Ruling clarifies avoidance powers of bankruptcy trustees

OCTOBER 2017 TERM

In a unanimous decision, the U.S. Supreme Court has added considerable clarity surrounding the avoidance powers of bankruptcy trustees everywhere. In its rejection of the statutory interpretation previously espoused by the 2nd, 3rd, 6th, 8th and 10th U.S. Circuit Courts of Appeals, the court narrowly construed an exemption to those powers, holding that use of a bank as an escrow agent does not shield a transaction from being reversed by the trustee. Merit Management Group, LP v. FTI Consulting, Inc., 2018 DJDAR 1757 (Feb. 27, 2018). In doing so, the court enhanced the trustee's power to avoid and reverse securities transactions in bankruptcy proceedings.

The Bankruptcy Code confers a trustee with the power to "avoid," or invalidate, certain transactions to maximize funds available for distribution to creditors. At issue in Merit was the scope of Section 546(e), an exception to the trustee's power to invalidate those transfers. Section 546(e) provides that bankruptcy trustees may not avoid transfers "made by or to (or for the benefit of)" financial institutions, arising from certain transactions, including settlement payments.

Before Merit, Section 546(e) was widely interpreted to protect transfers where financial institutions only act as "mere conduits" but are not themselves the transferee or transferor in the subject transaction. In affirming the 7th Circuit's decision, which is also consistent with the 11th Circuit's treatment of the issue, the high court narrowed the protections of Section 546(e).

The facts at issue in Merit are borne out of Valley View Downs, L.P.'s agreement to purchase Bedford Downs Management Corporation stock. Credit Suisse financed the $55 million purchase price and wired the $55 million to Citizens Bank of Pennsylvania, given that Citizens Bank had agreed to serve as the escrow agent for the transaction. Ultimately, Citizens Bank disbursed $16.5 million to petitioner (and Bedford Downs shareholder) Merit Management Group, LP in exchange for Merit's ownership interest.

When Valley View filed for Chapter 11 bankruptcy protection, the trustee of Valley View's litigation trust, respondent FTI Consulting, Inc., brought an avoidance action against Merit seeking to avoid and recover $16.5 million, i.e., the payment of Merit's portion of the purchase price, as a fraudulent transfer. Merit moved for judgment on the pleadings, arguing that the safe harbor in Section 546(e) barred the trustee from avoiding the transfer.

The district court granted the motion and the 7th Circuit reversed, holding that the safe harbor did not protect transfers in which financial institutions served as mere conduits.

Arguments by the Supreme Court were heard last November, and by affirming the 7th Circuit's decision, last week's opinion is in accord with the outcome many were expecting given the justices' line of inquiry at oral argument.

Although each side proffered policy arguments in its briefs and at oral argument about the systemic risk to financial markets, the potential effect on the leveraged buyout industry and broader implications on the economy, the "parade of horribles" argument was viewed as an attack on the plain language of the statute itself and ceded to what was ultimately a contextual and textual analysis, one the court deemed to be clear and as yielding a straightforward result.

The court examined the statutory history of Section 546(e), including the expansionist amendments promulgated and ultimately adopted by Congress over the years, and further tested the text of Section 546(e) against the canon of statutory interpretation disfavoring an interpretation that renders a provision ineffectual or superfluous. Unmoved by Merit's arguments, the court held that the scope of the safe harbor was coextensive with the scope of the avoiding powers.

Stated differently, to qualify for protection under the safe harbor, the otherwise avoidable transfer must itself be covered by Section 546(e). The focus belongs and remains on the transfer the trustee sought to avoid.

The court further bemoaned that both parties and the lower courts focused too much on (1) the words "by or to (or for the benefit of)" and (2) whether the financial intermediary had a beneficial interest in the transaction. Those questions, as Justice Sonia Sotomayor wrote, "put the proverbial cart before the horse."

Instead, the court pronounced that the first step was to identify the relevant transfer to test. Only once that identification was made could the court then determine whether that transfer was made by or to or for the benefit of a covered entity.

The court reasoned that once a debtor files for bankruptcy, the trustee has the option and power to file an avoidance action on any transaction it deems is subject to avoidance. In that action, the trustee must identify the transfer it seeks to set aside. In a motion to dismiss or other form of opposition, a defendant may then challenge the trustee's avoidance action and argue that the trustee failed to properly identify an avoidable transfer under the Bankruptcy Code.

Since the Merit trustee, FTI, solely sought to avoid the $16.5 million end-to-end transfer of Bedford stock from Valley View to Merit, it is that transaction that must be covered by Section 546(e). The intermediate, component transfers of Credit Suisse to Citizens Bank and Citizens Bank to Merit, transfers which the trustee did not seek to avoid, were not properly before the court and irrelevant to the inquiry. Had Merit sought to avoid either of those component transfers or contested FTI's designation of the Valley View to Merit transfer in the first place, the analysis may have been different.

And where the parties either concede or, at bottom, fail to dispute that either Valley View or Merit is a "financial institution" or other covered entity, the transfer falls outside the purview of the safe harbor.

To be sure, the court's decision in Merit leaves previously protected transactions vulnerable to reversal in an avoidance action. But it also makes clear that the record before the court was want of certain relevant and potentially dispositive arguments not raised below. In doing so, the high court has gifted all interested parties -- trustees, financial institutions and litigants alike -- a clear infrastructure for wrestling with avoidance actions, heightened anxieties when using intermediaries, and some potential arguments reserved for future challenges and defenses.