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Written by: Austin Boyd
Member, American Journal of Trial Advocacy
When a debtor is in bankruptcy, a trustee or other representative is placed in charge of the debtor’s estate. One of the most fundamental purposes of the bankruptcy code is “equality of distribution among the debtor’s creditors by returning to the estate assets which were preferentially, fraudulently, or otherwise improperly transferred.” This purpose is achieved by allowing the trustee to avoid certain transfers. This means that if the debtor made certain transfers of assets before a bankruptcy action is commenced, the trustee can make the third-party to whom the debtor transferred the assets, return those assets to the bankruptcy estate in order to achieve equality among the distribution of assets to the debtor’s creditors. This is known as the avoidance powers.
However, there are some limitations to these avoidance powers. These limitations, known as exceptions, essentially prevent the trustee from avoiding the transfer – they act as a safe-harbor or defense to the trustee’s avoidance powers. For example, the trustee may try to use their avoidance power to force a creditor to give back money the debtor paid to that creditor prior to the bankruptcy. In response, the creditor could try to use an exception to the avoidance power so they would not have to give the money back.
One of the exceptions is § 546(e), known as the securities exception or the safe-harbor defense. The currently codified version of § 546(e) is given in full:
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made 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, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A)of this title.
Previous Case Holdings and Interpretations:
Prior to the Merit decision, the circuit courts were split five to one on the application of § 546(e). The following five circuit courts held that § 546(e) was applicable when the entity was an intermediary. In 1991, the Tenth Circuit held that payments made to shareholders for their stock in a buyout were exempt from the avoiding powers of a trustee under § 564(e). Relying on the Tenth Circuit’s reasoning, the Third Circuit followed suit eight years later, holding that a payment for a corporation’s shares during a buyout is a securities transaction, which is included in a “settlement payment” and thus falls under § 546(e) and cannot be avoided by the trustee. A decade later, in 2009, the Eighth Circuit joined the Tenth and Third Circuits’ line of thinking concluding that such payments were outside of the avoidance powers for privately held stock.
Interestingly, that same year the Sixth Circuit heard a case dealing with privately held stock and explained that “Congress intended to protect publicly traded securities from market volatility caused by bankruptcy by means of § 546(e)” and that “the value of the privately held securities at issue [in this case] is substantial and there is no reason to think that unwinding that settlement would have any less of an impact on financial markets than publicly traded securities.” Thus, the Sixth Circuit held that “§ 546(e) is not limited to publicly traded securities but also extends to transactions, such as the leveraged buyout at issue here, involving privately held securities.” Most recently, in 2013, the Second Circuit joined the majority view by holding “that a transfer may qualify for the section 546(e) safe harbor even if the financial intermediary is merely a conduit.” The court explained that “[a] clear safe harbor for transactions made through these financial intermediaries promotes stability in their respective markets . . . .”
Representing the minority view, the Eleventh Circuit held that “11 U.S.C. § 546(e) does not bar the trustee in bankruptcy from avoiding payments the debtor corporation made to its shareholders in a leveraged buy-out.” The court reasoned that § 546(e) could only apply if a covered entity made or received a transfer and not when the entity was an intermediary:
Although the payments were presumptively settlement payments, section 546(e) is not applicable unless the transfer (or settlement payment) was ‘made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency.’ 11 U.S.C. § 546(e). Here, the transfers/payments were made by Munford to shareholders. None of the entities listed in section 546(e)—i.e., a commodity broker, forward contract merchant, stockbroker, financial institution, or a securities clearing agency—made or received a transfer/payment. Thus, section 546(e) is not applicable. True, a section 546(e) financial institution was presumptively involved in this transaction. But the bank here was nothing more than an intermediary or conduit. Funds were deposited with the bank and when the bank received the shares from the selling shareholders, it sent funds to them in exchange. The bank never acquired a beneficial interest in either the funds or the shares.
Since 1996, no other circuit court has sided with the Eleventh Circuit.
