Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code.  The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer.[1] The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.

Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor.  The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers.  Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities.  It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”[2]

The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford  Downs, a racino industry competitor.  The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.

The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection:  a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit.[3]  On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers.[4]  The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor.[5]  Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.

Bankruptcy practitioners and scholars are watching this case with great interest.  The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose.[6]  Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents.  These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place.[7]  They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.[8]

The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems.  The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending.  The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners,[9] and the Tribune unsecured creditors submitted a brief in support of Respondent.[10]

Visit HHR’s Bankruptcy Report for future updates on this case.

*Jiun-Wen Bob Teoh assisted with the preparation of this post.

[1]       FTI Consulting Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

[2]       11 U.S.C. § 546(e).

[3]       Brief for Petitioner at 2, Merit Management Group v. FTI Consulting, No. 16-784 (July 13, 2017).

[4]       Brief for Respondent at 2, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 11, 2017).

[5]       Id.

[6]       Brief of National Association of Bankruptcy Trustees as Amici Curiae Supporting  Respondent, at 3, 13-18, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[7]       Brief of Bankruptcy Law Professors Ralph Brubaker, et al. as Amici Curiae Supporting Respondent, at 4, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[8]       Id. at 1-2.

[9]       Brief of Various Former Tribune and Lyondell Shareholders as Amici Curiae Supporting Petitioners, Merit Management Group v. FTI Consulting, No. 16-784 (July 20, 2017).

[10]     Brief of Tribune Company Retirees and Noteholders as Amici Curiae Supporting Respondent, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).