The Supreme Court recently agreed to review the applicability of the safe harbor provision in section 546(e) of the Bankruptcy Code after differing interpretations of the statute created a split among the circuit courts. The ultimate outcome on the issue currently before the Supreme Court will undoubtedly impact how parties choose to structure their debt and asset transactions going forward.
Section 546(e) of the Bankruptcy Code states that the debtor “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 . . . .” In other words, section 546(e) limits a debtor’s avoidance powers with respect to certain types of securities-related transactions. Indeed, legislative history suggests the purpose of the safe harbor was to minimize instabilities in the commodities and securities markets by allowing for more certainty and finality in related transactions.
While certain transactions clearly fall within the safe harbor, like the sale of publicly traded securities by a brokerage firm or other financial institution, courts have been left with the difficult task of determining whether private transactions of securities should also be afforded the protection. Indeed, many private company transactions flow through financial institutions or financial participants or involve financial institutions as third-party lenders for leveraged buyouts and could implicate the safe harbor based on a straightforward reading of the statute. A majority of circuits addressing this issue have adopted the plain-reading, pass-through theory—a broad interpretation of the statute finding that such a transfer was “by or to” a financial institution as set forth by its plain language.
In the case taken up by the high court, FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, the Seventh Circuit rejected the majority view and took a narrow view of section 546(e), finding that the pass‑through of a security through a financial institution and the lending provided by a third‑party did not trigger the safe harbor provision under section 546(e). The case 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. Citizens Bank of Pennsylvania, serving as escrow agent, held the Bedford Downs shares, until Valley completed the transaction.
FTI, appointed as litigation trustee to pursue Valley’s estate’s avoidance actions, commenced a fraudulent transfer action against Merit, a 30% stakeholder in Bedford Downs, to recover Merit’s portion of the proceeds from the equity purchase. Merit argued 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 protected the transaction based on a plain language reading of the statute, finding that the transaction was “by or to” a financial institution because the transaction involved the two financial institutions. FTI appealed.
Upon appeal, the Seventh Circuit reversed the decision of the District Court. Finding the language of 546(e) to be ambiguous, the Seventh Circuit reviewed the intended purpose of the safe harbor provision, finding such purpose is to “protect the market from systematic risk and allow parties in the securities industry to enter into transactions with greater confidence—to prevent one large bankruptcy from rippling through the securities industry.” Determining that the transaction at issue of private stock for cash between two entities did not fall under the intended purpose of section 546(e), the Seventh Circuit ruled the safe harbor provision did not apply.
The Seventh Circuit’s interpretation of 546(e) is in line with a divided opinion from the Eleventh Circuit, Munford v. Valuation Research Corp., finding that a similar transaction involving a financial institution as merely a conduit did not trigger a section 546(e) safe harbor protection from clawback. However, the Second, Third, Sixth, Eighth, and Tenth Circuits all disagree, finding both the language of section 546(e) to be unambiguous and that an intermediary financial institution that touches a securities transaction set forth in the statute triggers the safe harbor protections, often citing the dissent in Munford.
Should the Supreme Court overturn the Seventh Circuit and agree with the majority of Circuits on this issue, it would cement the significant barrier created by section 546(e) for a debtor or its successor even to attempt a clawback of any major transaction. Given the Court’s relative speed in taking up the matter and its recent rulings on statutory interpretation, it may be the Court will do just that, leaving it to Congress to amend section 546(e) to provide the protections in line with its intended purpose.