Supreme Court Rules on Intermediaries’ Status in Allegedly Fraudulent Transfers under Bankruptcy Code

This week in Merit Management Group, LP v. FTI Consulting, Inc., No. 16-784, 2018 WL 1054879 (U.S. Feb. 27, 2018), the Supreme Court issued a long-awaited decision interpreting section 546(e) of the Bankruptcy Code. Specifically, the Court held that when various “Covered Entities”—namely, commodity brokers, forward contract merchants, stockbrokers, financial institutions, financial participants or securities clearing agencies—are mere conduits in a debtor’s allegedly fraudulent transfer to another party and do not make, receive or benefit from the allegedly fraudulent transfer, the transfers made to those Covered Entities are not relevant to whether the allegedly fraudulent transfer is protected from avoidance under section 546(e)’s safe harbor.

The case grew out of an allegedly fraudulent transfer involving a racetrack that went bankrupt. In 2007, Valley View Downs, LP (“Valley View”) and Bedford Downs Management Corp. (“Bedford”) agreed that Valley View would acquire all of Bedford’s shares (the “Bedford Shares”) for $55 million. To complete the transfer, Valley View (a) borrowed funds from Credit Suisse and other lenders and (b) transferred the $55 million to Citizens Bank of Pennsylvania (“Citizens”), who served as the escrow agent for the transaction. Citizens then distributed the $55 million to Bedford’s shareholders, including Merit Management Group, LP (“Merit”), which received $16.5 million in total.

In 2009, Valley View filed for bankruptcy. During Valley View’s bankruptcy proceedings, FTI Consulting, Inc. (“FTI”), as trustee of the In re Centaur, LLC et al. Litigation Trust, brought an avoidance action against Merit under section 548(a)(1)(b) of the Bankruptcy Code, arguing that Valley View’s transfer to Merit was constructively fraudulent because, among other things, Valley View was insolvent when it purchased the Bedford Shares and Valley View significantly overpaid for the Bedford Shares. Merit alleged that the transfer could not constitute a constructively fraudulent transfer under section 548(a)(1)(b) of the Bankruptcy Code because of section 546(e) of the Bankruptcy Code, which bars trustees and debtors-in-possession from avoiding (a) settlement payments made by, to or for the benefit of Covered Entities and (b) transfers made by, to or for the benefit of a Covered Entity in connection with a securities contract. Because Valley View’s transfer to Bedford was made by, to or for the benefit of both Citizens and Credit Suisse (i.e., Covered Entities ), Merit argued that the transfer was protected from avoidance under section 546(e) of the Bankruptcy Code.

The District Court agreed with Merit, but the Seventh Circuit reversed, holding that the language used in section 546(e) of the Bankruptcy Code—that a transfer be made by or to or for the benefit of a Covered Entity—refers to transfers made to “transferees,” which the Seventh Circuit previously concluded meant entities with (a) dominion over the money or (b) the right to put the money to one’s own purpose. Accordingly, the Seventh Circuit ruled that because neither Credit Suisse nor Citizens were transferees within the meaning of the definition in the Seventh Circuit (i.e., the party receiving the allegedly fraudulent transfer), Valley View’s transfers to Credit Suisse and Citizens were not relevant when determining whether Valley View’s transfer to Merit was protected from avoidance under section 546(e) of the Bankruptcy Court.

Merit sought and obtained certiorari, but the Supreme Court affirmed. The Court began by noting that, “before a court can determine whether a transfer was made by or to or for the benefit of a covered entity, the court must first identify the relevant transfer to test in that inquiry.” 2018 WL 1054879, at *7. Next, the Supreme Court reasoned that because section 546(e) is a safe harbor for transfers that are otherwise avoidable under the Bankruptcy Code, “the starting point for the §546(e) inquiry is the substantive avoiding power under the provisions expressly listed in the notwithstanding clause [of section 546(e) of the Bankruptcy Code] and, consequently, the transfer that the trustee seeks to avoid as an exercise of those powers.” Id. at *8. The Court further reasoned that “by referring back to a specific type of transfer that falls within the avoiding power, Congress signaled that the exception applies to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.” Id.

