546(e) provides that:

[T]he trustee may not avoid a transfer that is a …. settlement payment … made by or to (or for the benefit of) a … financial institution … or that is a transfer made by or to (or for the benefit of) a … financial institution … in connection with a securities contract.

Merit Management argued that the safe harbor applied because the payments were made by or to (or for the benefit of) two financial institutions—Credit Suisse and Citizens Bank. The Seventh Circuit held that the safe harbor did not protect Merit Management, because the financial institutions served as mere conduits.

The Supreme Court affirmed, holding that the only relevant transfer for purposes of determining if the § 546(e) safe harbor applies is the transfer that the trustee seeks to avoid. As the Court summarized, if there was a transfer from A→B→C→D, and the trustee seeks to avoid the A→D transfer, courts should look solely to the transfer the trustee seeks to avoid (A→D) to determine whether the safe harbor applies, rather than considering any component parts of the overarching transfer (A→B→C→D). With that framework—and the fact that Merit did not contend that either itself or Valley View were “financial institutions” as defined in the Bankruptcy Code—the Court affirmed that the safe harbor did not apply.

While the impact of Merit Management is difficult to forecast given the fact-based inquiry in this type of analysis, here are a few takeaways to consider:

  • Securities market participants may focus on achieving a transaction structure that gives them “financial institution” status in order to limit the risk of avoidance liability.
  • The Court noted in a footnote that neither party addressed whether either Valley View or Merit Management itself fell under the statutory definition of “financial institution,” which includes a reference to “customers” of financial institutions in certain circumstances. 11 U.S.C. § 101(22). Litigants and courts will likely need to analyze whether a transfer recipients that is not otherwise a “financial institution” still falls under that definition and qualifies for the safe harbor by virtue of being a customer.
  • The transaction structure in Merit Management was relatively straightforward and limited, and it is unclear how the analysis will ultimately be applied to more complicated and far-reaching transactions. For example, some commentators have asserted that such a ruling could have ripple effects for market participants that could inject uncertainty into and disrupt the marketplace. Although Merit Management included a section addressing that issue in its briefing, it did not sway the Court.