On February 27, 2018, the U.S. Supreme Court issued a highly anticipated ruling resolving a long-standing circuit split over the scope of the Bankruptcy Code’s "safe harbor" provision exempting certain securities transaction payments from avoidance as fraudulent transfers. In Merit Management Group LP v. FTI Consulting Inc., 2018 BL 65569, No. 16-784 (U.S. Feb. 27, 2018), the unanimous Court held that section 546(e) of the Bankruptcy Code does not protect transfers made through a financial institution to a third party, regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, the relevant inquiry is whether the transferor or the transferee in the transaction whose avoidance is sought is itself a financial institution.

The Section 546(e) Safe Harbor

Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee’s avoidance powers, including the power to avoid certain preferential and/or fraudulent transfers. Section 546(e) provides that the trustee may not avoid a pre-bankruptcy transfer which is a margin payment or settlement payment "made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of)" any of those entities in connection with a securities contract, commodity contract, or forward contract, unless the transfer was made with the actual intent to hinder, delay, or defraud creditors.

The purpose of section 546(e) is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583, 1982 WL 25042. The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id. With the enactment of section 546(e), Congress also sought to promote customer confidence in the markets by protecting market stability. See Kaiser Steel Corp. v. Charles Schwab & Co., 913 F.2d 846 (10th Cir. 1990) (citing S. Rep. No. 989, at 8 (1978)).

Five circuit courts of appeal have ruled that the section 546(e) safe harbor extends to transactions even where the financial institution involved is merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. See In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013) (the safe harbor is applicable where the financial institution was a trustee, and the actual exchange was between two private entities); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009) (section 546(e) is not limited to public securities transactions and protects from avoidance a debtor’s payments deposited in a national bank in exchange for the shareholders’ privately held stock during an LBO); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009) (the safe harbor applied even though the financial institution involved in the LBO was only the exchange agent); In re Resorts Int’l, Inc., 181 F.3d 505, 516 (3d Cir. 1999) (noting that "the requirement that the ‘commodity brokers, forward contract merchants, stockbrokers, financial institutions, and securities clearing agencies’ obtain a ‘beneficial interest’ in the funds they handle . . . is not explicit in section 546"); In re Kaiser Steel Corp., 952 F.2d 1230, 1240 (10th Cir. 1991) (rejecting the argument that "even if the payments were settlement payments, § 546(e) does not protect a settlement payment ‘by’ a stockbroker, financial institution, or clearing agency, unless that payment is to another participant in the clearance and settlement system and not to an equity security holder").

The Eleventh Circuit ruled to the contrary in In re Munford, Inc., 98 F.3d 604 (11th Cir. 1996). In Munford, the court held that section 546(e) did not shield from avoidance payments made by the debtor to shareholders in an LBO because the "financial institution" involved was only a conduit for the transfer of funds and securities—the bank never had a "beneficial interest" sufficient to qualify as a "transferee" in the LBO. In so ruling, the Eleventh Circuit wrote:

None of the entities listed in section 546(e)—i.e., a commodity broker, forward contract merchant, stockbroker, financial institution, or a securities clearing agency—made or received a transfer/payment. Thus, section 546(e) is not applicable. . . . True, a section 546(e) financial institution was presumptively involved in this transaction. But the bank here was nothing more than an intermediary or conduit. Funds were deposited with the bank and when the bank received the shares from the selling shareholders, it sent funds to them in exchange. The bank never acquired a beneficial interest in either the funds or the shares. . . . Importantly, a trustee may only avoid a transfer to a "transferee." See 11 U.S.C. § 550. Since the bank never acquired a beneficial interest in the funds, it was not a "transferee" in the LBO transaction.

The Seventh Circuit widened the circuit split on the issue when it agreed with the rationale of Munford in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016), aff’d, 2018 BL 65569, No. 16-784 (U.S. Feb. 27, 2018).

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"), for certain harness-racing and gambling licenses in a $55 million LBO transaction. The Cayman Islands Branch of Credit Suisse ("CS Cayman") financed the purchase and wired the $55 million purchase price to a bank (the "Escrow Bank") that acted as escrow agent for the exchange and disbursed the net proceeds to Bedford’s stockholders. After the LBO, Valley View filed for chapter 11 protection because its application for the gambling license was denied.

The chapter 11 litigation trustee for Valley View—FTI Consulting, Inc. (the "trustee")—sued Merit Management Group, LP ("Merit"), a shareholder in Bedford, alleging that Bedford’s transfer to Valley View and thence to Merit of approximately $16.5 million (30 percent of the $55 million) 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 Merit was protected by the section 546(e) safe harbor.

