Title 11 of the U.S. Bankruptcy Code contains provisions that allow some pre-bankruptcy transfers to be avoided, or "unwound," by a debtor in possession, trustee, or other party granted standing to do so. Among the types of transfers that may be avoided are fraudulent transfers, which arise when a bankrupt debtor previously transferred assets to another party while insolvent and for less than reasonably equivalent value.

But the Bankruptcy Code also limits the scope of these avoidance powers. One limitation is 11 U.S.C. § 546(e), which contains a "safe harbor" that provides that "the 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." 11 U.S.C. § 546(e).

On February 27, 2018, the U.S. Supreme Court issued a unanimous opinion in Merit Management Group, LP v. FTI Consulting, Inc., that limits the scope of the safe harbor provision under § 546(e) to the protection only of financial institutions (and certain other enumerated entities) from liability for an avoidable transfer, and does not shelter other participants in a transaction that may have received a transfer. This decision reversed the majority view interpreting the safe harbor protection as protecting certain types of transactions involving financial institutions, and not just the institutions themselves. The Merit decision therefore creates potential exposure for participants other than financial institutions in connection with numerous transactions previously thought to be protected, including the leveraged buy-out transaction at issue in Merit.

In Merit, Valley View Downs, LP, and Bedford Downs Management Corporation were initially competitors vying for the final harness-racing license in Pennsylvania. Both applied for the last license, and both were initially denied. Rather than compete a second time, the parties entered into an agreement in which Bedford Downs withdrew its license application in exchange for Valley View agreeing to purchase all of Bedford Downs' stock for $55 million. With no competition, Valley View received the license. Subsequently, Valley View applied for a separate gaming license to operate slot machines.

Valley View honored the agreement and acquired Bedford Downs. Valley View transferred $55 million to Credit Suisse, Credit Suisse wired $55 million to Citizens Bank (the agreed-upon third-party escrow agent), and Bedford Downs deposited all of its stock certificates in escrow with Citizens Bank. Merit Management Group, LP, received a $16.5 million distribution from Citizens Bank for its shares in Bedford Downs, and Valley View became the sole shareholder of Bedford Downs. But Valley View never received the gaming license to establish the racetrack casino, or "racino," and ultimately filed for chapter 11 bankruptcy.

FTI Consulting, acting as the trustee of a litigation trust formed in Valley View's bankruptcy case, filed an avoidance action to avoid the $16.5 million transfer to Merit on the basis that it was fraudulent. FTI argued that for purposes of assessing the applicability of the safe harbor of § 546(e), a court need look only at the transfer "relevant" to the avoidance action—that is, the one sought to be avoided—and the identity of the recipient of that "relevant" transfer. If the recipient of the "relevant" transfer was not an entity enumerated in § 546(e), the safe harbor did not apply.

Merit, on the other hand, contended that under § 546(e), a transaction could not be parsed in this fashion, and must be analyzed as encompassing all of its components, including, in this case, the transfers to Credit Suisse and Citizens Bank that preceded the transfer to Merit, each of which were financial institutions within the meaning of § 546(e). In previous litigation of the same issue in other cases, the U.S. Courts of Appeal for the Second, Third, Sixth, Eighth, and 10th Circuits had reached results consistent with Merit's contention. The 11th Circuit and, in the Merit case itself, the Seventh Circuit, reached results consistent with FTI's argument. The logic of the cases applying the § 546(e) safe harbor to the transaction as a whole, rather than a particular type of defendant, was perhaps best expressed by the Second Circuit in a 2016 decision: "Section 546(e) protects transactions rather than firms, reflecting a purpose of enhancing the efficiency of securities markets in order to reduce the cost of capital to the American economy." In re Tribune Co. Fraudulent Conveyance Litigation, 818 F.3d 98, 121 (2d Cir. 2016) (emphasis added).

The Supreme Court was apparently unmoved by this concern and sided with FTI. The Court held that under a "plain meaning" reading of the statute, the focus when analyzing the applicability of § 546(e) to an avoidance action should be on the transfer sought to be avoided—the "relevant" transfer—and on the defendant from whom that transfer is sought to be recovered. In other words, the Supreme Court turned the Second Circuit's reasoning on its head, and interpreted § 546(e) to protect firms, not transactions. Merit did not contend it was a financial institution or other entity enumerated in § 546(e), and accordingly, Merit, and the transfer to Merit, were not protected from the avoidance action.

Because § 546(e) has now been definitively interpreted only to protect the enumerated types of entities from being avoidance-action defendants under the circumstances therein described, but not transactions themselves even if involving those entities, the Merit decision will undoubtedly lead to increased fraudulent transfer litigation concerning pre-bankruptcy transactions, particularly transactions where (but not necessarily only where) financial institutions have acted only as intermediaries or conduits. In such situations, no longer can other entities that received transfers, including shareholders, be comfortable that such transfers cannot be unwound years later through Bankruptcy Code avoidance powers.

Ballard Spahr’s Business and Finance attorneys assist clients in leveraged buyouts, recapitalization, and similar transactions. The firm's Bankruptcy, Reorganization and Capital Recovery attorneys have a wealth of experience in corporate restructuring and fraudulent transfer litigation.


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