Resolving Circuit Split, US Supreme Court Holds Section 546(e) Safe Harbor Applies Only to Protected Parties

by Dechert LLP

Dechert LLP

The Bankruptcy Code allows trustees, as well as debtors-in-possession and in some circumstances creditors’ committees, to set aside and recover certain transfers for the benefit of the bankruptcy estate. The purpose of the avoidance powers is to maximize funds available for creditors and to ensure equality of distribution among creditors’ claims. The avoidance powers are not without bounds, however, as the Code sets forth a number of exceptions — most notably, the so-called “securities contract safe harbor” under Section 546(e) of the Bankruptcy Code. 

This week, the U.S. Supreme Court released its opinion in Merit Management Group, LP v. FTI Consulting, Inc., 583 U.S. __ (2018), unanimously affirming the judgment of the Seventh Circuit with respect to the proper scope of the securities safe harbor. As we previously covered in an article published in Law360, the Seventh Circuit held that transfers are not protected from avoidance under the § 546(e) safe harbor when a “financial institution” or other statutorily-protected entity merely acts as a conduit for the transfers and is not either the debtor or the real party in interest that ultimately received the payment from the financial institution conduit. In affirming the judgment, the Supreme Court concluded that when “determining whether the §546(e) safe harbor saves [a] transfer from avoidance liability, the Court must look to th[e] overarching transfer…[,]” rather than the transfer’s specific components, “to evaluate whether it meets the safe-harbor criteria….” To the extent the overarching transfer was not between (or for the benefit of) one or more statutorily-protected entities, but instead was made between two parties not otherwise shielded by the provisions of the statute, the safe harbor does not apply.

The Supreme Court’s decision revolves a long-standing circuit split on this issue, siding with what had been the minority view espoused by the Eleventh Circuit some 20 years ago in Munford v. Valuation Research Corp. and followed by the Seventh Circuit in Merit, and disagreeing with decisions by the Second, Third, Sixth, Eighth, and Tenth Circuits, which had represented every circuit-level decision between Munford and Merit.  As discussed below, Merit has important implications for various counterparties in securities transactions, most notably selling stockholders in leveraged buyout or “LBO” transactions, where years after the transaction closed and the transfers were made a trustee or other estate fiduciary in bankruptcy may claim that the transaction rendered the company insolvent and thus the transfer amounted to a constructively fraudulent transfer.  


Merit involved essentially a private securities sale transaction. Valley View Downs, the owner of a Pennsylvania horse racing venue, purchased 100% of the stock of another racetrack, Bedford Downs, in exchange for US$55 million cash. To finance the acquisition, Valley View borrowed US$55 million from a bank. A second bank, Citizens Bank of Pennsylvania, served as escrow agent, holding the purchase price before passing it along to the selling stockholders of Bedford Downs. 

The transaction allowed Valley View and Bedford to end their competition over securing a state-issued racing license. While Valley View was able to acquire a racing license, it was unable to secure a separate license to operate slot machines, which it needed to open its racing venue. Consequently, Valley View and its parent company, Centaur, LLC, filed for Chapter 11. 

The bankruptcy court confirmed a reorganization plan and appointed FTI Consulting to serve as trustee of the Centaur litigation trust. In its capacity as trustee, FTI then sued Merit Management Group, formerly a 30% stockholder of Bedford. FTI’s complaint sought the avoidance of Valley View’s payment of approximately US$16.5 million to Merit in exchange for the 30% stake in Bedford on the grounds that the payment was constructively fraudulent. 

Merit asserted a defense under the § 546(e) safe harbor. Section 546(e) of the Bankruptcy Code prohibits a trustee from avoiding transfers that are “margin payment[s]” or “settlement payment[s]” “made by or to (or for the benefit of)” certain entities defined in the statute—namely commodity brokers, forward contract merchants, stockbrokers, financial participants, securities clearing agencies, and “financial institutions.” It also protects transfers “made by or to (or for the benefit of)” these statutorily-protected entities “in connection with a securities contract.”

It was uncontested that Merit was not a statutorily-protected entity for purposes of the safe harbor. Nonetheless, Merit argued that the safe harbor applied because of the involvement of the banks, who the parties agreed were “financial institutions.” The district court held for Merit on the grounds that Valley View’s payment of cash for Merit’s stock in Bedford was “made by or to” a financial institution because the funds passed through the banks. In reversing the judgment of the district court, the Seventh Circuit held that the § 546(e) safe harbor does not protect transfers in which the statutorily-protected entities acted as “mere conduits.” The Supreme Court granted certiorari to resolve a split among the circuit courts regarding the proper application of the safe harbor. 


