2019 guide to Foreign Private Issuer status
A company organized outside the US subject to provisions of the US federal securities laws receives benefits if it qualifies as an FPI.
The Supreme Court recently agreed to review a case with potentially dramatic repercussions for investors that receive money from entities that later file for bankruptcy relief. In Merit Management Group, LP v. FTI Consulting, Inc., Docket No. 16-784, the high court will interpret for the first time the scope of the financial institution safe harbor for avoidance actions, potentially reversing the plurality of circuit courts that have given that provision a broad interpretation to protect defendants. This article will briefly discuss the suits to which investors can be subject, before outlining the terms of the provision that protects them from those suits, describing the competing interpretations of that provision that the Supreme Court will be asked to choose between in its upcoming term, and highlighting some aspects of the case that will serve as the vehicle for the Court’s decision.
When an entity enters bankruptcy, a trustee is appointed (or the entity itself is tasked, as a debtor-in-possession) to gather all its assets and distribute those assets to the debtor’s creditors. To increase the assets available for distribution, the trustee may “avoid,” or unwind, certain payments the debtor made in specified periods before the bankruptcy began. Leaving aside cases of actual fraudulent intent (which are not covered in the first place by the safe harbors discussed below) a trustee can recover two kinds of payments: those made for “less than reasonably equivalent value” while the debtor was insolvent or financially impaired (“fraudulent transfers”), and those on antecedent debts made in amounts that exceed the recovery the creditor would have received if the debtor had been liquidated (“preferences”) and that were made during time periods specified in the statute and while the debtor was insolvent. In other words, the trustee can force certain payees of the debtor to give back the money they have already received.
Allegations of fraudulent transfers arise particularly often in the context of leveraged buyouts, where the shares formerly held by individual shareholders are purchased by the company using the proceeds of secured debt. The secured debt incurred to purchase the former shareholders’ shares often leaves the company highly leveraged and vulnerable to market forces, which frequently leads to bankruptcy. The trustee for such a corporation frequently attempts to recover the money that was paid to the old shareholders, on the theory that the shares the company purchased from them were “less than reasonably equivalent value” for the price paid. The litigation arising from such a suit can be complex and costly, particularly in a trial on the debtor’s financial condition at the time of the buyout.
Some defendants are protected from these suits by a provision of the Bankruptcy Code known as the “financial institutions safe harbor.” Under Section 546(e) of the bankruptcy code:
the trustee may not avoid a transfer that is a margin payment . . . or settlement payment . . . 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 . . . or forward contract, that is made before the commencement of the [bankruptcy] case.
Defendants in avoidance actions frequently attempt to save themselves from having to litigate on the merits by arguing that payments in connection with LBOs that are made by means of banks—which is the norm in such complex transactions—are exempt from avoidance because they are made “by or to . . . financial institutions.” The federal Circuit Courts of Appeals have adopted varied interpretations of this provision. Most circuits—including the Second and Third Circuits, where the majority of large corporate bankruptcy cases are filed—have held that a transfer is made “by or to” a financial institution even when the financial institution acquires no interest in the property transferred (as, for example, when money is given by a company to a bank in order for the money to be distributed to a disparate group of beneficial transferees). See In re Kaiser Steel Corp., 952 F.2d 1230, 1240 (10th Cir. 1991); In re Resorts Int’l, Inc., 181 F.3d 505, 516 (3d Cir. 1999); In re QSI Holdings, Inc., 571 F.3d 545, 551 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 987 (8th Cir. 2009); Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V., 651 F.3d 329, 338–39 (2d Cir. 2011). Before last year, only one Circuit Court had reached a different conclusion: the Eleventh Circuit, in Matter of Munford, Inc., held that a transfer is not “by or to” a financial institution if the transaction of which the transfer was a part was structured in such a way as to make the financial institution a “conduit” for the transfer, rather than a transferor or transferee. 98 F.3d 604, 610 (11th Cir. 1996).
