Dabbling in Distress: U.S. Supreme Court to Hear Two Important Bankruptcy Issues Next Term

by Hogan Lovells
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Despite a modest uptick in recent years, it is still a relatively rare occasion for the Supreme Court of the United States to tackle issues involving bankruptcy. This term, however, the Supreme Court has granted certiorari in two bankruptcy appeals that could have important consequences for the financial community. In FTI Consulting, Inc. v. Merit Management Group, LP, the Court will define the parameters of the safe harbor of Bankruptcy Code section 546(e), which excludes certain financial transactions from the debtor’s avoidance powers. In PEM Entities LLC v. Levin, the Court will also determine whether federal or state law should apply when analyzing whether debt should be recharacterized as equity. Both cases could alter how financial transactions are structured and documented.

Merit Management Group, LP v. FTI Consulting, Inc., Case No. 16-784

In FTI Consulting, the Supreme Court will rule on the scope of the safe harbor provision in section 546(e) of the Bankruptcy Code. The Bankruptcy Code allows a debtor to clawback certain transactions, but the safe harbor provision provides that a 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 . . . .”  The safe harbor is intended to prevent distressed companies from disrupting the securities markets with an unfettered ability to avoid transactions.

The Supreme Court is reviewing a Seventh Circuit decision holding that a transaction involving third-party funding that passes through a financial institution is not protected from avoidance under the section 546(e) safe harbor. The Seventh Circuit, following the Eleventh Circuit’s ruling in Munford v. Valuation Research Corp., held that when a financial institution merely acts as a conduit for an otherwise private transaction, the safe harbor provision is not implicated and the transaction can be avoided. The Seventh and Eleventh Circuits reasoned that the purpose of the safe harbor provision is not thwarted in these transactions, since avoiding them wouldn’t threaten to disrupt the securities market.

The holdings of the Seventh and Eleventh circuit are at odds with several other circuit decisions construing the section 546(e) safe harbor provision broadly. The Second, Third, Sixth, Eighth, and Tenth Circuits consider the safe harbor provision triggered whenever an intermediary financial institution touches the debtor’s securities-related transactions listed in the statute. This interpretation assumes more finality for securities-related transactions and decreases a debtor’s ability to clawback any securities transactions that pass through outside financial institutions—even if those institutions are merely used as a conduit in a private securities transaction.

Ultimately, if the Supreme Court reverses the Seventh Circuit in FTI Consulting, the safe harbor provision will be cemented as a formidable obstacle for any debtor or successor seeking to avoid a securities-related transaction. If the Seventh Circuit decision is upheld, parties will have to consider how to better document private transactions in order to take advantage of the 546(e) safe harbor.

PEM Entities LLC v. Levin, et. al., Case No. 16-492

The recharacterization of debt in a bankruptcy proceeding can determine whether a claim is repaid or completely wiped out. Typically secured creditors are prioritized for repayment, while equity interests are the least likely to recoup their investment. When bankruptcy courts are faced with deciding whether to recharacterize debt as equity, most circuits follow the federal rule of decision and apply a multi-factor test. By contrast, the Fifth and Ninth Circuits apply state law to determine how to recharacterize debt. The fate of recharacterization can depend on what law the court applies – with recharacterization being more likely under federal law than state law.

In PEM Entities v. Levin, the bankruptcy court determined that, in aggregate, the price of the distressed loan, the lender’s insider status, the debtor’s creditworthiness at the time of the loan, the lender’s failure to enforce the original loan terms, and the fact that the insider made additional capital contributions to the debtor, weighed in favor of recharacterizing the debt as a capital contribution. Under North Carolina state law, however, the debt interest would not have been recharacterized because an insider loan creates a creditor obligation if the lender delivers a sum of money that the recipient agrees to return at a future time, regardless of whether repayment includes interest. A court applying North Carolina law to the facts of PEM Entities would likely have rejected recharacterization. On appeal, the Fourth Circuit affirmed the lower court’s application of federal case law and recharacterization.

The Supreme Court will determine whether federal or state law applies to a recharacterization analysis. If the Supreme Court requires bankruptcy courts to apply state law to determine the debt recharacterization analysis, reversing the Fourth Circuit’s decision in PEM Entities, then successfully recharacterizing debt to equity will become far more difficult. As a result, loans from insiders to distressed companies will likely be prioritized higher in the bankruptcy priority scheme than they otherwise would have in the majority of circuits applying federal case law.

Both of these cases could have a significant impact on how financial transactions will be structured going forward. Stay tuned.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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