Against this backdrop, the Supreme Court concluded that if Party A makes a transfer to Party D using Covered Entities B and C as mere conduits, and Covered Entities B and C do not make, receive or benefit from transfer, an action to avoid the transfer from Party A to Party D cannot be protected by section 546(e) simply because the transfer passed through Covered Entities B and C. As additional support for its holding, the Court noted that section 546(e) protects transfers that are settlement payments or made in connection with securities contracts, not transfers that merely involve settlement payments or securities contracts. As the Court explained:

The transfer that the trustee may not avoid is specified to be a transfer that is either a settlement payment or made in connection with a securities contract. Not a transfer that involves. Not a transfer that comprises. But a transfer that is a securities transaction covered under §546(e). The provision explicitly equates the transfer that the trustee may otherwise avoid with the transfer that, under the safe harbor, the trustee may not avoid. In other words, to qualify for protection under the securities safe harbor, §546(e) provides that the otherwise avoidable transfer itself be a transfer that meets the safe-harbor criteria.

See id. at *9.

Under the Supreme Court’s decision in Merit, when Covered Entities are mere conduits in an allegedly fraudulent transaction and do not themselves make, receive or benefit from the allegedly fraudulent transaction, the transfers made to such Covered Entities cannot protect the transfer between the debtor and the party that ultimately received the consideration from avoidance. Thus, Merit largely impacts non-Covered Entities, which can no longer successfully argue that an allegedly fraudulent transfer to a non-Covered Entity that passes through a Covered Entity is protected from avoidance under section 546(e).

Covered Entities are not similarly situated. Indeed, if a Covered Entity is a mere conduit but makes or receives a payment in connection with an allegedly fraudulent transfer between two non-Covered Entities, section 546(e) will bar an attempt to avoid the transfer between the non-Covered Entity and the Covered Entity, notwithstanding the fact that the Covered Entity is a mere conduit. See id. at *11 (“If the transfer that the trustee seeks to avoid was made by or to a securities clearing agency … then §546(e) will bar avoidance, and it will do so without regard to whether the entity acted only as an intermediary.”). Similarly, if a Covered Entity is a mere conduit that benefits from an allegedly fraudulent transfer, section 546(e) will bar an attempt to avoid the allegedly fraudulent transfer, notwithstanding the fact that the Covered Entity did not make or receive the payment. See id. (“The safe harbor will, in addition, bar avoidance if the transfer was made for the benefit of that securities clearing agency, even if it was not made by or to that entity. This reading gives full effect to the text of §546(e).”).

Although the Court’s decision in Merit will likely make it harder for non-Covered Entities to protect allegedly fraudulent transfers that involve Covered Entities from avoidance, the Court left open the possibility that Valley View’s transfer to Merit could have been protected from avoidance under section 546(e), notwithstanding its decision. For example, the Court noted that neither Valley View nor Merit alleged that they constituted a Covered Entity in connection with the allegedly fraudulent transfer. See id. at *5 n.2 (“The parties here do not contend that either the debtor or petitioner in this case qualified as a “financial institution” by virtue of its status as a “customer” under § 101(22)(A) … We therefore do not address what impact, if any, § 101(22)(A) would have in the application of the § 546(e) safe harbor.”). In addition, the Court noted that neither Valley View nor Merit “ask[ed] th[e] Court to determine whether the transaction at issue … qualifie[d] as a … ‘settlement payment’ or [a transfer] made in connection with a “securities contract.” Id. at *7. Thus, if pled differently, the Court could have determined that Valley View and/or Merit were Covered Entities in connection with an allegedly fraudulent transfer concerning a settlement payment or a securities contract, which, based on the Merit decision, may have resulted in the allegedly fraudulent transfer being protected from avoidance. Although it is unclear whether the Court would have accepted these arguments, courts in future cases will need to analyze these issues to determine the extent to which Merit restricts the use of section 546(e)’s safe harbor.