The Munford interpretation, however, was recently revitalized when the Seventh Circuit—which had not previously been called upon to render an opinion on the subject—handed down its decision in FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, 830 F.3d 690 (7th Cir. 2016). Somewhat unusually for a case of this nature, Merit did not begin with a leveraged buyout, but with a decision grounded in the harsh realities of the gaming industry. In 2003, Valley View Downs, LP was in competition with another racetrack, Bedford Downs, for the only harness-racing license available in Pennsylvania. Both Valley View and Bedford wanted to open what was called a “racino,” or a combination horse track and casino, but with only one horse racing license available in the state it was clear that only one could be successful. The two competitors realized that it would be in both their interests to “combine and conquer,” as the Seventh Circuit put it, and Valley View purchased all outstanding shares of Bedford for $55 million. The transaction was structured so that Valley View paid Bedford for the stock, and Bedford distributed the funds to its then-existing shareholders through Credit Suisse and Citizens Bank of Pennsylvania.
Unfortunately for Valley View, however, its gamble did not pay off. While it succeeded at getting its hands on the one remaining harness-racing license, it failed to secure the gambling license it would have needed to permit betting to take place at the track. Without that second license, Valley View filed for Chapter 11 bankruptcy in the District of Delaware and FTI Consulting was appointed as trustee of its estate. In its capacity as trustee, FTI sued Merit Management Group, LP (“Merit”), an entity that had held 30.007 percent of the stock of Bedford before the Valley View buyout. FTI argued that transfer of approximately $16.5 million on account of its shares of Bedford was a fraudulent transfer in violation of the Bankruptcy Code, and could therefore be avoided for the benefit of the Valley View estate. Because the District of Delaware is in the Third Circuit, which had already ruled that transfers through banks are subject to the safe harbor, FTI opted not to file its lawsuit in the bankruptcy court where Valley View’s bankruptcy case was pending and instead filed a new suit in the United States District Court for the Northern District of Illinois (in the Seventh Circuit), hoping that the District Court would choose to adopt the minority position on the safe harbor.
The District Court found the reasoning of the majority of circuits persuasive, and held that the safe harbor encompasses transfers that pass through financial institutions. Noting that the Seventh Circuit had previously held that the safe harbor was intended to prevent a “domino effect” where one firm’s bankruptcy would trigger further bankruptcies, allowing “one large bankruptcy [to] rippl[e] through the securities industry,” the District Court held that “[t]he word ‘transfer’ in the context of [the safe harbor] appears to refer to the movement of assets” as opposed to the transfer of beneficial interests in those assets. The District Court held that Merit was entitled to the safe harbor so long as the assets it had received in the buyout passed through a bank on their way from Valley View to Merit. FTI appealed the decision in Merit’s favor to the Seventh Circuit.
Writing for a unanimous panel, Chief Judge Diane Wood reversed the District Court. The Seventh Circuit held that the District Court had taken an overly inclusive view of what Congress meant by the word “transfer” in section 546(e), and that a court faced with a safe harbor defense should properly look at the entire transaction to figure out who gave what to whom. When Valley View bought out Bedford, for instance, what happened was not a series of transfers—from Valley View to Bedford; from Bedford to a bank; from that bank to another bank; and from that final bank to Merit and the other old Bedford shareholders—but a single transfer from Valley View to the Bedford shareholders. While that transfer was made through financial institutions, at no point (in the Seventh Circuit’s view) was there a transfer by or to a financial institution. Accordingly, the Seventh Circuit reversed the District Court’s opinion dismissing the lawsuit and remanded the case to the District Court for adjudication on the merits.
Understandably displeased with this result, Merit sought discretionary review by filing a petition for certiorari with the U.S. Supreme Court. On May 1, 2017—approximately 14 years after the initial Valley View buyout—the Supreme Court granted Merit’s certiorari petition and agreed to hear the case as part of its 2017–18 term, which begins in October of this year.
Merit’s briefing largely relies on the arguments that have carried the day at the plurality of Circuit Courts to consider the issue, and especially on the somewhat intuitive argument that whenever assets pass through multiple parties’ hands, the move from each party to the next is a “transfer.” Merit relies in particular on the history of the safe harbor provision: for much of the history of the Bankruptcy Code, section 546(e) referred only to transfers “by or to” financial institutions. It was only in 2006 that Congress extended the safe harbor to transfers “for the benefit” of a financial institution. Merit argues that the plurality interpretation is needed to give separate meaning to the three phrases “by,” “to,” and “for the benefit of,” because the narrow interpretation requires that a transaction be for the benefit of a financial institution in order to treat it as being “to” that institution.
Merit also argues that the narrow interpretation fails to give effect to the inclusion of “securities clearing agencies” in the section 546(e) list of entities. Because a securities clearing agency only serves as an intermediary and does not send or receive securities-related transfers for its own benefit, Merit says that the narrow interpretation would read transfers “by or to (or for the benefit of) a . . . securities clearing agency” out of the safe harbor entirely.
