Supreme Court Narrowly Interprets the Safe Harbor, Overrules the Majority of Circuits

February 27, 2018

Resolving a split of circuits, the Supreme Court ruled unanimously today in Merit Management Group LP v. FTI Consulting Inc. that the so-called safe harbor under Section 546(e) only applies to “the transfer that the trustee seeks to avoid.” In other words, using a bank as an escrow agent does not preclude a trustee from recovering a constructively fraudulent transfer under Section 548(a)(1)(B), when the trustee is seeking to recover from the ultimate recipient of the transfer but not from an intermediary bank.

The Supreme Court had been asked to resolve a split of circuits and decide whether the safe harbor applies when a financial institution is only a “mere conduit.” Instead, the unanimous opinion by Justice Sonia Sotomayor decided the case on a different and broader ground. The opinion may lead to a rethinking of safe harbor cases and might open the door to suits that previously were believed to rest comfortably within the safe harbor.

The Seventh Circuit Opinion

The case came to the Supreme Court from the Seventh Circuit, where a bankruptcy trustee had sued a selling shareholder in the leveraged buyout of a non-public company. The transaction was structured so that the purchase price for the stock initially came from an investment bank and was transferred to a commercial bank acting as escrow agent. As escrow agent, the bank paid a total of $16.5 million to the selling shareholder. The trustee sued the selling shareholder for receipt of a constructively fraudulent transfer.

The district court granted a motion to dismiss, reasoning that the safe harbor applied because the transfer included both a transfer from an investment bank and a transfer to a commercial bank, before the funds ended up in the hands of the selling shareholder.

On appeal, the Seventh Circuit reversed, in an opinion by Chief Circuit Judge Diane P. Wood. FTI Consulting Inc. v. Merit Management Group LP, 830 F.3d 690 (7th Cir. July 28, 2016).

The Seventh Circuit opinion stands for the proposition that routing consideration for an LBO of a non-public company through a financial institution cannot preclude a fraudulent transfer attack if it turns out that the seller was rendered insolvent.

Since the purchaser was buying stock, it was clear to the Seventh Circuit that the transfers were either a settlement payment or a payment in connection with a securities contract. The appeals court said it was therefore only necessary to decide whether the safe harbor protects transactions “simply [because they were] conducted through financial institutions.”

The Seventh Circuit refused to “interpret the safe harbor so expansively that it covers any transaction involving securities that uses a financial institution or other named entity as a conduit for funds.” Instead, the appeals court said “it is the economic substance of the transaction that matters.”

The Chicago-based appeals court therefore reversed the district court, which had utilized the safe harbor to dismiss the trustee’s suit.

The Seventh Circuit opinion deepened an existing circuit split because the Second, Third, Sixth, Eighth and Tenth Circuits have invoked the safe harbor when a financial institution is nothing more than a conduit. The Eleventh Circuit was aligned with the Seventh, requiring the financial institution to be more than a conduit.

The defendant-selling shareholder filed a petition for certiorari, which the Supreme Court granted in May 2017. Oral argument was held on Nov. 6.

The Unanimous Opinion

The seeds for Justice Sotomayor’s opinion were sown in an exchange at oral argument between Justice Anthony M. Kennedy and former Solicitor General Paul D. Clement, counsel for the trustee. Justice Kennedy asked whether the opinion should be qualified to require that the financial institution have an “equity participation” before the safe harbor applies.

Clement said he had a “simpler way to write the opinion[: by just looking] to the transfer that the trustee seeks to avoid.” And that’s what Justice Sotomayor did.

Laying out the statute in full text in her opinion, Justice Sotomayor traced the many amendments to the safe harbor, saying Congress “each time expand[ed] the categories of covered transfers or entities.”

In pertinent part, Section 546(e) provides that a trustee “may not avoid a transfer” that is a “settlement payment . . . made by or to (or for the benefit of) a . . . financial institution” or that “is a transfer made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract . . . .”

Justice Sotomayor framed the question as whether the safe harbor applied because the transfer was “‘made by or to (or for the benefit of) a . . . financial institution.’” She said that asking whether the bank had a beneficial interest in the transferred property “put the proverbial cart before the horse.”

Before deciding whether the transfer was made to a covered entity, “the court must first identify the relevant transfer,” she said.

Justice Sotomayor devoted the bulk of her opinion to explaining why the “language of Section 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 Section 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid.” She said the trustee properly identified the transfer as the sale of stock by the seller to the buyer, not intermediate transfers involving investment or commercial banks.

Uttering a phrase that will be cited countless times in the future, Justice Sotomayor cautioned that a trustee “is not free to define the transfer it seeks to avoid in any way it chooses.”

Justice Sotomayor devoted the final third of her 19-page opinion to refuting the selling shareholder’s arguments. The last part of her opinion arguably broadens the scope of the holding and makes the safe harbor more narrow than it is now generally understood to be.

She said that the addition of “(or for the benefit of)” in 2006 was only intended for the scope of the safe harbor to match the scope of the avoiding powers, where similar language is used. She rejected the selling shareholder’s contention that the language was intended to bar avoidance if the financial institution was an intermediary without a financial interest in the transfer.

Next, the selling shareholder mounted an argument based on the inclusion of a securities clearing agency as one of the entities covered by the safe harbor.

If the relevant transfer is from the buyer to the seller, Justice Sotomayor said, “the question then becomes whether the transfer was ‘made by or to (or for the benefit of)’ a covered entity,” such as a clearing agency.

Answering her own question, Justice Sotomayor said, “If the transfer that the trustee seeks to avoid was made ‘by’ or ‘to’ a securities clearing agency . . . , then Section 546(e) will bar avoidance, and it will do so without regard to whether the entity acted only as an intermediary.”

On the next page, Justice Sotomayor acknowledged there was “good reason to believe that Congress was concerned about transfers ‘by an industry hub.’” [Emphasis in original.]

She went on to say that the safe harbor protects securities transactions “‘made by or to (or for the benefit of)’ covered entities. See Section 546(e). Transfers ‘through’ a covered entity, conversely, appear nowhere in the statute.” 

What exactly did the justice mean by her statements?

It was generally understood, at least before today’s opinion, that a trustee could not recover a fraudulent transfer resulting from the sale of stock in a publicly held company, because the payoff to the selling shareholder would have been made through a “covered entity,” like a clearing agent. Does today’s opinion mean that a trustee for a public company can recover from selling shareholders but, of course, not from a clearing agent?

It had also been held that the LBO of a privately held company was protected by the safe harbor, if the sale of the stock utilized a bank somewhere in the stream of payments. It seems reasonably clear that an LBO of a privately held is no longer protected, unless the transferee is a financial institution.

However, what results if the transfer ends up in the coffers of a bank that held a lien on the stock being sold? May the trustee recover only from the beneficial owner of the stock but not from the bank where the money ended up?

The meaning of Merit Management will be debated in other contexts. For instance, the Second Circuit held in Note Holders v. Large Private Beneficial Owners (In re Tribune Co.), 818 F.3d 98 (2d Cir. 2016), that the safe harbor bars suits by creditors under state law to recover payments made in securities transactions.

In Tribune, the Second Circuit concluded that Congress intended broad protection for securities markets, even to the extent of barring creditors from prosecuting claims that belong to them and not to bankruptcy trustees. DoesMerit Management undercut the Second Circuit’s notion that the safe harbor broadly immunizes any transaction involving securities whenever there has been a bankruptcy?

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