The Seventh Circuit’s Ruling

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," Valley View and Merit were not "parties in the securities industry," but simply "corporations that wanted to exchange money for privately held stock." The Escrow Bank and CS Cayman, the "financial institutions" involved, were merely conduits. Accordingly, the Seventh Circuit ruled, section 546(e) does not apply.

Examining the history of section 546(e), the Seventh Circuit explained that nothing Congress did in originally enacting the safe harbor, or in later expanding its scope to other types of actors in the securities industry, including financial institutions, indicates "that the safe harbor applie[s] to those institutions in their capacity as intermediaries." According to the court, "[T]he safe harbor has ample work to do when an entity involved in the commodities trade is a debtor or actual recipient of a transfer, rather than simply a conduit for funds."

The ruling effectively rekindled a two-decade-long circuit split that had largely faded into obscurity before the Seventh Circuit chose to resurrect the minority approach articulated by the Seventh Circuit in Munford but rejected by five other circuits.

The Supreme Court agreed to review the Seventh Circuit’s decision on May 5, 2017.

The Supreme Court’s Ruling

Writing for the unanimous court, Justice Sotomayor sided with the Seventh and Eleventh Circuits, thus rejecting the rule that had long prevailed in, among other places, New York and Delaware bankruptcy courts. She stated that "the plain meaning of section 546(e) dictates that the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid"—i.e., the transfer to the ultimate transferee, as distinguished from intermediate transfers to financial institutions acting merely as conduits between the debtor and the ultimate transferee. In the absence of any allegation that either Valley View or Merit was a "financial institution" or other entity covered by section 546(e), the Court ruled that the transfer at issue fell outside the safe harbor.

According to Justice Sotomayor, lower courts that have examined whether the "financial institution" or other covered entity must have a beneficial interest in or dominion and control over the transferred property to qualify for the section 546(e) safe harbor "put the proverbial cart before the horse." Before a court can determine whether a transfer was "made by or to (or for the benefit of)" a covered entity, she wrote, "the court must first identify the relevant transfer to test in that inquiry."

Justice Sotomayor agreed with the trustee’s argument that, in accordance with the language of section 546(e), the specific context in which that language is used, and "the broader statutory structure," the relevant transfer for purposes of the safe harbor "is the overarching transfer that the trustee seeks to avoid" rather than "component part[s]" of the transfer effected through financial institution intermediaries with no beneficial interest in the funds transferred.

Justice Sotomayor rejected Merit’s argument that, by amending section 546(e) in 2006 to add the language "(or for the benefit of)," Congress intended to add to the scope of the safe harbor entities having only a "beneficial interest" in a transfer and to abrogate Munford. Noting the absence of any support cited by Merit for this position in the text of section 546(e) or its legislative history, Justice Sotomayor stated that there is a simpler explanation for the addition of the language. Congress was merely ensuring, she wrote, that the "scope of the safe harbor matched the scope of the avoiding powers," which contain the same language (citing sections 547(b)(1) and 548(a)(1)). Therefore, she explained, nothing in the 2006 amendment "changed the focus of the §546(e) safe-harbor inquiry on the transfer that is otherwise avoidable under the substantive avoiding powers."

Finally, Justice Sotomayor rejected Merit’s contention that, because Congress intended to take a comprehensive "prophylactic" approach to securities and commodities transactions, it would be incongruous to read section 546(e) such that its application would depend on the "identity of the investor and the manner in which it held its investment," rather than the nature of the transaction generally. This perceived purpose, she wrote, "is actually contradicted by the plain language of the safe harbor."

Outlook

FTI Consulting is a game changer, particularly in the Second and Third Circuits, where New York and Delaware bankruptcy courts presiding over the greatest volume of cases involving transactions that may implicate the section 546(e) safe harbor have long ruled to the contrary. Going forward, deal participants, such as selling shareholders, in LBO transactions or dividend recapitalizations involving companies whose financial condition is questionable cannot, by means of financial institution intermediaries or other qualifying conduits, rely on section 546(e) to protect LBO transfers from avoidance. Instead, potential defendants will have to focus on the substantive elements of the avoidance causes of action.

Interestingly, in a footnote, the Court acknowledged that the Bankruptcy Code defines "financial institution" broadly to include not only entities traditionally viewed as financial institutions, but also the "customers" of those entities, when they act as agents or custodians in connection with a securities contract. Merit was a customer of one of the conduit banks, yet never raised the argument that it therefore also qualified as a financial institution for purposes of section 546(e). For this reason, the Court did not address the possible impact of Merit’s customer status on the scope of the safe harbor.

Looking to the future, FTI Consulting may cause deal participants to restructure transactions so that they qualify for the section 546(e) safe harbor.