Kramer Levin Naftalis & Frankel LLP

The Supreme Court has granted certiorari in Merit Management Group L.P. v. FTI Consulting Inc. to resolve a circuit split over the interpretation of Section 546(e) of the Bankruptcy Code, the “safe harbor” provision that shields specified types of payments “made by or to (or for the benefit of)” a financial institution from avoidance on fraudulent transfer grounds. Specifically, Bankruptcy Code Section 546(e) provides that a debtor or trustee cannot avoid settlement payments, payments made in connection with a securities contract, or other specified types of transfers if they are “made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency. ...” 11 U.S.C. Section 546(e) (emphasis added).

For decades, courts of appeal have been divided over whether this safe harbor applies when neither the debtor/transferor nor the actual transferee is a financial institution — that is, when the only financial institutions involved in the transaction are banks, brokers, or other institutions serving merely as intermediaries or conduits. Until recently, only one circuit court (the Eleventh Circuit, in a 1996 decision) had held that a financial institution must be more than an intermediary for the safe harbor to apply. Five circuit courts (the Second, Third, Sixth, Eighth and Tenth Circuits) have held to the contrary. In July 2016, the Seventh Circuit sided with the Eleventh Circuit. In May 2017, the Supreme Court granted cert. to resolve this dispute. 

The Case
Merit Management, the defendant in this case, was a 30% shareholder of Bedford Downs, a racetrack company. Bedford was competing with another racetrack owner, Valley View Downs, for the same racing license. Bedford and Valley View ultimately entered into a settlement agreement, under which Valley View acquired all of Bedford’s common stock for $55 million. Valley View made its payments to Bedford shareholders through Credit Suisse (Valley View’s lender), which distributed the funds to Citizens Bank of Pennsylvania (the escrow agent), which in turn distributed the payments to Bedford’s shareholders.

Valley View subsequently filed for bankruptcy and confirmed a Chapter 11 plan of reorganization. FTI Consulting, as trustee for the litigation trust created under Valley View’s plan, commenced an action against Merit, alleging that the Bedford/Valley View transaction was made for less than reasonably equivalent value and seeking to avoid the payment made to Merit. Merit responded that, because that payment was made through financial institutions (Credit Suisse and Citizens Bank), the transaction could not be avoided under the safe harbor provision.
Both the bankruptcy court and the district court sided with Merit, holding that it was shielded from liability under Section 546(e)’s safe harbor provision. The lower courts relied on the decisions of the five circuit courts that have held that a transfer can qualify under this safe harbor even if the financial institution serves merely as a conduit or intermediary and has no beneficial interest in the transfer. 
The Seventh Circuit Decision
In a unanimous decision authored by Chief Judge Diane Wood and joined by Judges Posner and Rovner, the Seventh Circuit reversed, rejecting the conduit theory. FTI Consulting Inc. v. Merit Management Group L.P., 830 F.3d 690 (2016). In so doing, the Seventh Circuit adopted and expanded upon the analysis set forth in the Eleventh Circuit’s 1996 decision, Munford v. Valuation Research Corp., 98 F.3d 604 (11th Cir. 1996), which had rejected the safe harbor defense on the ground that the bank involved in the transaction never acquired a beneficial interest in the funds.
Chief Judge Wood’s opinion began by addressing the text of Section 546(e). In contrast to a number of circuit courts that have read the statute’s “plain meaning” to mandate application of the safe harbor if a bank is involved as an intermediary, the Seventh Circuit found the phrase “made by or to (or for the benefit of)” to be ambiguous.

To resolve this ambiguity, the Seventh Circuit considered the statutory context and history of Section 546(e), as well as congressional intent. The court found that each of these considerations supported the conclusion that the financial institution involved in the transaction must be more than a conduit to trigger the safe harbor. For example:  

  • Sections 544, 547 and 548 of the Bankruptcy Code empower the trustee/debtor to avoid transfers “made by” the debtor “to or for the benefit of” a creditor/transferee. If the safe harbor provision is read in parallel fashion, it insulates only transactions “made by” a debtor that is a financial institution or other protected entity, as well as transactions “to” a creditor/transferee that is a financial institution or other protected entity.
  • Similarly, Section 546’s safe harbor should be read in context with other provisions that protect financial institutions and similar entities. Section 548(d)(2) provides that financial institutions that receive a margin or settlement payment are deemed to take for value, giving them an additional defense to fraudulent conveyance actions. This defense is available only to defendants who are financial institutions, not to defendants who deposited funds into a bank.
  • Other safe harbor provisions are similar in this regard. For example, Section 548(a)(2) provides a safe harbor for charitable contributions “made by a natural person” “to a qualified religious or charitable entity or organization.” The “by” refers to debtors who are natural persons, and the “to” refers to defendants that are charitable organizations, not conduits.
  • It is widely recognized that a bank that is only an intermediary, not a beneficial transferee, is not a “transferee” for purposes of the Bankruptcy Code’s fraudulent transfer and preference provisions, and therefore is not subject to liability. The safe harbor provision should similarly be read to cover only banks that are actual transferees, not mere conduits.
  • Congress enacted Section 546(e)’s predecessor in response to a specific case, in which the trustee of a commodity broker’s bankruptcy estate sued a clearing association to recover payments the broker had made to the association in connection with cottonseed oil futures, which declined in value drastically. Congress responded, in 1982, by creating the safe harbor to protect financial institutions that were the recipients of transfers of this kind. Nothing in the legislative history indicated that the safe harbor was meant to protect financial institutions acting as intermediaries. 

The Seventh Circuit acknowledged that five other courts of appeal had reached a contrary conclusion, but decided nevertheless that the minority view, adopted by the Eleventh Circuit in Munford, was correct. The Seventh Circuit considered but rejected Merit’s argument that Congress had disapproved of Munford and had overruled it in 2006 by adding the “for the benefit of” language to Section 546(e). The court observed that if Congress had wanted to provide that a financial institution acting as a conduit was entitled to a safe harbor, it could have said so explicitly.

Some Observations
The Supreme Court will consider this case in the next term. If the Supreme Court affirms the Seventh Circuit, its ruling will eliminate a defense that, for the past several decades, has protected transferees — particularly shareholders — from liability in a large number of fraudulent transfer cases, including suits seeking to recover transfers made in connection with LBOs and leveraged recapitalizations. Debtors whose bankruptcies were precipitated by transactions of this sort would potentially have an enhanced ability to recover value for the benefit of creditors. 

It is striking that the Seventh Circuit panel that unanimously decided Merit included not only Chief Judge Diane Wood, a prominent liberal jurist, but also Judge Richard Posner, a leading advocate of the free-market-oriented “law and economics” school. Their opinion provides a comprehensive and persuasive rebuttal of the analysis adopted by five other courts of appeal, which to many observers had become accepted wisdom. The continued viability of that accepted wisdom is now in doubt.

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