In our last article, we discussed the U.S. Supreme Court’s acceptance for review of the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016), cert. granted, No. 16-784, 197 L. Ed. 2d 894 (U.S. May 1, 2017). The Seventh Circuit had held that the Bankruptcy Code safe harbor provision did not prevent the avoidance of a transfer where a financial institution acted as a mere conduit for, and thus had no beneficial interest in, a challenged transfer.
While the majority of circuit courts (the Second, Third, Sixth, Eighth, and Tenth) had interpreted section 546(e) of the Bankruptcy Code more broadly, allowing the safe harbor to apply in such a situation, the Seventh Circuit instead joined the minority view of the U.S. Court of Appeals for the Eleventh Circuit.
The Supreme Court, in Merit Management Group, LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), also sided with the minority view. The Court held that section 546(e) does not protect transfers made through a financial institution to a third party regardless of whether the financial institution had a beneficial interest in the transferred property. Instead, “the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid.”
The controversy in Merit arose from a buyout of shareholders as part of a leveraged buyout transaction.
In 2003, two racetrack operators, Valley View Downs, LP and Bedford Downs, were competing for the remaining harness-racing license available in Pennsylvania. The license was needed to open a “racino” (a combination horse track and casino). When their separate efforts to obtain the license failed, the two companies agreed to merge, with Valley View purchasing all of Bedford Downs’s stock for $55 million.
The transaction was facilitated through Citizens Bank of Pennsylvania as the escrow agent. Valley View arranged for the Cayman Islands branch of Credit Suisse to finance the $55 million purchase price. Credit Suisse wired the funds to Citizens Bank, which, as escrow agent, also accepted stock certificates of the Bedford Downs shareholders. At closing, Valley View received the Bedford Downs stock certificates, and thereafter, Citizens Bank disbursed the funds to the Bedford Downs shareholders, including Merit. Afterward, however, Valley View failed to secure a separate gaming license, and ultimately ended up seeking bankruptcy protection.
In the course of the bankruptcy case, FTI Consulting—the appointed litigation trustee—sued Merit Management Group, LP (a Bedford Downs shareholder) to avoid, under sections 544, 548(a)(1)(B), and 550 of the Bankruptcy Code, Merit’s portion of Valley View’s transfer to the Bedford Downs shareholders. Merit, which had been a 30 percent shareholder in Bedford Downs, had received $16.5 million in the transaction.
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The Bankruptcy Code gives a trustee (or a chapter 11 debtor-in-possession or a creditors’ committee, depending on the circumstances of the case) the power to avoid certain transfers or obligations incurred by the debtor before the bankruptcy filing. These “avoiding powers” help to implement one of the core principles of bankruptcy: equal distribution of assets among similarly situated creditors.
Certain types of transfers, however, are protected from these avoiding powers. For instance, section 546(e) of the Bankruptcy Code, commonly known as the securities safe harbor provision (and also referred to as the “settlement payment defense”), protects from avoidance all “settlement payments” made “by or to (or for the benefit of)” certain enumerated financial entities. 11 U.S.C. § 546(e).
In a motion for judgment on the pleadings, Merit asserted that the section 546(e) safe harbor barred FTI from avoiding the Valley View to Merit transfer because the transfer was a “settlement payment . . . made by or to (or for the benefit of)” a covered “financial institution”—here, Credit Suisse and Citizens Bank. The District Court agreed, ruling that the safe harbor applied even if the settlement payment merely passed through financial institutions. On appeal, the Seventh Circuit disagreed, holding that the section 546(e) safe harbor did not protect transfers in which financial institutions are mere conduits.
The Supreme Court upheld the Seventh Circuit’s decision, though on different reasoning.
When interpreting the scope of the safe harbor, the lower courts had focused primarily on two issues: the meaning of the words “by or to (or for the benefit of)” as used in section 546(e) of the Bankruptcy Code safe harbor, and the question of whether the statute requires that a participating “financial institution” (or other covered entity) have a beneficial interest in, or dominion and control over, transferred property. The Supreme Court’s view was that this analysis “put the proverbial cart before the horse.”
Instead, the Court instructed that a court’s first inquiry should be to identify the relevant transfer itself. The Court explained that the “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 framed this transfer as “the Valley View-to-Merit end-to-end transfer [along with] all its component parts.”
