The Bankruptcy Code provides bankruptcy trustees, debtors, and creditor committees with “avoidance powers” that allow them to set aside and recover certain transfers that a debtor made before filing for bankruptcy. These avoidance powers are, however, limited by a number of exceptions enumerated in the Bankruptcy Code, including the securities safe harbor at § 546(e). Section 546(e) protects from avoidance any transfer “made by or to (or for the benefit of) . . . a financial institution” if the transfer is a “settlement payment” or made “in connection with a securities contract.”
The Supreme Court recently held in Merit Management Group, LP v. FTI Consulting, Inc. that § 546(e) does not apply to transfers in which financial institutions are mere intermediaries. In doing so, the Supreme Court resolved a circuit split, unanimously rejecting the majority rule in the Second, Third, Sixth, Eighth, and Tenth Circuits that the safe harbor applied to such transfers. As such, this decision leaves certain transactions previously thought inviolate vulnerable to later being unwound if one of the parties files for bankruptcy within the relevant statutory period.
For many years, almost every circuit court to consider the question held that the safe harbor of § 546(e) protected transfers subject to it even if a financial institution was involved only as a conduit for payment to another entity. Such a transfer was at issue in Merit Management, where two companies, which neither party contended were financial institutions, effected a stock purchase agreement by using financial institutions as intermediaries. More specifically, the purchaser transferred money to a bank, which then transferred it to a second bank. That bank, in turn, disbursed the purchase money to the seller-shareholders in exchange for their shares, which ultimately wound their way back up the chain to the purchaser. One of these shareholders was the petitioner, Merit Management Group, LP.
Not long after this transaction, the purchaser and its parent company filed for bankruptcy. The respondent, FTI Consulting, Inc., was appointed as a trustee of the parent company’s litigation trust and, in that role, sued Merit in federal district court to avoid the stock purchase as a fraudulent transfer. Merit defended, arguing that, because the transfer included a “settlement payment . . . made by or to” two different financial institutions, the transfer was protected under § 546(e).
The U.S. District Court for the Northern District of Illinois agreed with Merit, but the Seventh Circuit reversed and held, contrary to the majority view, that the safe harbor did not apply to transactions in which financial institutions served only as mere conduits.
The Supreme Court’s Opinion
In affirming the Seventh Circuit’s decision, the Court began by framing the issue before it. The Court noted that the parties and lower courts had “dedicate[d] much of their attention” to whether and when a transfer to or by a financial institution might qualify for protection under § 546(e). But the Court found that this “put the proverbial cart before the horse”: “Before a court can determine whether a transfer [fits into that inquiry] . . . , the court must first identify the relevant transfer to test in that inquiry.”
On that issue, FTI had argued that the relevant transfer was the overarching transaction that it sought to avoid: a stock purchase between two non-financial-institution parties. Merit, on the other hand, argued the majority view that each of the component parts of the transaction were relevant; and, if any of those component parts of the transfer fit into the securities safe harbor, the entire transfer was protected.
The Court rejected the majority rule and agreed with FTI that the relevant transfer is the one the trustee seeks to avoid:
The transfer that . . . ‘the trustee may not avoid’ is specified to be ‘a transfer that is’ either a ‘settlement payment’ or made ‘in connection with a securities contract.’ Not a transfer that involves. Not a transfer that comprises. But a transfer that is a securities transaction covered under § 546(e).
The Court found that “[a]pplying that understanding of the safe-harbor provision to this case yields a straightforward result.” FTI sought to avoid the stock purchase and not any of the individual “component transactions by which that overarching transfer was executed.” Thus, “the Court must look to the overarching transfer . . . to evaluate whether it meets the safe-harbor criteria.” And, as no one argued that the purchaser or seller in that overarching transaction was a “financial institution” “the transfer falls outside of the § 546(e) safe harbor.”
This decision plainly rejects what was, in many judicial circuits, a long-held interpretation of § 546(e). Whether it will have significant long-term effects hinges, in part, on whether parties that use financial institutions as intermediaries can in effect bypass the Court’s holding by arguing that they are themselves “financial institutions.” Indeed, the Bankruptcy Code provides that “customers” of “financial institutions” are, under certain circumstances, “financial institutions.” That issue that was not argued by the parties in Merit Management and thus, although highlighted by the Court, was not ruled upon.