On Feb. 27, 2018, the U.S. Supreme Court issued an important decision in Merit Management Group LP v. FTI Consulting Inc., limiting the scope of the securities safe harbor in 11 U.S.C. § 546(e). That safe harbor immunizes from the avoiding powers of the bankruptcy trustee certain types of transfers, including settlement payments, in securities transactions “made by or to (or for the benefit of)” qualifying securities or financial entities.
Writing for a unanimous court, Justice Sonia Sotomayor held that the safe harbor applies only with respect to the overarching transfer that the bankruptcy trustee is actually seeking to avoid. In the case before the court, since neither the transferor nor the transferee of the transfer sought to be avoided was an entity protected under § 546(e), the court held that the safe harbor did not apply. The fact that protected financial institutions were used as intermediaries to effect that overarching transfer did not change the result and trigger the safe harbor, given that the transfers made “by or to” those qualifying entities were not targeted by the trustee for avoidance.
The decision has far-reaching import and makes it much more likely that a trustee will be able to successfully avoid securities transfers, including leveraged buyouts. If the court had held the other way, challenged transfers involving securities transactions would have been effectively unavoidable unless made in cash. Parties could have immunized a securities transaction from the risk of bankruptcy avoidance by including a financial institution as a conduit of the money. Simply closing into escrow through a bank would have made the entire transaction unavoidable, because a transfer would have been made “by or to” a qualifying entity. After the Supreme Court decision, though, using that strategy will not trigger the safe harbor. Only if one of the parties involved in the targeted transfer itself qualifies as a covered institution under § 546(e) will the safe harbor apply.
To understand the court’s opinion, a careful examination of the facts and applicable law is warranted. Valley View Downs (the eventual Chapter 11 debtor) wanted to develop a “racino” (race track plus casino) in Pennsylvania and, to enhance its chances, engineered a deal to buy out all the stock of its principal competitor, Bedford Downs Management Corp., for $55 million. Merit Management Group — the target of the fraudulent transfer action at issue — was a major (30 percent) shareholder of Bedford, and as such would eventually receive about $16 million of the purchase price. The buyout was complex, but as relevant to the instant litigation, involved the following basic structure: Valley View borrowed the purchase price from Credit Suisse (a financial institution) pursuant to credit agreements; Credit Suisse transferred the $55 million purchase price directly to Citizens Bank of Pennsylvania (another financial institution) as escrow agent; Citizens Bank then transferred the purchase price to the shareholders of Bedford, including Merit Management, in exchange for the transfer of the stock.
Thus, in sum, the economic substance of the transaction was this: Valley View purchased Bedford’s stock, including that held by Merit.
The form was that Valley View borrowed the purchase price from Credit Suisse, and Credit Suisse delivered the purchase price on Valley View’s behalf to an escrow agent (Citizens Bank), which transferred the purchase price to Bedford’s shareholders, who delivered the stock in exchange. Thus, in form, money passed through the hands of two financial institutions, but neither of those financial institutions was a real party in interest.
Eventually, Valley View filed Chapter 11, a litigation trust was created pursuant to a confirmed plan, and FTI Consulting was named litigation trustee, with the power to bring avoidance actions on behalf of the estate. FTI sued Merit to avoid the stock purchase as a constructively fraudulent transfer under § 548(a)(1)(B) and § 544(b)(1), on the grounds that Valley View did not receive reasonably equivalent value in exchange, and was insolvent at the time of the transfer. Merit interposed the defense that avoidance was barred by the safe harbor of § 546(e).
If the transaction had been structured in the way portrayed by figure 1 above, then there is no question that § 546(e) would not apply. Neither Valley View nor Merit is a qualifying protected entity under that statute. So, too, if Credit Suisse had loaned the money to Valley View, and if Valley View had then transferred the funds directly to Merit in exchange for the stock, the safe harbor without question would not apply. Should it change the result if financial institutions are used as intermediaries, to transfer funds from one real party in interest (Valley View) to another (Merit), as portrayed in figure 2? The Supreme Court held no, given that the trustee is seeking only to avoid the ultimate transfer from Valley View to Merit, and is not seeking to avoid any of the transfers made by or to Credit Suisse or Citizens Bank.
In the transaction at issue, no one seriously argued that either Credit Suisse or Citizens Bank was a beneficiary of the transfers, within the meaning of the safe harbor, and thus the “for the benefit of” prong in the parenthetical was not triggered. Thus, the only way the safe harbor could apply would be if the transfers were “by or to” a financial institution, in the sense intended by § 546(e). The court held, though, that they were not, because those transfers were not ones the trustee sought to avoid.
As the court explained it, the entire transfer was A→B→C→D. The transfer the trustee sought to avoid as constructively fraudulent was A→D (e.g., Valley View to Merit), and since neither A nor D was a protected party under the safe harbor, it did not apply. While “B” and “C” (e.g., Credit Suisse and Citizens Bank, both of whom were protected parties under the safe harbor) were involved in effectuating the entire transaction, none of the transfers made by or to B or C were ones the trustee sought to avoid. That is, the court properly concluded that the “transfers” referenced in the safe harbor can only be ones as to which avoidance is sought.
The court’s holding makes eminent sense and is consistent with the statutory text, structure and purpose of the avoiding powers. Notably, though, most courts of appeals (including the jurisdictions where most big cases are filed, namely the Second Circuit, covering New York, and the Third Circuit, covering Delaware) had held the other way, and had applied the safe harbor even if the financial institutions were mere conduits and not targeted for avoidance. Those courts reasoned that the plain language of § 546(e) applied even in conduit cases because transfers were made “by or to” those institutions (in the court’s explanation noted above, parties “B” and “C”) in the course of executing the entire transaction, even if those transfers were not for their “benefit.” Given the liberal venue rules, almost any corporate debtor could file in New York or Delaware, and thus, in structuring a securities buyout, plan to close in escrow through a financial institution and be certain that the buyout was unavoidable. No more.
The Supreme Court properly reasoned that the expansive reading of the safe harbor “put the proverbial cart before the horse.” Instead, “the court must first identify the relevant transfer to test.” The court held 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.” Given that the targeted transfer of A→D is the only appropriate focus of the § 546(e) safe harbor, the presence of B and C in the chain of transfers is irrelevant and does not trigger the safe harbor.
The court’s holding restores a semblance of sanity to the scope of the securities safe harbor. The focus now is only on the affected parties involved in the targeted transfer. If those parties are not themselves entities covered by the safe harbor, it will not apply, nor is there any plausible reason why it should. Requiring congruence between the application of the safe harbor and the transfer for which avoidance is sought furthers the core principles of bankruptcy without implicating any of the risks for which the safe harbor was enacted.
Left to be determined is how far-reaching the court’s narrowing of the focus of the § 546(e) safe harbor will be. Certainly, the decision in Merit Management will open up private securities buyouts to avoidance, and may well do the same in public company buyouts. Selling shareholders in potentially fraudulent buyouts now face a clear risk of clawback — as they should. There is no legitimate policy reason why a constructively fraudulent transfer should be immune from recovery from parties who are not qualifying financial entities.
This article was originally published by Law360.
Charles Tabb is of counsel at Foley & Lardner LLP in Chicago and the Mildred Van Voorhis Jones chairman in law at the University of Illinois. Tabb’s treatise, "The Law of Bankruptcy," was cited by the U.S. Supreme Court in its decision last week in Merit Management Group LP v. FTI Consulting Inc.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.