Split Increases Uncertainty as to Extent of Safe Harbors

A recent decision by the U.S. Court of Appeals for the Seventh Circuit, currently under consideration for review by the U.S. Supreme Court, rekindles a circuit split regarding the interpretation of §546(e), which is one of the “safe harbor” provisions enacted to minimize displacement in the commodities and securities markets in the event of a major bankruptcy affecting those markets. Section 546(e) protects a payment to or for the benefit of a financial institution on a securities contract and prevents a trustee from avoiding such pre-petition transactions. The existing split focuses on the role of the financial institution, with the Seventh Circuit now joining the Eleventh Circuit in ruling that a transaction in which the financial institution is a “mere conduit” is not protected by the safe harbor, while the Second, Third, Sixth, Eighth and Tenth Circuits have ruled that the participation by a financial institution is sufficient to bring the transaction within the safe harbor. The Seventh Circuit decision highlights that even when a transaction is structured to be within the safe harbor, it may not qualify for protection, particularly when the transaction occurs in the context of a financially troubled company. Courts, at least in the Seventh and Eleventh Circuits, may look beyond the plain language of a statute and focus instead on the economic substance, rather than the form, of a transaction.

In FTI Consulting v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016), the Seventh Circuit held that §546(e) of the Bankruptcy Code, which protects transactions “made by or to (or for the benefit of)” a variety of financial entities (including brokers as well as financial institutions), did not prevent a bankruptcy trustee from avoiding a transfer which was merely channeled through a financial institution. Courts in five other circuits, including the Second Circuit, have ruled otherwise, holding that the plain language of §546(e) protects transfers made through financial institutions. The Seventh Circuit, however, joining the minority view held by the Eleventh Circuit, focused on the economics of the underlying transaction, and found that financial institutions must be more than mere conduits for a transaction for the §546 safe harbor to apply.

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