The New Supreme Law of the Land:
On February 27, 2018, in Merit Mgmt. Grp., LP v. FTI Consulting, Inc., the United States Supreme Court clarified if and when the securities exception applies regarding transactions involving financial institutions. In Merit, two “racinos” (in this case horse racing), Valley View Downs, LP (“Valley View”) and Bedford Downs Management Corporation (“Bedford”) competed against each other for the last remaining harness-racing license to be issued by Pennsylvania. Both parties were denied the remaining license, so the two reached a deal – Valley View would acquire Bedford in a $55 million corporate buyout. As a result of this deal, Valley View obtained the harness-racing license from the Pennsylvania Harness-Racing Commission. Valley View financed the deal using Credit Suisse’s Cayman Island branch (“Lender”), which wired the money to the third-party escrow agent, Citizens Bank of Pennsylvania (“Escrow”). One of the shareholders of Bedford, Merit Management Group, LP (“Merit”), received $16.5 million for the sale of their share of stock to Valley View.
Unfortunately, Valley View was unable to secure a license for their slot machines in the timeframe allowed by the financing package, and, as a result, never got to open their racino, and ultimately filed for Chapter 11 bankruptcy. FTI Consulting, Inc. (“FTI”) was appointed trustee of the Chapter 11 reorganization plan. As trustee, FTI sought to avoid the $16.5 million transfer from Valley View to Merit for Merit’s share of the stock Valley View purchased. In its complaint, FTI argued “that the transfer was constructively fraudulent. . . because Valley View was insolvent when it purchased Bedford Downs and ‘significantly overpaid’ for the Bedford Downs stock.” In response, Merit argued that the § 546(e) securities safe-harbor defense applied and, therefore, they did not have to return the $16.5 million to Valley View.
The district court held that the securities exception applied because “the financial institutions transferred or received funds in connection with a ‘settlement payment’ or ‘securities contract.’” The Seventh Circuit reversed on the grounds that the securities exception did not apply when the financial institutions were “mere conduits.” The Supreme Court granted certiorari due to the split among the circuit courts regarding the application of § 546(e).
At issue in Merit was whether the § 546(e) security safe-harbor defense could be used only to the over-arching transfer that the trustee seeks to avoid (e.g. A à D), or if it could be applied to any component part of the transfer (e.g. A à B à C à D). In this instance, ‘A’ would be Valley View, ‘B’ would be the Lender, ‘C’ would be the Escrow, and ‘D’ would be Merit. Justice Sotomayer, speaking for a unanimous Court, concluded that the “only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid” (i.e. the over-arching transfer).
The Court relied on both plain-meaning and contextual interpretation in support of its decision. The Court reasoned that the opening clause “[n]otwithstanding sections . . .” indicated that the overall transaction the trustee sought to avoid was what “notwithstanding” was derogating from because the sections that followed “notwithstanding” were the overall avoidance powers that the trustee had at its disposal. Likewise, the Court added that the last clause “except under section 548(a)(1)(A) of this title” indicates that Congress “refer[ed] back to a specific type of transfer that falls within the [trustee’s] avoiding power[s],” which is the overall transfer and not any of its components. Furthermore, the statute explicitly states that “the trustee may not avoid . . . a transfer that is either a ‘settlement payment’ or made ‘in connection with a securities contract.’” The Court further reasoned that because the statute did not expressly use the words “involve,” “comprises,” or a similar word, Congress intended the securities safe-harbor defense to only apply to the overarching transfer. Thus, the securities exception only applies to the overarching transfer the trustee seeks to avoid.
Impacts on the Future of Bankruptcy Law
The resounding impression is that the future may not be what you think it is; but not so fast! It is important to read footnotes and oral argument transcripts! Donald L. Swanson, an attorney in Nebraska, provides some interesting insight and analysis of this case on his blog. The Merit decision seemingly resolves the circuit split regarding the applicability of the securities exception to the trustee avoidance powers. But interestingly, as Mr. Swanson posits, “[t]he opinion, at first read, appears to dramatically narrow the reach and effect of the § 546(e) safe harbor defense. But an issue identified in Footnote 2 of the opinion may change that to an expansive reach and effect.” Mr. Swanson also stated that the Court would likely have ruled in favor of Merit had Merit argued it was a customer and was, therefore, included in the definition of financial institution. In his blog post, Mr. Swanson summarized Justice Breyer’s position in oral argument:
[w]hat Justice Breyer is saying in oral argument is that Merit Management should have won—at every stage of the proceeding—if it had simply raised the “financial institution” definition as part of its § 546(e) defense. He’s irritated that Merit Management failed to do so. And he vents frustration in this rhetorical question during oral argument.