FTI, on the other hand, framed the transfer as “the overarching transfer between Valley View and Merit of $16.5 million for purchase of the stock.” The Court agreed with FTI’s framing of the transfer.
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In arriving at this conclusion, the Court considered the statutory language of section 546(e) and the context in which that language is used. The Court reasoned that the very first clause—“[n]otwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title”— instructs that section 546(e) operates as an exception to avoidance powers afforded to the trustee under Chapter 5 of the Bankruptcy Code. “From the outset, therefore,” the Court wrote, “the text makes clear that the starting point for the §546(e) inquiry is the substantive avoiding power under the provisions expressly listed in the ‘notwithstanding’ clause and, consequently, the transfer that the trustee seeks to avoid as an exercise of those powers.”
Similarly, the Court reasoned, the very last clause—“except under section 548(a)(1)(A) of this title—reiterates that the focus of the inquiry is the avoidable transfer. Even the section’s heading—“Limitations on avoiding powers”—reinforces that reading.
Moreover, the Court found that the statutory structure also reinforced the Court’s reading of section 546(e). The Court, quoting the Seventh Circuit, explained that the Bankruptcy Code safe harbor “creates both a system for avoiding transfers, and a safe harbor from avoidance.” Given this structure, the Court found it was “only logical to view the pertinent transfer under §546(e) as the same transfer that the trustee seeks to avoid pursuant to one of its avoiding powers.” To this end, the trustee must identify a transfer that is properly subject to avoidance under the Bankruptcy Code.
A defendant can, of course, argue that the trustee did not properly identify the transfer, and assert any defenses with respect to the component parts of the transfer. The Court instructed, however, that “[i]f a trustee properly identifies an avoidable transfer . . . the court has no reason to examine the relevance of the component parts when considering a limit to the avoiding power, where that limit is defined by reference to an otherwise unavoidable transfer.”
The Court ultimately concluded that, because Merit did not contest FTI’s identification of the Valley View-to-Merit transfer as the transfer to be avoided, the Credit Suisse and Citizens Bank component parts were irrelevant to the section 546(e) analysis. And ignoring those components, the transfer the trustee put in issue was not subject to the section 546(e) safe harbor.
Unlike the lower courts, the Supreme Court’s decision in Merit did not turn on whether section 546(e) requires that the “financial institution” or other covered entity have a beneficial interest in or dominion and control over, the transferred property. The Court did, however, briefly address the issue in considering Congress’s purpose in enacting the safe harbor.
Merit argued that Congress’s intent was to “advanc[e] the interests of parties in the finality of transactions” and broadly protect the securities industry by providing a safe harbor for transactions not only “to” those entities (thus protecting the entities from direct financial liability), but also “by” these entities to non-covered entities. The Supreme Court rejected this argument, stating that while there is “good reason to believe that Congress was concerned about transfers ‘by an industry hub’” (as the safe harbor saves from avoidance certain securities transactions “made by or to (or for the benefit of)” covered entities) “[t]ransfers ‘through’ a covered entity . . . appear nowhere in the statute.”
In reviewing the scope of the Bankruptcy Code safe harbor provision, the Court discounted the complexity of the component parts of a typical corporate transaction, instead concentrating on the overarching transfers that a litigant seeks to avoid. In this case, the transfer FTI sought to avoid was the Valley-View-to-Merit transfer. The component parts, which involved various financial institutions, were not relevant to the inquiry.
The Supreme Court’s decision to interpret section 546(e) of the Bankruptcy Code so narrowly may have a substantial impact on the mergers and acquisitions and securities markets, as some transactions involving financial institutions as conduits may no longer be protected from avoidance in the event of a subsequent bankruptcy proceeding by a counterparty. In future application of the Bankruptcy Code safe harbor exception, the lower courts will be tasked with identifying the true transfer that is subject to avoidance in order to determine whether safe harbor applies.
In addition, we suspect that disputes concerning the stated scope of the relevant transaction to be avoided, and whether an entity at the receiving end of the transaction qualifies as a “financial institution,” will be at the center of future litigation involving the securities safe harbor.
The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of the law firms with which the authors are associated. Learn more about Erin N. Brady, of Hogan Lovells, and Anna Kordas, of Jones Day.
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