Over the last twenty years, courts have increasingly insulated transactions from avoidance as fraudulent transfers by invoking the so-called “settlement payment” defense codified in section 546(e) of the Bankruptcy Code. The safe harbor has been interpreted in the Second and Third Circuits and elsewhere as precluding debtors, trustees and creditors committees from clawing back otherwise objectionable pre-bankruptcy transfers solely because the money at issue flowed through a bank or other financial institution. Given the ubiquity of financial institutions in leveraged buyouts, dividend recapitalizations, stock buy backs and other transactions, the conventional wisdom was that section 546(e) shielded a wide array of business dealings from scrutiny upon the bankruptcy of one of the transacting parties, particularly in the New York and Delaware courts that administer many of the largest and most complex insolvencies in the country.
Last week, the Supreme Court cast the future applicability of the section 546(e) safe harbor into considerable doubt. In a unanimous decision in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., the Court held that the settlement payment defense does not apply to transfers in which financial institutions serve merely as intermediaries or “conduit”. Since the vast majority of transactions previously covered by the safe harbor involved banks who were merely intermediaries or conduits, the Supreme Court opened the door for the potential avoidance of many transfers that had previously been viewed as otherwise protected under the safe harbor.
Section 546(e) of the Bankruptcy Code, states that, except in the case of actual fraud, a trustee of the bankruptcy estate “may not avoid a transfer that is . . . a transfer 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 . . . .” The majority of courts have interpreted this provision broadly, and found that many public and private company transactions that flow through financial institutions or financial participants or involve financial institutions as third-party lenders implicate the safe harbor because they involve transfers “by or to” a financial institution.
Merit arose from a bankruptcy involving racetrack operator Valley View Downs, LP. Prior to its bankruptcy, Valley purchased equity of an additional racetrack, Bedford Downs, through a $55 million leveraged buyout financed by Credit Suisse. Credit Suisse wired the $55 million to Citizens Bank of Pennsylvania, serving as escrow agent, who also held the Bedford Downs shares until Valley completed the transaction. Once the transaction was completed, Citizens Bank released Bedford Downs’ shares to Valley and the proceeds to Bedford Downs’ shareholders.
FTI, appointed as litigation trustee in the bankruptcy to pursue the Valley estate’s avoidance actions, commenced a fraudulent transfer action in the district court against Merit, a 30% stakeholder in Bedford Downs, to recover Merit’s portion of the proceeds from the transaction (approximately $16.5 million). Merit challenged the avoidance action arguing that the transaction was protected by section 546(e) because the transaction was made “by or to” certain financial institutions, namely Citizens Bank and Credit Suisse. The District Court agreed with Merit, and found that the section 546(e) safe harbor applied. On appeal, the Seventh Circuit reversed, finding that although Credit Suisse and Citizens Bank are financial institutions under the Bankruptcy Code, the safe harbor should not apply where financial institutions act as mere conduits to the ultimate transaction between two parties. The court noted that intended purpose of the safe harbor – which is to “protect the market from systematic risk and allow parties in the securities industry to enter into transactions with greater confidence” – simply was not implicated by an LBO transaction involving private companies. The Seventh Circuit’s decision disagreed with a majority of circuits that have ruled on the issue, most notably the Second and Third Circuits, which found the plain language of section 546(e) includes intermediary/conduit transactions.
Merit appealed, and in a unanimous decision written by Justice Sotomayor, the Supreme Court upheld the Seventh Circuit’s decision. In her opinion, Justice Sotomayor stressed that “the plain meaning of § 546(e) dictates that the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid.” For Merit, that meant the district court should have only looked to the transfer between Valley as purchaser and Merit as seller while disregarding the transfers to (and roles played) by the financial institutions that handled and facilitated those transfers.
The Merit decision now allows trustees to overcome one hurdle (albeit a major one) in attempting to avoid LBO transactions and others that implicate the section 546(e) safe harbor, potentially providing an additional avenue of recovery for general unsecured creditors who have been seeing reduced percentage distributions in many recent cases that include prenegotiated asset sales and restructuring support agreements. The extent to which unsecured creditors may capitalize on this new development going forward will depend on how future courts fill the remaining gaps in the Supreme Court’s analysis of section 546(e) still left after its decision in Merit. That process will begin in earnest in the Tribune Fraudulent Conveyance Litigation, which has essentially been on hold pending Merit’s outcome. Ultimately, as we noted when the Supreme Court first granted certiorari in Merit, it will likely be left to Congress to amend section 546(e) either to comport with the original intent of the provision or to reflect the far broader interpretation upon which transacting parties in the U.S.’s financial centers had come to rely.