LIMITING THE SAFE HARBOR UNDER § 546(E), OR TRUSTEES MAY BE OFF TO THE RACINO
6/1/2018
First published in the Oregon State Bar Debtor-Creditor Newsletter Vol. XXXVII, No. 2By Susan Alterman, Kell, Alterman & Runstein, LLC; Margot Seitz, Farleigh Wada Witt
In a unanimous opinion, the United States Supreme Court finally clarified the limits of certain avoidance powers of bankruptcy trustees in transactions involving financial intermediaries in Merit Mgt. Group, LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018). At issue was whether a settlement payment made to a financial institution acting as an intermediary is within the scope of 11 U.S.C. § 546(e), which creates a safe harbor for (and protects from clawback) payments made “by” or “to” certain types of entities, including financial institutions.
Section 546 gives bankruptcy courts the power to avoid certain types of payments made by the debtor before filing. Section 546(e) is an exception to that general rule. It generally protects from avoidance “settlement payments” and other transfers made in connection with a securities contract, if the payment is “made by or to (or for the benefit of)” a financial institution (or certain other entities). Congress enacted this provision in 1982 at the behest of the SEC to protect the securities settlement and clearing process from attack. Since then, Congress has expanded this safe harbor several times to more broadly protect financial institutions, commodity brokers, forward contract merchants, stockbrokers, financial participants, and securities clearing agencies.
The federal circuits have applied the exception two ways. The Second, Third, Sixth, Eighth and Tenth Circuits have held that any transaction involving a financial institution intermediary is protected, even when the institution is simply a conduit and does not directly benefit from the transfer. Other courts, including the Seventh and Eleventh Circuits, have held that for the safe harbor to apply, the financial institution must be an actual party to the transaction, not merely an intermediary.
The Merit case presented the issue squarely. In 2007, the debtor borrowed funds from Credit Suisse to buy the outstanding stock of Bedford Downs, a combination racecourse and casino – cleverly dubbed a “racino.” The funds moved from the lender, Credit Suisse, to escrow agent Citizens Bank of Pennsylvania. The escrow agent collected the signed stock certificates and disbursed the proceeds, including $16.5 million, to Bedford’s largest shareholder, Merit Management Group (“Merit”).
Fascinating in theory, the racino proved less lucrative in execution. Shortly after buying the stock, the debtor filed its Chapter 11 petition. FTI Consulting was appointed as Trustee of a litigation trust under the debtor’s confirmed plan. The Trustee sought to recover the $16.5 million the debtor had paid to Merit. The Trustee alleged the transfer was constructively fraudulent under § 548(a)(1)(B) because the debtor was insolvent when it purchased the stock and argued that the debtor had received less than reasonably equivalent value when it paid for the seemingly worthless enterprise.
In response, Merit argued that the transfer was protected from clawback by § 546(e) because it was made using Credit Suisse and Citizens Bank as financial institution intermediaries. Merit argued that the exemption applied because the transfer was a “settlement payment … made by or to (or for the benefit of)” financial institutions – Credit Suisse and Citizens Bank. Merit alleged that the safe harbor was not meant to apply only in cases where a financial institution directly benefits from the transfer but should cover any transaction where a financial institution acts as a lender or escrow agent. The District Court agreed, holding that the transaction was indeed exempt from avoidance. The Seventh Circuit reversed, holding that the relevant transfer was not the intermediate transfers involving Credit Suisse and Citizen’s bank. Instead, the Circuit Court found that the relevant consideration is the overall transaction in which the debtor agreed to make the payment. The court concluded that the safe harbor provision cannot be used to protect transfers made through a bank where the bank was not a direct party to the underlying transaction.
Merit petitioned for certiorari asking the US Supreme Court to resolve the conflict among the circuits as to the proper application of the § 546(e) safe harbor. The Court clarified the law on February 27, 2018, in an opinion by Justice Sotomayor. The Court concluded that the Trustee can avoid a transfer if the funds to be clawed back moved through a financial institution that acted only as a conduit in the transaction. The Court’s starting point was formulating the test to be applied: “[b]efore a court can determine whether a transfer was made by or for the benefit of a covered entity, the court must first identify the relevant transfer to test that inquiry.” Id. at 886.
