In bankruptcy, one of the “powers” granted to a trustee is the ability to undo previously completed transactions in order to facilitate payments to creditors. However, the Bankruptcy Code prevents a trustee from unwinding certain types of transactions. The safe harbor provision of 11 U.S.C. § 546(e) protects financial institutions performing securities transactions from having to disgorge payments initially made by a now bankrupt company. Litigation over this safe harbor statute has greatly increased in recent years, particularly in efforts to unwind payments from failed brokerage firms and investment banks. These contentious cases often involve high stakes litigation.
The circuit courts have been split, however, on how broad Congress intended these protections from clawback actions to be. Particularly, does the safe harbor protect only those particular market players (e.g., banks, brokers, and clearinghouses), or do those protections also cover anyone receiving payments through those market players (e.g., when a bank or broker serves as a conduit)?
This issue made its way to the U.S. Supreme Court from the Seventh Circuit in Merit Management Group v. FTI Consulting. In Merit, Valley View Downs, LP, the owner of a Pennsylvania racetrack, sought a buyout of Bedford Downs, a competing racetrack. To finance the merger, Valley View borrowed money from a financial institution, Credit Suisse, with payments made in escrow to Citizens Bank, a financial institution serving as Bedford Downs’ escrow agent. It was undisputed that both Credit Suisse and Citizens Bank were financial institutions. The petitioner here, Merit Management Group, was a 30% shareholder in Bedford Downs that received approximately $16.5 million as a result of that merger.
After Valley View later filed bankruptcy, the trustee sough to unwind the $16.5 million payment to Merit Management, arguing that the payment was a fraudulent transfer under 11 U.S.C. § 548(a)(1)(A) and was, therefore, subject to the trustee’s avoidance powers. Merit Management argued in response that because the payment was a transfer made by a financial institution in connection with a securities contract, it was protected by the safe harbor under § 546(e).
The U.S. District Court for the Northern District of Illinois agreed with Merit Management. The lower court ultimately held that even though Merit Management was not a financial institution under § 546(e), because Citizens Bank and Credit Suisse (which were § 546(e) institutions) served as conduits for the transfer, then the transfer was protected by the safe harbor provision. On appeal, the Seventh Circuit, in a unanimous panel, reversed the lower court and held that the safe harbor provision did not protect transfers in which § 546(e) institutions did not themselves benefit but merely served as conduits.
The Supreme Court heard oral argument in this case on November 6, 2017. The Court’s decision could have significant implications on the basic tension in the Bankruptcy Code between the maximization of creditor recoveries and the protection of financial markets. If the Supreme Court reverses the Seventh Circuit, it will essentially maintain the status quo while possibly frustrating bankruptcy estates seeking to maximize recoveries for creditors. If, however, the Supreme Court affirms the Seventh Circuit, it could encourage more aggressive bankruptcy avoidance litigation and possibly force an adjustment in market practices to protect against this type of action.