Mr. Swanson thus concluded:
The bankruptcy courts and appellate courts will now need to figure out exactly how the “financial institution” definition issue fits into the Merit Management result. And it looks like the inclusions of “customer” in the § 101(22) definition of “financial institution” will enable many avoidance action defendants to utilize the § 546(e) defense.
This recent decision may help creditors receive more money in bankruptcy because the estate will not have to pay the litigation expenses associated with disputes over this issue. While this is good news for creditors, the shareholders in these instances likely will be frustrated, to say the least. The majority of shareholders in cases similar to this will not see the fairness in having to give back the money that they were paid for their share of stock. But, therein lies the uniqueness of the Bankruptcy Code – some parties will have to sacrifice for the benefit of others, especially in Chapter 11 reorganization cases.
However, maybe these parties will not always have to sacrifice in these types of instances. As Mr. Swanson suggested and Justice Breyer hinted, maybe bankruptcy lawyers should argue their client is covered by the safe-harbor defense because they are a customer of the financial institution. If Merit’s lawyers would have argued this at the district level, would the case have risen to the Supreme Court? No one can be certain. The only thing that is certain is that almost all similarly situated parties likely will try to use this argument in the future as part of their § 546(e) safe-harbor defense. Only time will tell if more resolution is needed around § 546(e). For now, as Mr. Swanson explained: “the rationale [of Merit] is incomplete, until the full effect of the Footnote 2 issue is worked out.”
2 Bankruptcy Law Manual § 9:1 (5th ed. 2017).
2 Bankruptcy Law Manual § 9:10 (5th ed. 2017).
Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S.Ct. 883, 893 (2018).
Id. at 888.
11 U.S.C.A. § 546(e) (West 2006).
138 S.Ct. 883 (2018).
Merit Mgmt. Grp., 138 S.Ct. at 892.
Id. at 897 n.6.
In re Kaiser Steel Corp., 952 F. 2d 1230, 1240 (10th Cir. 1991).
In re Resorts Int’l, Inc. 181 F. 3d 505, 515-16 (3rd Cir. 1999).
Contemporary Indus. Corp. v. Frost, 564 F. 3d 981, 986 (8th Cir. 2009) (“[P]ayments made to selling shareholders in the course of a leveraged buyout qualify as settlement payments within the plain meaning of § 546(e)”).
In re QSI Holdings, Inc., 571 F. 3d 545, 550 (6th Cir. 2009).
Id. at 547.
In re Quebecor World (USA) Inc., 719 F. 3d 94, 99 (2d Cir. 2013).
Id. at 100.
In re Munford, Inc. 98 F. 3d 604, 606 (11th Cir. 1996).
Id. at 610.
138 S. Ct. 883 (2018).
Merit Mgmt. Grp., 138 S.Ct. at 895.
Id. at 890 (defined as “a racing facility with slot machines”).
Id. at 890.
Id. at 891.
Merit Mgmt. Grp., 138 S.Ct. at 891.
Id. at 891-92.
Merit Mgmt. Grp., 138 S.Ct. at 892.
Id. at 888.
Id. at 892-93.
Merit Mgmt. Grp., 138 S.Ct. at 893.
Id. at 894.
Donald L. Swanson, Supreme Court’s Bankruptcy Opinion on § 546(e): Merit Management v. FTI Consulting, and an Important Footnote 2, Mediatbankry.com, https://mediatbankry.com/2018/03/01/supreme-court-bankruptcy-opinion-on-§-546e-merit-management-v-fti-consulting-and-an-important-footnote-2/ (last visited Mar. 19, 2018).