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
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).
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).
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 "Aà
D" with "B" and "C" acting as
intermediaries, where the entire transaction amounted to a transfer
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
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.
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 Aà B 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.
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