On February 27, 2018, the Supreme Court handed down a unanimous opinion, authored by Justice Sotomayor, resolving a Circuit split over the interpretation of Section 546(e) of the Bankruptcy Code, the “safe harbor” provision that shields specified types of payments “made by or to (or for the benefit of)” a financial institution from avoidance on fraudulent transfer grounds.

Bankruptcy Code Section 546(e) provides that a debtor or trustee cannot avoid settlement payments, payments made in connection with a securities contract, or certain other specified types of transfers if “made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency . . . .” 11 U.S.C. Section 546(e) (emphasis added).

Courts of appeal have been divided for decades over whether this safe harbor applies when neither the debtor/transferor nor the ultimate transferee is a financial institution — that is, when the only financial institutions involved in the transaction are banks, brokers, or other institutions serving merely as intermediaries or conduits in connection with a transfer. The Seventh and Eleventh Circuits had held that a financial institution must be more than an intermediary for the safe harbor to apply. Five circuit courts (the Second, Third, Sixth, Eighth and Tenth Circuits) had held to the contrary, giving broader scope to the safe harbor.

In the Merit decision, the Supreme Court sided with the Seventh and Eleventh Circuits narrowly applying the safe harbor and in concluding that “[t]he language of §546(e), the specific context in which that language is used, and the broader statutory structure all support the conclusion that the relevant transfer for purposes of the §546(e) safe harbor inquiry is the overarching transfer that the trustee seeks to avoid under one of the substantive avoidance provisions.” Merit Management Group L.P. v. FTI Consulting Inc., --- S. Ct. ---, 2018 WL 1054879 *6 (2018).

The Facts

Merit Management, the appellant in the case, was a 30% shareholder of Bedford Downs, a racetrack company. Bedford was competing with Valley View Downs, another racetrack owner, for the same racing license. Bedford and Valley View ultimately entered into an agreement, under which Bedford withdrew its application for the racing license, and Valley View acquired all of Bedford’s common stock for $55 million. Valley View made its payments to Bedford shareholders through Credit Suisse (Valley View’s lender), which distributed the funds to Citizens Bank of Pennsylvania (the escrow agent), which in turn distributed the payments to Bedford’s shareholders, including Merit, which received $16.5 million.

Valley View was ultimately unable to open its racing operations, filed for bankruptcy, and confirmed a Chapter 11 plan of reorganization. FTI Consulting, as trustee for the litigation trust created under Valley View’s plan, commenced a fraudulent transfer action under Section 548 of the Bankruptcy Code against Merit, alleging that the Bedford/Valley View transaction was made for less than reasonably equivalent value and seeking to avoid the $16.5 million payment made to Merit on account of its ownership interest in Bedford. Merit replied that, because that payment was made through financial institutions (Credit Suisse and Citizens Bank), the transaction was protected by the safe harbor provision of Section 546(e) and could not be avoided.

Both the bankruptcy court and the district court sided with Merit, holding that it was shielded from liability under Section 546(e)’s safe harbor. The lower courts relied on the decisions of the five circuit courts that have held that a transfer can qualify under this safe harbor even if the financial institution serves merely as a conduit or intermediary and has no beneficial interest in the transfer. The Seventh Circuit, however, reversed the lower courts, finding that the transfer from Valley View to Merit was not protected by Section 546(e).

The Opinion

Justice Sotomayor explained that the case at bar presented a scenario where the safe harbor provision was being applied to a transfer that was executed in multiple stages, from “AàD” with “B” and “C” acting as intermediaries, where the entire transaction amounted to a transfer from AàBàCàD. Id. at *3. Merit argued that the component parts of the transfer must be considered, including the transfer of funds from Credit Suisse to Citizens Bank (from “B” to “C”), and from Citizens Bank to Merit (from “C” to “D”). FTI, on the other hand, argued that the Court should consider, for the purposes of whether to apply the safe harbor protections, the transfer from Valley View to Merit (from “A” to “D”) without zeroing in on the component parts of the transfer that involved Credit Suisse and Citizens Bank for the purposes of applying the safe harbor provision.

