On February 27, 2018, the United Supreme Court issued its decision in Merit Management Group, LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), which significantly curtailed the ability of a defendant in an action commenced by a bankruptcy trustee under Chapter 5 of the Bankruptcy Code to utilize the “safe harbor” provision for transfers made for the benefit of financial institutions under Section 546(e).[1]
It is undisputed that the Bankruptcy Code provides a trustee with authority to avoid and recover for the benefit of a bankruptcy estate fraudulent transfers to third-parties.[2] The Bankruptcy Code, however, also imposes limitations on these avoidance powers. One such limitation appears in Section 546(e), which prohibits a trustee from avoiding certain transfers made for the benefit of a financial institution:
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.
11 U.S.C. § 546(e).
Section 546(e) was originally intended to protect the integrity of the market and to reduce the systemic risk to the markets that could result from undoing historic transactions upon which counter-parties had relied. A split of authority developed among the circuit court of appeals regarding whether Section 546(e) barred lawsuits by bankruptcy trustees if a financial institution or bank was involved in the transaction as a mere conduit. The Supreme Court resolved this split of authority in Merit.
The facts of Merit involved two companies, Valley View (the “Debtor”) and Bedford Downs (“Bedford”), competing to obtain a license from the State of Pennsylvania to operate a race track. When the Debtor and Bedford both faced difficulty in obtaining such a license, they entered into an agreement whereby Bedford would no longer compete with the Debtor to obtain a race track license. In exchange, the Debtor would purchase all of Bedford’s stock for $55 million after it obtained the license. After this agreement was finalized, the State of Pennsylvania awarded the Debtor a license to operate a race track. The Debtor then proceeded to consummate the transaction to purchase Bedford’s stock by arranging for Credit Suisse to finance the $55 million purchase price. Credit Suisse wired the $55 million to Citizens Bank of Pennsylvania, which would act as the third-party escrow agent for the transaction. The $55 million purchase price was eventually distributed to Bedford’s shareholders after the expiration of a multiyear indemnification holdback period. Merit Management Group, LP (“Merit”), one of Bedford’s shareholders, received approximately 16.5 million from the transaction.
The Debtor was unable to obtain a separate gaming license for the operation of slot machines and eventually filed a voluntary bankruptcy petition under Chapter 11. The Debtor confirmed a Chapter 11 Plan of Reorganization, which created a litigation trust to evaluate any avoidance actions that could be commenced for the benefit of creditors. The trustee of the litigation trust (the “Trustee”) filed a complaint against Merit seeking to avoid the $16.5 million transfer from the Debtor as a constructively fraudulent transfer under Section 548(a)(1)(B). Merit filed a motion for judgment on the pleadings under FRCP 12(c), arguing that the safe harbor provision under Section 546(e) prohibited the Trustee from avoiding the transfer as it was a settlement payment made for the benefit of a financial institution as a result of the involvement of Credit Suisse and Citizens Bank of Pennsylvania. In essence, Merit was presenting the argument that had been accepted by some circuit courts of appeal that the presence of a financial institution in a transaction, even if that financial institution was a mere conduit, implicated the protections of Section 546(e).
The United States District Court for the Northern District of Illinois granted the motion for judgment on the pleadings and the Court of Appeals for the Seventh Circuit reversed, holding that the safe harbor provision under Section 546(e) did not protect transfers in which financial institutions served as mere conduits.
The dispute was then appealed to the Supreme Court, which affirmed the decision of the Seventh Circuit. The Supreme Court held that the only transfer that is relevant for the purpose of applying the safe harbor is the transfer that the Trustee is seeking to avoid. Since the overarching transfer at issue in Merit was the Debtor’s purchase of Bedford’s stock and, therefore, a transfer from the Debtor to the shareholders of Bedford, the protections of Section 546(e) were not implicated. Id. at 897.
The implication of the Supreme Court’s decision in Merit is to limit the application of Section 546(e) to only those lawsuits where a bankruptcy trustee is seeking to recover a transfer from a financial institution or other covered entity in Section 546(e). Defendants in litigation commenced by bankruptcy trustees can no longer raise the protections of Section 546(e) simply because a financial institution may have acted as a conduit or intermediary in the transaction.
The full text of the Supreme Court’s decision in Merit can be accessed here.
[1] Unless otherwise indicated, all chapter and section references are to the Bankruptcy Code, 11 U.S.C. §§ 101-1532, and to the Federal Rules of Bankruptcy Procedure, Rules 1001-9037. The Federal Rules of Civil Procedure will be referred to as “FRCP” and the Federal Rules of Bankruptcy Procedure will be referred to as “FRBP.” The Local Rules of Practice for the United States Bankruptcy Court for the District of Nevada shall be referred to as the “Local Rules”.
[2] Section 548 permits a trustee to avoid any transfer “of an interest of [a] debtor” that was made two-years before the petition date if the debtor made such transfer with the intent to hinder, delay, or defraud creditors, or if the debtor received less than equivalent value for such transfer. 11 U.S.C. § 548(a). Section 544(b) further provides a trustee with the ability to avoid any transfer of an “interest of the debtor that is voidable under applicable law by a creditor holding an unsecured claim”. 11 U.S.C. § 544(b). In other words, Section 544(b) provides a trustee with derivative standing to avoid any transfer of property that could have been avoided by an unsecured creditor under state law. Finally, Section 550 identifies the parties from whom the trustee may recover either the transferred property or the value of that property to return to the bankruptcy estate. 11 U.S.C. § 550.