In a case that could have significant, long-term ramifications for the holders of stock and other securities, the U.S. Supreme Court vastly limited the scope of a Bankruptcy Code “safe harbor” that shields certain transfers made in connection with a securities transaction from a trustee’s bankruptcy avoidance powers. After the Supreme Court’s decision, a securities transfer is not protected under Bankruptcy Code section 546(e)’s “safe harbor” by merely passing the funds through a bank, broker or similar financial intermediary before reaching the ultimate transferee.

In Merit Management Group, LP v. FTI Consulting, Inc., No. 16-784, slip op. at 18 (U.S. Feb. 27, 2018), the Supreme Court unanimously held that the relevant transfer that may be shielded by section 546(e) is the transfer that the plaintiff is seeking to avoid. Stated another way, a specific transfer will not be shielded by section 546(e) merely because another transfer made as a component part of a larger overall transaction would be shielded by section 546(e) (such as a transfer made by a bank forwarding a settlement payment to a shareholder or escrow agent in connection with a larger stock purchase transaction – which is what occurred in Merit Management). Instead, to be protected from avoidance under section 546(e), any transfer that the plaintiff seeks to avoid must satisfy all the requirements of section 546(e).

Significant implications of Merit Management going forward include:

• The section 546(e) safe harbor will apply to fewer transfers — dividends, redemptions and other securities payments will not be shielded from avoidance simply because the funds passed through a bank, broker or similar financial intermediary.

• Trustees and debtors in bankruptcy will likely seek to avoid and recover with greater frequency pre-bankruptcy transfers made to shareholders — so shareholder beware.

• Other transfer safe harbors within the Bankruptcy Code are likely to be invoked by shareholders and other parties facing avoidance claims as a result of the decreased scope of section 546(e).

The Bankruptcy Code grants bankruptcy trustees the power to “avoid” certain types of transfers, or clawback payments, that were made from a debtor to another party before bankruptcy. In addition to granting the trustee these avoidance powers, the Bankruptcy Code also contains defenses that impose some limits on their exercise. At issue in Merit Management was the securities safe harbor of section 546(e), which, at its essence, provides that the trustee may not avoid a transfer that is a margin or settlement payment (as defined in the Code) or a payment made in connection with a securities contract that is “made by or to (or for the benefit of)” a defined list of intermediaries, such as financial institutions or forward contract merchants.

In Merit Management, the bankruptcy trustee of the debtor’s estate sought the return of $16.5 million that had been paid by the debtor to a shareholder in a pre-bankruptcy stock purchase agreement through a series of related transfers. Specifically, the debtor caused one of its banks, Credit Suisse, to make a payment to Citizens Bank of Pennsylvania as escrow agent, and then the escrow agent forwarded the funds to the shareholder after the shareholder’s shares had been tendered to the agent. Later, the debtor filed for bankruptcy, and thereafter a litigation trustee sued the shareholder on the ground that the shareholder received a constructively fraudulent transfer in that the debtor did not receive reasonably equivalent value for the $16.5 million stock payment that it made to the shareholder (thereby depriving the debtor of much-needed assets). The shareholder, however, argued that the $16.5 million was shielded from the trustee’s avoidance power through the section 546(e) safe harbor because the funds had first passed from Credit Suisse to Citizens Bank — both of which are protected entities under the safe harbor when the transfer is a settlement payment.

The issue decided by the Supreme Court was: Which transfer is relevant when determining whether the section 546(e) safe harbor applies and prevents the clawback of funds? The shareholder argued that the Court should consider every “component” transfer that occurred on the funds’ way from the debtor to the shareholder, including the three transfers that were “made by or to” financial institutions as required under section 546(e). In contrast, the trustee argued that the only transfer that should be evaluated for safe harbor eligibility is the transfer that it sought to avoid pertaining to the debtor and the shareholder, regardless of how the money got from point A to point B. Thus, under the trustee’s view, the section 546(e) safe harbor does not apply because the transfer between the debtor and the shareholder is the only relevant inquiry, and neither the debtor nor the shareholder is a protected entity that meets the safe harbor test of section 546(e).

The Supreme Court agreed with the trustee and concluded that the “overarching” transfer between the debtor and the shareholder was all that was to be considered. The transfers that were made by and to financial institutions on the money’s route to the shareholder were not the relevant transfers that the trustee sought to avoid.

As a result of Merit Management, shareholders and other security holders need to be cautious about the transactions they enter into and the risk they will encounter, knowing now that the section 546(e) safe harbor will likely not apply to their transactions. Of particular concern are situations where dividends or stock redemptions or repurchases are made by a debtor that may be experiencing some type of financial distress. In these instances, shareholders may require solvency or fairness opinions in connection with the transactions (to better insulate themselves from a later insolvency attack). In addition, it is possible, depending on the nature of the transaction, that other bankruptcy safe harbor provisions may be used, such as those for repo or swap transactions. Furthermore, because Merit Management merely narrows, but does not eliminate, the section 546(e) safe harbor, it is possible that new transactional structures may evolve over time that, at least arguably, will permit transfer recipients to claim that the 546(e) safe harbor applies. But for the present, there is no denying that Merit Management has, in one fell swoop, significantly altered the already rocky landscape of one of the Bankruptcy Code’s most critical safe harbor provisions.