First, the Court looked to the plain language of the statute and the title of Section 546 – “Limitations on avoiding powers” – and concluded that “the transfer that the trustee seeks to avoid [is] the relevant transfer for consideration of the §546(e) safe-harbor criteria.” Id. at *7. The Court explained that FTI brought the lawsuit to avoid the broader transfer from Valley View to Merit, not simply a specific component part of the transaction. Because Section 546(e) begins with the clause “Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title,” the Court reasoned that the safe harbor provision serves as an exception to the trustee’s existing avoiding powers, and the relevant inquiry is the applicability of the trustee’s substantive avoidance powers in this first clause.

Turning to Merit’s primary contention that the 2006 addition to Section 546(e) of the parenthetical “(or for the benefit of)” was intended to abrogate the Eleventh Circuit’s decision in In re Munford, Inc., 98 F. 3d 604, 610 (11th Cir. 1996) (finding safe harbor provision inapplicable to transfers where financial institution only acted as intermediary), the Court deduced that the addition was instead included by Congress to ensure that “the scope of the safe harbor matched the scope of the avoiding powers.” Id. at *8. The Court maintained that the inclusion of this parenthetical served to reinforce the notion that the safe harbor provision applies to transfers otherwise avoidable under the Bankruptcy Code.

Additionally, in response to Merit’s argument that the safe harbor provision was intended by Congress to comprehensively cover commodities and securities transactions in order to provide finality to such transactions, the Court again turned to the language of Section 546(e), pointing out that “[t]he safe harbor saves from avoidance certain securities transactions ‘made by or to (or for the benefit of )’ covered entities” but that “[t]ransfers ‘through’ a covered entity, conversely, appear nowhere in the statute.” Id. at *9.

In concluding that the safe harbor provision should be applied to the overarching transfer from Valley View to Merit, the Court stated that neither party contended that either Valley View or Merit was itself a financial institution or an entity covered under the statute, and thus the transfer at issue fell outside the scope of the safe harbor provision.

Looking Ahead

The long-awaited decision in Merit serves to eliminate a defense that for decades has protected transferees — particularly shareholders — from liability in a large number of fraudulent transfer cases, including suits seeking to recover transfers made in connection with LBOs and leveraged recapitalizations. Debtors whose bankruptcies were precipitated by transactions of this sort now may have an enhanced ability to recover value for the benefit of creditors. The Court’s decision should stem concerns that Section 546(e) was inappropriately providing near universal protection to an overly broad set of transactions, often leaving creditors with little recourse. After all, in the modern world, almost every transaction is made through a bank or financial institution.

Courts must now parse out, however, the extent to which parties in safe harbor disputes have freedom to strategically define the relevant “transfer” and related transferors and transferees. While the decision briefly mentions Bankruptcy Code Section 550, which identifies parties that the trustee may recover property from to augment the bankruptcy estate, the extent to which the decision impacts Section 550 is unclear. There are scenarios in which one could read Section 546(e) to define the only voidable transfer as a transfer from AàB with “C” and “D” liable as transferees of the transfer, in which case it would indeed be the status of “B”, not “D”, which determines the Section 546(e) safe harbor. Justice Sotomayor briefly addresses this issue by noting that “the trustee is not free to define the transfer that it seeks to avoid in any way it chooses” and that “[i]nstead, that transfer is necessarily defined by the carefully set out criteria in the Code.” Id. at *7. Practitioners, though, will surely seek to explore on the bounds of how a transfer may be framed.

Relatedly, the facts of the Merit case were straightforward: The transferor and transferee were in direct privity and known to each other. But consider a scenario where “A” is a debtor, “B” is the Depository Trust Company (“DTC”), “C” is numerous DTC broker/dealer participants and “D” is a mass of anonymous broker/dealer customers. Is it clear that “D” is the transferee whose status determines the application of Section 546(e)? There may well be circumstances where the answer is less straightforward. Courts and practitioners will continue to face questions in scenarios like this relating to how to define the relevant transfer and transferor/transferee, but the Merit decision has provided useful guidance on the scope of the safe harbor defense moving forward.