In a decision significantly impacting the ability of a plaintiff to prosecute avoidance actions, the United States Supreme Court, in Merit Management Group, LP v. FTI Consulting, Inc., 583 U.S. ___ (2018), unanimously held that a transfer of funds, where a financial institution served as a mere conduit, does not entitle the recipient of the transfer to avail itself of the “safe harbor” defense provided for in section 546(e) of the Bankruptcy Code. Focusing on the construction and plain meaning of the statutory language, the Court’s ruling resolved the current split among circuits interpreting and applying § 546(e).
In Merit, Valley View Downs, LP and Bedford Downs Management Corporation wanted to open a combination horse track and casino, but only one horse harness-racing license was available in Pennsylvania. After determining that it would be in their best interests to combine efforts rather than compete against each other, Valley View acquired Bedford by purchasing all of its outstanding shares for US$55 million. Credit Suisse financed Valley View’s purchase and wired the funds to an escrow account with Citizens Bank of Pennsylvania. In turn, Bedford’s shareholders, including Merit Management Group, escrowed their stock certificates with Citizens Bank. As part of the closing, Valley View received the stock certificates and the shareholders received US$55 million from the escrow accounts.
Despite Valley View being awarded the harness-racing license, it was unable to secure the requisite gaming license to operate, and ultimately filed bankruptcy in Delaware. Following confirmation of Valley View’s reorganization plan, FTI Consulting, Inc. was appointed to serve as the trustee of the plan’s litigation trust. FTI sued Merit Management in the District Court for the Northern District of Illinois to unwind Valley Views’ “significantly over[priced]” purchase of stock certificates, alleging the transfer was constructively fraudulent under the Bankruptcy Code because Valley View did not receive reasonably equivalent value. The District Court held that § 546(e) safe harbor shielded the transfer to Merit Management from being avoided because Credit Suisse and Citizens Bank, as financial institutions, transferred or received funds in connection with the transaction. On appeal, the Seventh Circuit Court of Appeals disagreed and found that the transfer was not protected by the safe harbor because the financial institutions were merely conduits.
Writing for a unanimous court, Justice Sotomayor sided with the Seventh and Eleventh Circuits (and rejected the rulings of a majority of the circuits – the Second, Third, Sixth, Eighth, and Tenth Circuits) finding a transfer is not “by or to (or for the benefit of)” a financial institution if the financial institution served as a mere conduit for the transfer. In its opinion, the Court found that the plain language of § 546(e), the context in which the language was used, and the broader structure of the statute supported the interpretation that § 546(e) denies safe harbor where a financial institution serves as a mere conduit for payments made by a debtor to a defendant.
Guided by the relevant section heading (“Limitations on avoiding powers”) and the plain language of § 546(e) (which begins with the clause “Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title”), the Court determined that the safe harbor is a limitation on the trustee’s avoidance power and thus the starting point is to determine the avoidance power at issue and analyze the overarching transfer that the plaintiff is seeking to avoid. The Court was unpersuaded by Merit’s argument that the component parts of the transaction should be examined, instead siding with FTI that the only relevant transfer was the overarching transfer, which in this case was Valley View’s purchase of Bedford’s stock from Merit. As such, the Court found that Credit Suisse’s and Citizens Bank’s participation as conduits for the overall transfer was irrelevant to the analysis under § 546(e).
As part of its analysis, the Court also rejected Merit’s argument that the added parenthetical “(or for the benefit of)” to § 546(e) in 2006 was meant to abrogate the Eleventh Circuit’s ruling in In re Munford, Inc., 98 F. 3d 604 (11th Cir. 1996), which found § 546(e) was not applicable to transfers where the financial institution was only an intermediary. The Court found nothing in the text or legislative history to support this argument and determined that the language was added to make § 546(e) consistent with the avoidance powers of other substantive avoidance provisions (e.g., § 547(b)(1)). In fact, the Court found the added parenthetical reinforced the connection between § 546(e) and the applicable avoidance power, thus bolstering its analysis that the applicability of § 546(e) must be measured against the transfer that the plaintiff is seeking to avoid.
Finally, the Court addressed Merit’s contention that it was Congress’ intent to broadly protect the securities industry by providing a safe harbor for transactions “to” those entities covered by the safe harbor, but also “by” those entities, thereby protecting non-covered entities. The Supreme Court disagreed with this argument stating that “[t]ransfers ‘through’ a covered entity, conversely, appear nowhere in the statute.” Ultimately, the Supreme Court found the plain language of § 546(e) to be straightforward: § 546(e) does not protect transfers where financial institutions serve as mere conduits. As a result, because neither Valley View nor Merit was a financial institution, the transfers at issue were not covered by the safe harbor in § 546(e).
The Supreme Court’s limitation on the § 546(e) safe harbor is a significant setback to defendants in avoidance litigation, taking away what has become a commonly raised defense in complex avoidance litigation over leveraged buyouts and other pre-bankruptcy financial transactions, since most, if not all, similar transactions involve funds passing through financial institutions on their way to the ultimate transferee. As a result, we expect to see more trustees and committees (especially in the Second and Third Circuits) seeking to avoid those transfers given that a defendant can no longer argue that merely because the funds passed through a financial institution they are exempt from being avoided.