Investors currently relying on certain of the Bankruptcy Code's safe harbor provisions to save them from clawback claims should consider finding new shelter. The U.S. Supreme Court in Merit Management Group, LP v. FTI Consulting, Inc.,1 unanimously ruled that one aspect of the safe harbor under Section 546(e) of the Bankruptcy Code2 does not prohibit a bankruptcy trustee (or creditors' committee or litigation trust) from seeking to clawback transfers that are constructive fraudulent conveyances and/or preferences where a "financial institution" (or other covered entity such as a clearing agency or stockbroker) was acting as an intermediary. A significant majority of circuits who had ruled on this issue, including the Second and Third Circuits, had previously ruled that this aspect of the safe harbor insulated a wide range of securities and other transactions from clawback risk because those transactions involved the use of banks or stockbrokers acting as intermediaries. As a consequence of this decision, parties who had previously assumed the benefit of this safe harbor may still be exposed to clawback risk.
This case will provide significant leverage to bankruptcy trustees, creditors' committees or litigation trusts' seeking to clawback otherwise avoidable payments made to certain investors in connection with distressed transactions and leveraged buyouts (such as the shareholders in the Tribune and Lyondell bankruptcies) even though a financial institution was used in a transaction as an intermediary. The key beneficiaries of this decision are unsecured creditors that otherwise might not receive a recovery in bankruptcy cases.
Financial institutions (and other covered entities) will take comfort from the Supreme Court's acknowledgements that Supreme Court's interpretation of the safe harbor will not impact the protections granted to them under the statute as a protected entity.3
KEY TAKE AWAY FOR MARKET PARTICIPANTS
Sophisticated market participants, including investment funds, who do not otherwise fall into the definition of "financial institution" (or other type of covered entity) should note that the Supreme Court's ruling specifically did not disturb other important provisions of the safe harbor. Specifically, the Supreme Court did not address whether investors that hold their securities as a customer of a commercial or savings bank could or could not benefit from the safe harbor because the definition of "financial institution" includes not only banks themselves, but also their customers when such bank is acting as agent or custodian for a customer. In addition, the Court did not address what types of transaction qualify as a "settlement payment" or are made in connection with a "securities contract" - which by their own enumerated definitions have an extremely broad scope. While these aspects of the safe harbor defense will undoubtedly be tested in future litigations, market participants should be guided by this decision in structuring their securities and distressed transactions and being aware of the additional risks that it has created.