Merit countered that the Supreme Court should look at all component parts of the transaction, not just the ultimate end-to-end transfer. Merit urged the court to find that because those component parts included transactions to and from financial institutions, § 546(e) prohibits the Trustee from avoiding the transfer. In contrast, the Trustee argued that the only relevant transfer is the actual transfer the Trustee sought to avoid — the transfer of the $16.5 million from the debtor to Merit. Because neither the debtor nor Merit were financial institutions, the Trustee argued that the safe harbor did not apply. The Supreme Court agreed with the Trustee.
In ruling that the safe harbor did not apply and the transfer was avoidable, the court held that “the language of § 546(e), the specific context in which that language is used, and the broader statutory structure all support the conclusion that the relevant transfer for purposes of the § 546(e) safe-harbor inquiry is the overarching transfer that the Trustee seeks to avoid.…” Id. at 886. The Court’s decision was straightforward — using a financial institution to finalize transfers of stock and funds is not sufficient to exempt the underlying transaction from the traditional application of the Trustee’s avoidance powers under § 546(e).
The long-term effect of the decision is unclear. We will likely see additional rounds of litigation over the definition of “financial institution.” The Supreme Court pointed out in a footnote that the definition in 11 USC § 101(22) includes “customers” of a bank when the bank is acting as an “agent” or “custodian” for that customer. That may provide a toehold for transferees to try once again to broaden the scope of protected transferees under § 546(e). We may also see trustees having somewhat increased control in avoidance litigation since they can now define the “relevant transfer,” impacting the scope of the safe harbor. Lastly, commentators Alex Wolf and Ronald Mann have suggested that the ultimate effect of the decision will be both the increased ease of challenging overpriced leveraged-buyout transactions that end with the acquirer in bankruptcy and the “ripple effect” affecting market participants. As Mann notes, in the end, the people most likely to benefit from the decision may be litigators, who will continue to challenge (and defend) financial intermediary transactions.
11 U.S. Code § 546 – Limitations on avoiding powers
- US Code
- Notes
- Authorities (CFR)
(1)the later of—
(A)
2 years after the entry of the order for relief; or
(B)
1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202, or 1302 of this title if such appointment or such election occurs before the expiration of the period specified in subparagraph (A); or
(2)
the time the case is closed or dismissed.
(b)
(1)The rights and powers of a trustee under sections 544, 545, and 549 of this title are subject to any generally applicable law that—
(A)
permits perfection of an interest in property to be effective against an entity that acquires rights in such property before the date of perfection; or
(B)
provides for the maintenance or continuation of perfection of an interest in property to be effective against an entity that acquires rights in such property before the date on which action is taken to effect such maintenance or continuation.
(2)If—
(A)
a law described in paragraph (1) requires seizure of such property or commencement of an action to accomplish such perfection, or maintenance or continuation of perfection of an interest in property; and
(B)
such property has not been seized or such an action has not been commenced before the date of the filing of the petition;
such interest in such property shall be perfected, or perfection of such interest shall be maintained or continued, by giving notice within the time fixed by such law for such seizure or such commencement.
(c)
(1)Except as provided in subsection (d) of this section and in section 507(c), and subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof, the rights and powers of the trustee under sections 544(a), 545, 547, and 549 are subject to the right of a seller of goods that has sold goods to the debtor, in the ordinary course of such seller’s business, to reclaim such goods if the debtor has received such goods while insolvent, within 45 days before the date of the commencement of a case under this title, but such seller may not reclaim such goods unless such seller demands in writing reclamation of such goods—
(A)
not later than 45 days after the date of receipt of such goods by the debtor; or
(B)
not later than 20 days after the date of commencement of the case, if the 45-day period expires after the commencement of the case.