Merit’s brief also claims that the Seventh and Eleventh Circuits fail to properly distinguish between avoidance and recovery of transfers. In addition to the avoidance provisions, which permit a trustee to avoid certain transfers and obligations of the debtor, the Bankruptcy Code contains a separate section (section 550) that describes the transferees from whom the trustee may seek recovery “to the extent that a transfer is avoided” under the Code’s avoidance provisions. That provision, which the Seventh Circuit relied on for evidence of the Code’s general policies, distinguishes between the “initial transferee” in an avoided transfer and “immediate or mediate transferee[s] of such initial transferee,” providing the two categories of defendants with different defenses to a trustee’s suit.
Merit’s briefing also appeals broadly to the policies of the Bankruptcy Code, arguing that “a broadly protective interpretation of the safe harbor is consistent with the context and purpose of the statute.” Merit also asserts that the Seventh Circuit erred by using Congress’s stated goal when the avoidance provisions were initially enacted to interpret provisions that have been amended since Congress stated that goal. The brief speaks extensively about the need for “bright-line limitations” to reflect the “legislative balancing of interests” between the need to recover assets for the benefit of creditors and the need to protect the financial markets from interference. On this last note, Merit expresses concern that the Seventh Circuit’s approach will require investors to keep reserves against liability after the sale of securities, rather than injecting liquidity back into the markets.
FTI’s brief in response relies on the arguments that carried the day in the Seventh Circuit. In particular, FTI appeals to the Justices’ common sense and leans heavily on the policy argument that the mode of transfer (whether through a bank or not) should not be permitted to determine whether a transfer is avoidable, and that the beneficial recipient should be a potential defendant regardless whether it receives a bank transfer or a briefcase full of unmarked bills. FTI argues that the “transfer” to which the safe harbor applies should be understood to refer the flow of assets from origin to destination, not to each movement of assets from one set of hands to the next. FTI’s argues that the “step” by which assets pass from a debtor to a financial institution is better characterized as a “transaction by which the challenged transfer [from the debtor to the recipient] is executed.”
In addition to raising the argument that the distinction imposed by the broad reading of the safe harbor does not make sense on a practical level, FTI’s brief traces the origin of the provision back to an attempt to abrogate a district court decision in which a trustee was permitted to go forward with litigation to avoid a transfer from a commodity broker to a clearinghouse. FTI argues that applying the safe harbor broadly would undercut congressional intent by making the statute go far beyond what it asserts were Congress’s narrow aims.
Merit’s arguments are likely to appeal to the textualists on the Court, especially Justices Kagan, Alito, Roberts and Thomas. Justices Sotomayor, Breyer, Ginsburg, and Kennedy may instead be swayed more by the policy arguments the parties put forward about the need to protect the integrity of the financial markets, but it is unclear which party’s policy arguments the Justices are likely to find more convincing. Justice Gorsuch, the most recent addition to the Court, does not have enough of an opinion-writing record on the Supreme Court to attempt to predict which sort of arguments are likely to sway him. In sum, the Supreme Court could easily come down either way on this case, and businesses should be prepared for the fallout either way.
If the Seventh and Eleventh Circuits’ narrow reading of the safe harbor is upheld, the result could be severe for the former shareholders of bought-out companies. Such shareholders—especially holders of small positions—are generally not involved participants in these transactions, instead relying on the companies’ leadership. Shareholders rarely get a say in the structure of these transactions, and there is little holders of equity can do to mitigate the risk of avoidance actions arising from buyouts. Nevertheless, shareholders in such situations should carefully weigh their risks when presented with the option to sell, and recently bought-out shareholders should be aware of the risk that the Supreme Court may deprive them of the benefit of the safe harbor if their former holdings go into bankruptcy.
If the plurality view is upheld, shareholders will remain exposed to the same extent they were before the Seventh Circuit weighed in. Even so, investors should take this opportunity to carefully scrutinize the transactions through which they are bought out in order to accurately assess whether those transactions will fall into the safe harbor and weigh their litigation risk accordingly.
A company organized outside the US subject to provisions of the US federal securities laws receives benefits if it qualifies as an FPI.
Sustainable finance is a key priority for the EU and is high on the regulatory agenda for asset managers and other financial institutions.