March 13, 2018
By: Mark N. Parry
The United States Supreme Court’s unanimous decision in Merit Mgmt. Grp., LP, v. FTI Consulting, Inc., ___ U.S. ___ (February 27, 2018), resolves a split among various circuit courts of appeals and brings to a dramatic halt the progression of decisions in the past 18 years that had been interpreting section 546(e) of the Bankruptcy Code to severely curtail the bankruptcy avoidance powers granted under the Bankruptcy Code (Section 544 through Section 553). [click here for link to U.S. Supreme Court decision]
Section 546(e) prohibits a trustee (or debtor in possession) from avoiding a transfer that would otherwise be avoidable, if the transfer was made by, to, or for the benefit of a “financial institution” (or other covered entity) either as a margin or settlement payment or in connection with a securities, commodities or forward contract. Because virtually every transfer passes through one or more financial institutions during its passage from the debtor to the defendant, defendants sought to focus the courts on the intermediary steps, arguing that the involvement of a financial institution in the journey of the funds provided the defendant with a “safe-harbor” from any avoidance action. During the past two decades, more and more courts accepted this expansive interpretation of section 546(e), rejecting the argument that the involvement of a financial institution that was a mere conduit, or acquired no beneficial interest in the property passing through its hands, did not provide the ultimate recipient with a defense.
In Merit, the Supreme Court side-stepped this conduit-analysis approach to the question, opting for a more linguistic solution. According to the Court, the safe-harbor of section 546(e) was intended to mirror the avoidance powers it negated. Thus, the proper inquiry was to look at the transfer that the trustee sought to avoid (and only that transfer, not any intermediary steps), and then ask whether that specific transfer rested within the safe-harbor. Where a trustee seeks to avoid a transfer by the debtor to or for the benefit of some transferee (the “Transferee”), the occurrence of intermediate transfers involving financial institutions along the way are irrelevant. What matters is whether either the debtor or the Transferee was a “financial institution” (or other covered entity). In short, the court must first identify the relevant transfer of which avoidance is sought in order to test whether it was made by, to, or for the benefit of, a financial institution (or other covered entity).
Merit involved the trustee of a litigation trust asserting the avoidance powers of debtor Valley View Downs, LP (“Valley View”). The trustee sought to avoid a $16.5 million transfer made by Valley View to Merit Management Group, LP (“Merit”) as a constructive fraudulent transfer under section 548(a) of the Bankruptcy Code. Merit had received those funds in exchange for its stock in Bedford Downs Management Corporation, which Valley View had acquired. Finding that the transfer sought to be avoided was from Valley View to Merit, the Supreme Court quickly concluded that neither was a “financial institution” and, therefore, that section 546(e) had no application to the case. The Court found immaterial the fact that Valley View’s lending bank, Credit Suisse, had wired the funds to another financial institution, Citizens Bank of Pennsylvania, which was the third-party escrow agent for the share sellers and which released the funds to the defendant share seller at closing. It was immaterial because that was not the transfer that the trustee’s complaint sought to avoid.
The Supreme Court’s decision in Merit is fatal to any avoidance action (involving a securities, commodity or forward transaction) that describes the transfer to be avoided as one made to a “financial institution” or other covered entity. In order to avoid the application of section 546(e) based on the Merit decision, any avoidance action would have to define the transfer to be avoided as one made to an entity that is not a financial institution (or other covered entity) in connection with a securities, commodities or forward transaction.
While the Supreme Court may have ended the wholesale evisceration of the avoidance powers by section 546(e), that does not mean that litigation involving the issues raised by this section will end. As some commentators have noted, it is possible that the definition of “financial institution” may extend to the customers of such an institution for which it served as agent or custodian. The Merit decision may also refocus the defendant on attacking the plaintiff’s definition of the transfer sought to be avoided as being improper (“a defendant … is free to argue that the trustee failed to properly identify an avoidable transfer under the Code, including any available arguments concerning the role of component parts of the transfer.” (Merit ___ U.S. ___ (February 27, 2018), *14)). It is also not clear that the Merit interpretation of section 546(e) would protect a financial institution that is sued as a subsequent transferee, from whom an avoided transfer may be recovered under section 550.
If you have any questions about the Merit decision, or about other legal issues involving avoidance actions under the Bankruptcy Code, contact Mark Parry at (212) 554-7860 or mparry@MosesSinger.com, or any other member of Moses & Singer’s Business Reorganization, Bankruptcy and Creditors' Rights practice area.
Mr. Parry is Chair of Moses & Singer's Dispute Resolution Practice Group and a partner in the Business Reorganization, Bankruptcy and Creditors' Rights practice area.