(2)
If a seller of goods fails to provide notice in the manner described in paragraph (1), the seller still may assert the rights contained in section 503(b)(9).
(d)In the case of a seller who is a producer of grain sold to a grain storage facility, owned or operated by the debtor, in the ordinary course of such seller’s business (as such terms are defined in section 557 of this title) or in the case of a United States fisherman who has caught fish sold to a fish processing facility owned or operated by the debtor in the ordinary course of such fisherman’s business, the rights and powers of the trustee under sections 544(a), 545, 547, and 549 of this title are subject to any statutory or common law right of such producer or fisherman to reclaim such grain or fish if the debtor has received such grain or fish while insolvent, but—
(1)
such producer or fisherman may not reclaim any grain or fish unless such producer or fisherman demands, in writing, reclamation of such grain or fish before ten days after receipt thereof by the debtor; and
(2)
the court may deny reclamation to such a producer or fisherman with a right of reclamation that has made such a demand only if the court secures such claim by a lien.
(e)
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.
(f)
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer made by or to (or for the benefit of) a repo participant
or financial participant, in connection with a repurchase agreement and that is made before the commencement of the case, except under section 548(a)(1)(A) of this title.
(g)
Notwithstanding sections 544, 545, 547, 548(a)(1) (B) and 548(b) of this title, the trustee may not avoid a transfer, made by or to (or for the benefit of) a swap participant or financial participant, under or in connection with any swap agreement and that is made before the commencement of the case, except under section 548(a)(1) (A) of this title.
(h)
Notwithstanding the rights and powers of a trustee under sections 544(a), 545, 547, 549, and 553, if the court determines on a motion by the trustee made not later than 120 days after the date of the order for relief in a case under chapter 11 of this title and after notice and a hearing, that a return is in the best interests of the estate, the debtor, with the consent of a creditor and subject to the prior rights of holders of security interests in such goods or the proceeds of such goods, may return goods shipped to the debtor by the creditor before the commencement of the case, and the creditor may offset the purchase price of such goods against any claim of the creditor against the debtor that arose before the commencement of the case.
(i)
(1)
Notwithstanding paragraphs (2) and (3) of section 545, the trustee may not avoid a warehouseman’s lien for storage, transportation, or other costs incidental to the storage and handling of goods.
(2)
The prohibition under paragraph (1) shall be applied in a manner consistent with any State statute applicable to such lien that is similar to section 7–209 of the Uniform Commercial Code, as in effect on the date of enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, or any successor to such section 7–209.
(j)
Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) the trustee may not avoid a transfer made by or to (or for the benefit of) a master netting agreement participant under or in connection with any master netting agreement or any individual contract covered thereby that is made before the commencement of the case, except under section 548(a)(1)(A) and except to the extent that the trustee could otherwise avoid such a transfer made under an individual contract covered by such master netting agreement.
(Pub. L. 95–598, Nov. 6, 1978, 92 Stat. 2597; Pub. L. 97–222, § 4, July 27, 1982, 96 Stat. 236; Pub. L. 98–353, title III, §§ 351, 393, 461, July 10, 1984, 98 Stat. 358, 365, 377; Pub. L. 99–554, title II, §§ 257(d), 283(l), Oct. 27, 1986, 100 Stat. 3114, 3117; Pub. L. 101–311, title I, § 103, title II, § 203, June 25, 1990, 104 Stat. 268, 269; Pub. L. 103–394, title II, §§ 204(b), 209, 216, 222(a), title V, § 501(b)(4), Oct. 22, 1994, 108 Stat. 4122, 4125, 4126, 4129, 4142; Pub. L. 105–183, § 3(c), June 19, 1998, 112 Stat. 518; Pub. L. 109–8, title IV, § 406, title IX, § 907(e), (o)(2), (3), title XII, § 1227(a), Apr. 20, 2005, 119 Stat. 105, 177, 182, 199; Pub. L. 109–390, § 5(b), Dec. 12, 2006, 120 Stat. 2697.)
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