The U.S. Supreme Court recently accepted for review 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), to consider the following issue: “whether the safe harbor of Section 546(e) of the Bankruptcy Code prohibits avoidance of a transfer made by or to a financial institution, without regard to whether the institution has a beneficial interest in the property transferred, consistent with decisions from the U.S. Courts of Appeals for the 2nd, 3rd, 6th, 8th, and 10th Circuits, but contrary to the decisions of the U.S. Courts of Appeals for the 7th and 11th Circuits.”
In Merit Management, the Seventh Circuit joined the Eleventh Circuit in holding that the safe harbor provision did not prevent a bankruptcy trustee from avoiding a transfer in which a financial institution acted as a mere conduit for, and thus had no beneficial interest in, a challenged transfer. This position is in stark contrast to the majority view, which holds that the plain language of section 546(e) does not require a financial institution to obtain a beneficial interest in transferred funds for the safe harbor to apply. The Supreme Court’s resolution of this issue will have important ramifications for investors in any number of financial transactions, perhaps most notably those participating in leveraged buyout (LBO) transactions, because participants in LBO transactions—which have historically received safe harbor protection in most jurisdictions—are common targets of clawback claims.
The safe harbor provision (also referred to as the “settlement payment defense”) codified in section 546(e) of the Bankruptcy Code provides that:
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the 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, or that is a transfer 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, … commodity contract, … or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
11 U.S.C. § 546(e) (emphasis added). Section 546(e) of the Bankruptcy Code protects all “settlement payments” made “by or to (or for the benefit of)” the enumerated entities from avoidance during a subsequent bankruptcy case (i.e., from clawback actions for fraudulent and preferential transfers). The purpose of the safe harbor provision, as described by the Second Circuit, is to avoid “[u]nwinding settled securities transactions” through avoidance claims brought months or even years after the transactions closed, which risks “seriously undermin[ing] … markets in which certainty, speed, finality, and stability are necessary to attract capital.” In re Tribune Co. Fraudulent Conveyance Litig., 818 F.3d 98, 119 (2d Cir. 2016).
Consistent with this goal, courts generally have interpreted the safe harbor broadly. The Second, Third, Sixth, Eighth and Tenth Circuits, for example, have found that section 546(e) protects transfers made through financial institutions even where those institutions act as mere conduits, finding the plain language of section 546(e) to be dispositive. The Seventh Circuit in Merit Management disagreed with this majority view.
The case stemmed from a buyout of shareholders as part of an LBO transaction. In 2003, Valley View Downs, LP, operator of a racetrack in Pennsylvania, agreed to merge with another racetrack, Bedford Downs. The purpose of the merger was to boost Valley View’s chances of obtaining the last available license in the state required to operate a “racino” (a combination horse track and casino). The buyout involved an acquisition of all shares of Bedford Downs for $55 million and was facilitated through Citizens Bank of Pennsylvania as the escrow agent. Valley View borrowed money from Credit Suisse and other lenders to finance the transaction. After the transaction closed, Valley View was unable to get all of its necessary licenses. It ultimately sought bankruptcy protection.
Subsequently, FTI Consulting—the litigation trustee appointed in the bankruptcy proceeding—sued Merit Management Group, a former 30% shareholder in Bedford Downs, to avoid as a fraudulent transfer Merit Management’s portion of Valley View’s transfer to Bedford Downs’s shareholders under Bankruptcy Code sections 544, 548(a)(1)(B), and 550. In response, Merit Management argued that the transfers should not be avoided because they were “made by or to” a financial institution when they were financed by Credit Suisse and held in escrow by Citizens Bank and that the transfers were thus protected under the section 546(e) safe harbor. It was undisputed that the transfers at issue constituted “settlement payment[s]” under section 546(e). It was similarly undisputed that Credit Suisse and Citizens Bank were “financial institution[s]” within the language of the statute. The issue, then, was whether section 546(e)’s language providing safe harbor to transfers “made by or to” financial institutions includes institutions that act merely as a conduit for the transfer, and do not benefit from it. The lower court dismissed FTI’s claims, ruling that the safe harbor applied even if the settlement payment merely passed through financial institutions. On appeal, however, the Seventh Circuit disagreed.
A three-judge panel of the Seventh Circuit reversed the district court decision, ultimately holding that “section 546(e) does [not] protect transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), where the entity is neither the debtor nor the transferee, but only the conduit.” The Seventh Circuit (as courts are required to do) began its analysis by examining the plain meaning of section 546(e). Upon doing so, it found that the phrases “by or to” and “for the benefit of” were ambiguous, and that it was thus unclear from the plain language of the statute whether Congress intended the safe harbor to protect transfers made through financial intermediaries. The court then went on to examine the statute’s purpose and context within chapter 5 of the Bankruptcy Code (which deals with avoidance actions), concluding that, on the whole, chapter 5 supported an interpretation that section 546(e) was not intended to protect transfers where a financial institution was merely an intermediary. The court also relied on its prior decision in Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890 (7th Cir. 1988), in which it found that a bank that acted as a financial intermediary and received no benefit from the transfer was not a transferee under chapter 5 of the Bankruptcy Code.
In addition, the Seventh Circuit panel in Merit Management examined the legislative history of section 546(e) to determine whether its more limited reading of this section would undermine Congressional policy and goals. The court recognized that the legislative purpose of the statute is to protect the markets from “systemic risk” by ensuring that the bankruptcy of one participant in the securities industry does not trigger the failure of other institutions through the avoidance of transfers. The court concluded that avoiding what resembles an LBO transaction would not impose any systemic risk on, or create a “ripple effect” in, the markets, particularly where only Merit Management and Valley View—neither of which were banks or other entities specified in section 546(e)—would be impacted by avoidance. According to the court, its narrow interpretation would, however, still protect transfers that involved a financial institution (or other entity listed in section 546(e)) as either a debtor or an ultimate transferee.
The Supreme Court will soon have an opportunity to decide the proper interpretation of section 546(e) of the Bankruptcy Code: the broad interpretation adopted by the majority of Circuits, or the narrow interpretation adopted by the Seventh and Eleventh Circuits. The Court’s adoption of the minority view would likely have a substantial impact on the mergers and acquisitions and securities markets. For years, parties to financial transactions have relied on the safe harbor provision to protect settlement payments from avoidance in the event of a subsequent counterparty bankruptcy. This reliance has lent predictability and stability to the markets. In fact, many market participants routinely draft their contracts and other agreements to fit within the majority interpretation of the safe harbor provision. Were the Supreme Court to adopt the minority view articulated by the Seventh Circuit, there would likely be a significant impact on the markets, exposing a number of preexisting transactions—including perhaps most notably LBO transactions—to avoidance in the event of a counterparty bankruptcy. On the one hand, parties now contemplating entering into contracts historically protected under the safe harbor should consider how their transactions might be impacted if the Supreme Court does adopt the minority view, and no longer protects transfers that involve financial institutions as mere conduits. On the other hand, were the Supreme Court to adopt the majority view, holding that transfers made through financial institutions as intermediaries are protected under the safe harbor, there likely would be little change in the markets, because it would remain difficult for trustees in bankruptcy to unwind securities transactions.
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 firm with which the authors are associated.
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