Supreme Court Unanimously Clarifies Avoidance Action Exposure

Background
The Bankruptcy Code provides broad powers to the bankruptcy estate to avoid and recover prepetition transfers of the debtor’s property that are preferential or are actually or constructively fraudulent. However, section 546(e) provides that the bankruptcy estate may not employ these broad powers to avoid any “settlement payment” or a transfer “in connection with a securities contract” if such payment or transfer is “made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency” unless such payment or transfer is actually fraudulent under section 548(a)(1)(A). These categories of protected counterparties are terms that are defined in section 101, and the terms “settlement payment” and “securities contract” are defined in section 741 (in particular, any contract for the purchase or sale of a security is within the definition of a “securities contract”).

Avoidance actions sometimes are the only source of recovery for unsecured creditors and therefore are a consideration in allocating value among competing creditor classes. Because many settlement payments or payments in connection with a securities contract are effected through an intermediary that is a protected entity under section 546(e), the applicability of this safe harbor is a significant issue in many restructuring contexts. In particular, courts had reached different conclusions on whether a transfer is protected merely by being routed through an entity that is protected under section 546(e) but serves only as an intermediary or conduit for that transfer. The Second, Third, Sixth, Eighth and Tenth Circuits had held that such transfers are protected by the safe harbor, while the Seventh and Eleventh Circuits had held to the contrary.

Some decisions have expanded the effect of section 546(e) even further by relying on its broad language and purpose to preempt other claims that are not explicitly encompassed by the statutory text. While courts have reached varying conclusions on the scope of section 546(e) and on whether its language or key terms are ambiguous, it is broadly acknowledged that this safe harbor, which was first enacted in 1982 in response to a decision exposing a clearing association to potential avoidance liability and subsequently amended in 1984, 2005 and 2006 to encompass additional categories of entities and transactions, was intended by Congress to minimize systemic disruption to commodities and securities markets in the event of a major bankruptcy of a participant in those markets.

Discussion
The Merit Management decision resulted from an appeal from the Seventh Circuit’s decision in August 2016 holding that the section 546(e) safe harbor does not protect transfers merely by being effectuated through a financial intermediary. The underlying facts were that Valley View Downs, a racetrack owner, had acquired all shares of a competitor, Bedford Downs, in exchange for $55 million. Valley View Downs arranged to borrow the funds needed for the acquisition, and the funds were wired from Credit Suisse to Citizens Bank, as escrow agent for the Bedford Downs shareholders. Valley View Downs filed for bankruptcy shortly afterwards. Subsequently, FTI Consulting, as trustee of a litigation trust with the Valley View Downs estate claims, commenced an action against Merit Management Group (“Merit”), a 30 percent shareholder in Bedford Downs, seeking to avoid and recover the $16.5 mm consideration paid to Merit as a constructively fraudulent transfer. It was undisputed that the transfer at issue was either a “settlement payment” or a payment made “in connection with a securities contract,” that neither Valley View Downs nor Merit was a financial institution or other protected entity under section 546(e), and that the transfers had passed through Credit Suisse and Citizens Bank, each of which was a financial institution protected under section 546(e). On appeal after the district court had entered judgment on the pleadings in favor of Merit, the Seventh Circuit disagreed with the majority view and joined the Eleventh Circuit in holding that a transfer of funds is not “made by or to (or for the benefit of)” a financial institution for purposes of section 546(e) merely because the funds pass through a financial institution acting as a conduit.

In a 9-0 decision, the Supreme Court affirmed the Seventh Circuit’s judgment and held that the relevant transfer for determining the applicability of the section 546(e) safe harbor is the transfer to be avoided by the bankruptcy trustee, rather than any “component parts” of that transfer. The Supreme Court did not find section 546(e) to be ambiguous and reached its decision based on “the language of §546(e), the specific context in which that language is used, and the broader statutory structure” of the avoidance powers and safe harbor. Notably, the Supreme Court pointed out in a footnote that a financial institution is defined to include, among other things, “. . . when any such Federal reserve bank, receiver, liquidating agent, conservator or [commercial or savings bank, industrial savings bank, savings and loan association, trust company, or federally-insured credit union] is acting as agent or custodian for a customer . . . such customer,” but that neither party contended that Merit was a “financial institution” under such definition. The Supreme Court rejected Merit’s policy-based argument for broad applicability of section 546(e), that the safe harbor was intended to encompass all transactions made through a protected entity in order to promote finality in the securities markets, as being inconsistent with the statutory text.

Implications
Merit Management eliminates a significant limitation on potential avoidance action exposure. However, many potential defendants—and some of the deepest pockets—may fall within one of the categories of protected entities under section 546(e), namely, commodity brokers, forward contract merchants, stockbrokers, financial institutions, financial participants, or securities clearing agencies. In particular, some potential defendants may qualify as financial participants, which may be satisfied by, among other things, having gross mark-to-market positions of at least $100 million in securities contracts with the debtor or other non-affiliated entities at any time in the 15 months prior to the petition date. All market participants should review their qualifications (or those of their investment vehicles) for such protected status, and should consider the “customer as financial institution” argument explicitly not addressed by the Supreme Court. The exposure is likely greatest for smaller investment vehicles or stockholders receiving distributions or being bought out in a leveraged buyout scenario. This risk may prompt such investors to trade out of positions shortly before a transaction that may expose the holder to avoidance action risk even if such trade is effectuated at some discount to the consideration being offered for such transaction. Overall, the decision is likely to lead to additional litigation as these issues are developed and may provide additional opportunities in the distressed space.