The Circuit Courts of Appeal have split on whether a prepetition transfer made by a debtor is avoidable if the transfer was made through a financial intermediary that was a mere conduit. Today, the Supreme Court unanimously resolved the split by deciding that transfers through “mere conduits” are not protected. This is a major (and adverse) decision for lenders, bondholders and noteholders who receive payments through an intermediary such as a disbursing agent.

Merit Management Group, LP v. FTI Consulting, Inc., No. 16-784 (Feb. 27, 2018) involved a potential fraudulent transfer of a securities payment from party A to party D. However, before reaching D, the transfer went through parties B and C, both of whom were “financial institution” intermediaries protected from fraudulent transfer actions related to certain securities payments by the safe harbor provision of section 546(e) of the Bankruptcy Code. In a decision sure to have long-reaching effects, the Supreme Court held that the only relevant transfer for purposes of determining the applicability of section 546(e) is the ultimate transfer that the trustee seeks to avoid. For example, where A transfers property to D through the use of intermediary financial institutions B and C, and the trustee seeks to avoid the transfer from A to D, the transfer from A to D acts as the only relevant transfer and is therefore not protected absent an independent right under a safe harbor.

In Merit Management, Valley View Downs LP (“Valley View”) and Bedford Downs Management Corp. (“Bedford Downs”) entered into an agreement under which Valley View, subject to obtaining the last available harness-racing license in Pennsylvania, would purchase all of Bedford Downs’ stock for $55 million. Valley View was granted the license and arranged for the Cayman Islands branch of Credit Suisse to wire $55 million to a third-party escrow agent, Citizens Bank of Pennsylvania (“Citizens Bank”). Bedford Downs’ shareholders also deposited their stock certificates with Citizens Bank to be held in escrow, and Citizens Bank disbursed the $55 million over two installments, of which Bedford Downs shareholder Merit Management Group LP (“Merit”) received $16.5 million. The closing statement for the transaction reflected Valley View as the “Buyer,” the Bedford Downs shareholders as the “Sellers,” and $55 million as the “Purchase Price.” Ultimately, Valley View was unable to achieve its goal of opening a racetrack casino, or “racino”, and with its parent company Centaur, LLC, filed for chapter 11 bankruptcy. After confirmation of a chapter 11 reorganization plan, FTI Consulting, Inc. (“FTI”) was appointed to serve as litigation trustee, and in its capacity as such, filed suit against Merit in the Northern District of Illinois to avoid the $16.5 million transfer from Valley View, alleging the transfer to be constructively fraudulent under section 548(a)(1)(B) of the Bankruptcy Code. Notably, FTI did not seek to avoid the intermediate transfers, from Valley View to Credit Suisse (i.e. A to B), Credit Suisse to Citizens Bank (B to C), or from Citizens Bank to Merit (C to D).

Merit filed a motion for judgment on the pleadings, arguing that the safe harbor of 546(e) protected the transfer because it was a “settlement payment . . . made by or to (or for the benefit of)” a covered “financial institution”—i.e., the intermediaries Credit Suisse and Citizens Bank. The District Court granted the motion, but the Seventh Circuit reversed. The Supreme Court affirmed, finding that neither Valley View nor Merit constituted covered “financial institutions,” and the language and context of section 546(e) support the view that the only relevant transfer for purposes of determining the applicability of the section 546(e) safe harbor is the transfer that the trustee seeks to avoid. Transfers where “financial institutions” (or other section 546(e) entities) act as “mere conduits” for an ultimate transferee that is not a “financial institution” (or other section 546(e) entity) are not exempt from avoidance actions.

Merit Management is certain to have profound implications for firms that provide loans, purchase public or private notes, or receive distributions through a third-party such as a facilities agent, indenture trustee, or disbursement agent. The decision drastically narrows the protections of the section 546(e) safe harbor as to transfers involving section 546(e)-covered entities only in an intermediate capacity (and not as an initial transferor or ultimate transferee), leaving each seriatim transferee vulnerable to the effects of avoidance. Any ostensible finality of closed deals that involved a section 546(e)-covered intermediary and might therefore have seemed safeguarded from avoidance, may yet be jeopardized by the prospect of significant clawbacks long after the dust has settled.