Supreme Court Clarifies Securities Safe Harbor Under Bankruptcy Code

HIGHLIGHTS:

• In a unanimous decision, the U.S. Supreme Court ruled against the petitioner in Merit Management Group, LP, Petitioner v. FTI Consulting, Inc., affirming the decision of the U.S. Court of Appeals for the Seventh Circuit.
• The Supreme Court determined that the relevant transfer for purposes of the Section 546(e) safe harbor inquiry is the transfer that is sought to be avoided under the Bankruptcy Code and not any intermediate transfers that are components of the overarching transfer.
• As grounds for its decision, the Supreme Court determined that the language of Section 546(e), the specific context in which that language is used and the broader statutory structure of the Bankruptcy Code all supported the conclusion that the relevant transfer for purposes of the Section 546(e) safe harbor inquiry is the overarching transfer that the trustee seeks to avoid under one of the substantive avoidance provisions.

In a 9-0 decision, the U.S. Supreme Court determined on Feb. 27, 2018, that the relevant transfer for purposes of the Section 546(e) safe harbor inquiry is the transfer that is sought to be avoided under the Bankruptcy Code and not any intermediate transfers. In a decision written by Justice Sonia Sotomayor, the Supreme Court ruled against the petitioner in Merit Management Group, LP, Petitioner v. FTI Consulting, Inc., affirming the decision of the U.S. Court of Appeals for the Seventh Circuit and overruling several other federal circuit courts.

Case History

In FTI, the question before the Court was whether a payment of approximately $16.5 million for the purchase of corporate shares was excepted from avoidance as a constructively fraudulent transfer under Section 548(a)(1)(B) of the Bankruptcy Code by the securities safe harbor under Section 546(e) of the Bankruptcy Code. The Bankruptcy Code gives a trustee in bankruptcy the power to avoid certain transfers of the debtor's property, subject to limitations on the use of those powers. One of the limitations on a bankruptcy court's exercise of its avoidance powers is the securities safe harbor provision, which, among other things, provides that "the trustee may not avoid a transfer that is a ... settlement payment ... made by or to (or for the benefit of) a ... financial institution ... or that is a transfer made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract."¹

In 2003, Valley View Downs LP and Bedford Downs Management Corp. were competing for an award of the last harness-racing license in Pennsylvania. After both of their applications were denied, Valley View and Bedford resolved their competition and agreed that Bedford would withdraw as a competitor and Valley View would purchase all of Bedford Downs' stock for $55 million if Valley View was successful in obtaining the harness racing license. Subsequently, Valley View was awarded the last harness-racing license, and Valley View proceeded with acquiring the shares in Bedford. Valley View arranged financing for the acquisition of the shares, and Valley View's lender wired the $55 million purchase price to a second bank that acted as a third-party escrow agent. The shareholders of Bedford, including the petitioner in FTI, Merit Management Group LP, also deposited their shares with the escrow agent. At closing, Valley View received the Bedford stock certificates, and the second bank acting as escrow agent made two payments to the Bedford shareholders, including Merit, which received approximately $16.5 million.

After failing to comply with the terms of its financing package, Valley View and its parent company filed for Chapter 11. The bankruptcy court confirmed a reorganization plan and appointed FTI Consulting Inc. to act as trustee of the litigation trust established under the confirmed plan. The trustee then filed suit against Merit in the Northern District of Illinois, seeking to avoid the payment of the $16.5 million from Valley View to Merit in exchange for Merit's stock in Bedford as being a constructively fraudulent transfer under Section 548(a)(1)(B) of the Bankruptcy Code. The trustee alleged that Valley View was insolvent when it purchased Merit's shares and that Valley View had paid more than what the shares were worth. Merit moved for summary judgment, arguing that the Section 546(e) safe harbor insulated the transfer from avoidance because the transfer was a "settlement payment ... made by or to (or for the benefit of) a covered financial institution", i.e., the bank financing the acquisition of the stock and the bank that acted as the third-party escrow agent.

The District Court granted Merit's summary judgment motion, determining that Section 546(e) applied because the two banks were financial institutions that had transferred or received the funds in connection with a "settlement payment" or "securities contract." Upon appeal, the U.S. Court of Appeals for the Seventh Circuit reversed the District Court, concluding that the securities safe harbor provision did not protect transfers in which financial institutions acted as mere conduits. The Seventh Circuit's holding was in conflict with the broad approach taken by the majority of other circuit courts of appeal that had concluded, essentially, that if any of the parties protected by Section 546(e) were in the chain of transfers, the entire transfer was immunized from avoidance under the securities safe harbor.

Supreme Court Goes Against Majority View, Confirms Seventh Circuit Ruling

Justice Sotomayor, writing for a unanimous Court, affirmed the Seventh Circuit's decision, overruling several other circuit court decisions, and held that in applying Section 546(e) courts should look only to the actual transfer that is sought to be avoided and ought not to look at any intermediate transfers. In a graphic illustration, that Court stated that if a transfer goes from A to B to C to D, and the bankruptcy trustee looks to avoid the transfer from A to D, the involvement of B and C is irrelevant, and the court should look only to the overarching transfer from A to D.

According to the Court, the opening language of Section 546(e), "[n]otwithstanding sections 544, 545, 547, 548(a)(1)(B) and 548 (b)," made clear that what was at issue was a challenged-transfer specific exception to the general avoidability of the challenged transfer. The language requires that a court look to the actually challenged transfer, which, going back to the graphic illustration, was the transfer from A to D. If the transfer sought to be avoided was from A to B, a financial institution, B could try to invoke the safe harbor. Similarly, if the transfer sought to be avoided was from C, a financial institution, to D, C could try to invoke the safe harbor. Because, however, the trustee sought to avoid the overarching transfer from A to D, D cannot try to invoke the safe harbor unless it is a protected party under Section 546(e) in its own right.

Analysis

Because of the former majority position of the circuit courts of appeal, sophisticated mergers and acquisitions lawyers would set up all stock transfers, including straight private company stock acquisitions and leveraged buyouts, so that the consideration would pass through a financial institution. Because the consideration passed through a financial institution, and then the financial institution would pass the consideration on to the seller, the payments were "by or to" a financial institution and, consequently, protected from avoidance under the safe harbor provision. After FTI, the parties to such a transaction can no longer have such an expectation.

There is one aspect of the FTI decision, however, that begs additional consideration and could be the seed that grows into a revitalization of the approach supported by the majority of the circuit courts of appeals. The term "financial institution" is defined under the Bankruptcy Code to include not only banks but also their customers under certain circumstances. Financial institution means: "(A) a Federal reserve bank, receiver, liquidating agent, conservator or entity acting as agent or custodian for a customer ... in connection with a securities contract ... such customer [.]"² Because the parties in FTI did not argue that either Valley View or Merit qualified as a "financial institution" by virtue of its status as a customer under Section 101(22)(A), the Court did not consider what impact, if any, Section 101(22)(A) would have in the application of the safe harbor provision of Section 546(e). There may come a time, however – perhaps in the not-too-distant future – when such an argument is made successfully and the FTI decision is distinguished on that basis. 
   

Notes

¹ 11 U.S.C. §546(e).

² 11 U.S.C. §101(22)(A).

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