On appeal, Merit argued that “the Court should look not only to the Valley View-to-Merit end-to-end transfer, but also to all of its component parts.” Because it was undisputed that such components included transfers “by and to” financial institutions, Merit argued that § 546(e) barred avoidance. FTI, on the other hand, argued that the only relevant transfer was the overarching transfer between Valley View and Merit of US$16.5 million for Merit’s stock in Bedford Downs, which was the transfer FTI sought to avoid. 

The Supreme Court agreed with FTI. According to the Court, the focus must be on the transfer that the plaintiff, here FTI, seeks to avoid. FTI sought to avoid the transfer made to Merit, not a transfer made to the banks. Since it was undisputed that Merit was not a financial institution or another protected party specified in § 546(e), any protection available to the banks, is not available to Merit.

Merit’s arguments, based on the literal interpretation of § 546(e) were rejected by the Supreme Court for various reasons, but principally, since they could not overcome the ruling that the focus must be on the defendant-transferee rather than on any other participant in the chain. Nevertheless, the Court rejected even Merit’s contextual argument. 

The Court first noted that § 546(e) starts by providing that “[n]otwithstanding [the avoidance sections], the trustee may not avoid a transfer….” That language according to the Court indicates that the focus is on the transfer that would have been avoidable, absent the safe harbor. 

Second, the Court rejected Merit’s argument that the parenthetical “to (or for the benefit of)” in § 546(e) meant it was unnecessary for a financial institution or other statutorily-protected entity to have a beneficial interest in the transferred assets, and therefore a transaction “by or to” such an entity should qualify for the safe harbor. In support, Merit pointed to the fact that the protected entities include securities clearing agencies, and since clearing organizations always act as intermediaries in the settlement of securities transactions, the safe harbor must have intended to protect transfers made to intermediaries even when they act as mere conduits. The Court held, however, that under its interpretation of § 546, securities clearing agencies, as all other protected entities, will be covered by the safe harbor whether they acted as the real party in interest or as a mere intermediary; but their protection is nowhere extended to transferees that are not enumerated in the section. 


Merit is now the law of the land. As a consequence, parties other than those listed in § 546(e) will not receive the safe harbor’s protection where a financial institution merely served as an intermediary for the transaction. This is probably most significant for selling stockholders in the leveraged buyout context, where there is risk that years after the LBO closed, a trustee, debtor-in-possession, or perhaps a creditors’ committee will argue that the consideration provided to the selling stockholders and other parties involved in the LBO rendered the company insolvent and thus the buyout effectuated a constructively fraudulent transfer. By overturning long-standing precedents from the Second and Third Circuits, which oversee the two districts that handle the lion share of the biggest Chapter 11 cases—the Southern District of New York and the District of Delaware (as well as reversing decisions of the Sixth, Eighth, and Tenth Circuits), the Supreme Court’s Merit decision has the potential to dramatically shift parties’ assessments of the risks associated with such transactions. 

Significantly, the decision might impact ongoing fraudulent transfer litigation stemming from Tribune media’s massive 2007 leveraged buyout. There, the litigation trustee appointed as part of Tribune’s former bankruptcy proceedings has been attempting to “claw back” approximately US$8 billion in payments made to 5,500 former Tribune shareholders as part of the buyout. While the breadth of Merit’s impact on other cases is yet to be seen, one can expect that trustees and others wielding avoidance powers will undoubtedly be vigorous in bringing avoidance actions against transferees of the debtor’s assets, especially in large, failed LBOs. 

Is the Door Still Slightly Ajar?

Merit conceded that it was not a protected party, a concession that proved costly. As the Supreme Court noted in footnote 2 to the opinion, the term “financial institution” is defined to include the customer of the financial institution when the financial institution acts for the customer in the transaction. But Merit did not argue that either it, or the debtor qualified as financial institutions by virtue of the definition. The fate of such an argument, had it been made, is hard to judge. But since the term “customer” for the purposes of this definition is not defined, we predict that it will be the new frontier in the slew of section 546(e) fraudulent transfer litigation that is sure to come. 

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