On February 27, 2018, the U.S. Supreme Court resolved a circuit split under the Bankruptcy Code and determined that where funds passed through financial institutions acting as payment conduits, where the ultimate transfer sought to be avoided was not the type of transaction protected by the safe harbor provisions of the Bankruptcy Code, the safe harbor provisions of Bankruptcy Code Section 546(e), shielding transfers through financial institutions from avoidance actions by bankruptcy trustees, was inapplicable.
The Supreme Court found that prior circuit decisions applying the safe harbor simply because financial institutions were intermediaries in the transfer is not consistent with the language or intent of the safe harbor provisions.
In Merit Management Group, LP v. FTI Consulting, Inc., the Supreme Court examined the sections of the Bankruptcy Code that allow trustees in bankruptcy (which can include a debtor in possession) to set aside and recover certain pre-petition transfers to third parties for the benefit of the bankruptcy estate. Specifically, the Merit case presented a question under Section 548(a) of the Bankruptcy Code, which provides that a trustee may avoid fraudulent transfers “of an interest of the debtor in property.”  Section 546(e) of the Bankruptcy Code sets out limits on the exercise of the avoidance power and states that the bankruptcy trustee “may not avoid a transfer that is a margin payment . . . or settlement payment . . . made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency . . . in connection with a securities contract.” 11 U.S.C. Section 546(e).
For decades, courts have split over the issue whether the Section 546(e) safe harbor provision protects transfers where a financial institution acts only as an intermediary and is not the ultimate transferee in a multi-step transaction. The Seventh and Eleventh Circuits have long held that financial institutions must be more than an intermediary and must have some beneficial interest in the transfer, in order to shield the transfer under the safe harbor provisions. Meanwhile, the majority position held in the Second, Third, Sixth, Eighth and Tenth Circuits has been that the presence of a financial institution at any point in the transfer creates protection from the clawback.
Valley View Downs, LP (“Valley View”), a racetrack company, agreed to purchase all of the stock of its competitor company Bedford Downs Management Corp. (“Bedford Downs”) for $55 million as part of a larger $850 million transaction. Valley View arranged for the Cayman Islands branch of Credit Suisse to wire $55 million to third-party escrow agent Citizens Bank of Pennsylvania. The shareholders of Bedford Downs, including petitioner Merit Management Group, LP (“Merit”), also deposited their stock certificates into escrow. Citizens Bank disbursed the $55 million over two installments according to the agreement, of which petitioner Merit received approximately $16.5 million from the sale of its Bedford Downs stock to Valley View.
Valley View was unable to obtain a gaming license and ultimately filed for Chapter 11 bankruptcy along with its parent company, Centaur, LLC. FTI Consulting, Inc., the respondent, was appointed as trustee of the Centaur litigation trust. FTI sought to avoid the $16.5 million transfer from Valley View to Merit for the sale of Bedford Downs’ stock, arguing that it was constructively fraudulent under §548(a)(1)(B) because Valley View was insolvent at the time it purchased the stock, and had significantly overpaid. Merit argued that the §546(e) safe harbor barred FTI from avoiding the transfer because it was a “settlement payment . . . made by or to (or for the benefit of)” two “financial institutions,” specifically Credit Suisse and Citizens Bank. Both the Bankruptcy Court and District Court agreed with Merit holding that the transfer qualified under the safe harbor provision because the financial institutions transferred or received funds in connection with a “settlement payment” or “securities contract,” but the Seventh Circuit reversed the lower courts’ decision and held that §546(e) did not protect transfers in which financial institutions served as mere conduits or intermediaries with no beneficial interest in the transaction.
Opinion and Conclusion
In a unanimous opinion delivered by Justice Sotomayor, the Supreme Court affirmed the Seventh Circuit’s decision, refusing to broaden the safe harbor provision of Section 546(e) to protect a purchase of securities outside of the scope of the securities industry participants protected by Congress, notwithstanding the participation of financial institutions in the transaction as “mere conduits”.
After reviewing the plain language of the statute and the Congressional history, the Court concluded that the “relevant transfer for purposes of the § 546(e) safe harbor is the same transfer that the trustee seeks to avoid pursuant to its substantive avoiding powers,” meaning the “overarching transfer” from Valley View to Merit, not the component parts of the transfer that included transactions to and from financial institutions. Id. at *12.
This decision means that the use of financial institutions as a conduit or intermediary will not immunize a transaction from fraudulent transfer or other avoidance risk. Courts will look to the overall nature of the transaction and the identity of the ultimate participants in the transaction to determine if it is the type of transfer intended to be protected by 546(e), or one with only incidental use of financial participants. Arguably, this ruling might have a ripple down effect on the market by increasing uncertainty where transfers are paid to multiple beneficiaries through a bank or corporate trust company, in connection with transactions involving financially distressed or insolvent companies. Ultimately, the Court interprets § 546(e) narrowly as a specialized and limited safe harbor which only protects industry participants, not routine transactions that might involve securities.
The Supreme Court decision did not focus on the nature of the transaction or analyze whether the transaction at issue in the case qualifies as a transfer that is a “settlement payment” or made in connection with a “securities contract” as those terms are used in § 546(e)