Fraudulent conveyance litigation arising from failed leveraged buyout transactions is frequently pursued in bankruptcy proceedings as the sole source of recovery for creditors. Targets of these actions typically include those parties who received the proceeds generated by the LBO, including the debtor's former shareholders. However, until now, in many circuits these lawsuits were blocked by the safe harbor provisions contained within Section 546(e) of the Bankruptcy Code, if the proceeds of the challenged transaction flowed through a financial institution such as a bank, even if that bank was not otherwise materially involved in the deal. As a result of a very recent decision by the U.S. Supreme Court, that outcome has now changed in Merit Management Group v. FTI Consulting, 583 U.S. ____ (2018), 2018 U.S. LEXIS 1514.

In Merit, the Supreme Court held that a plain statutory reading of the safe harbor provisions within Section 546(e), requires a court to review the actual transfer sought to be avoided, and not just the use of intermediaries along the way. In other words, as the Supreme Court noted, in a transaction that involves transfers from A → B → C → D, where B and C are financial institutions, and the transfer the trustee seeks to avoid is the one from A → D, the fact that B and C are financial institutions will not in and of itself immunize the transaction.

In bankruptcy, certain transfers made by the debtor to a third party before the case began may be “clawed back” for the benefit of creditors, as detailed in Chapter 5 of the Bankruptcy Code. However, the code also provides certain safe harbors which may block the recovery of those funds. At issue in Merit was 11 U.S.C. Section 546(e), which provides that: “Notwithstanding Sections 544, 545, 547, 548(a)(1)(B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in Section 101, 741, or 761 of this title, or settlement payment, as defined in Section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, … that is made before the commencement of the case, except under Section 548(a)(1)(A) of this title.”

Merit concerned the transfer of funds related to the acquisition of a harness-racing license in Pennsylvania. Two entities, Valley View Downs LP, and Bedford Downs Management Corp., were in competition for the last such available license. To resolve the deadlock, Bedford Downs agreed to withdraw its application in return for Valley View purchasing all of Bedford Downs' stock for $55 million, which not surprisingly, was contingent on Valley View obtaining the license. After Valley View obtained the license, it used Credit Suisse to wire a $55 million payment to Citizens Bank of Pennsylvania, the escrow agent in the transaction. These funds were ultimately disbursed to Bedford Downs' stockholders, including Merit, which netted approximately $16.5 million from the transaction. Unfortunately, Valley View never successfully started a “racino” (a race-track casino), causing its parent corporation to commence a Chapter 11 bankruptcy proceeding in 2010. The Bankruptcy Court confirmed a reorganization plan the following year, and appointed FTI Consulting, Inc. as litigation trustee.

FTI brought suit against Merit in the U.S. District Court for the Northern District of Illinois, seeking to avoid the $16.5 million transfer on the grounds that it was a constructively fraudulent transfer under 11 U.S.C. Section 548(a)(1)(B). The district court granted Merit's motion for judgment on the pleadings relying on the interpretation of the phrase “by or to (or for the benefit of) … a financial institution” in Section 546(e), FTI Consulting v Merit Management Group, 541 B.R. 850, 854 (N.D. Ill. 2015). The district court held that the transfer to Merit was “'by or to' a financial institution because two financial institutions transferred or received funds in connection with a 'settlement payment' or 'securities contract.'” On appeal, the U.S. Court of Appeals for the Seventh Circuit reversed, holding that where a financial institution acts as a “mere conduit” in a securities transaction, the transferee cannot avail itself of the Section 546(e) safe harbor. FTI Consulting v. Merit Management Group, 830 F.3d 690 (7th Cir. 2016). The Supreme Court granted certiorari on May 1, 2017, to address the growing split among the circuits over the interpretation of this safe harbor provision where financial institutions were involved in the transaction, see Merit Management Group v. FTI Consulting, 2017 U.S. LEXIS 2831 (May 1, 2017).

In a unanimous ruling, the Supreme Court affirmed the Seventh Circuit. It held that “the transfer that the trustee seeks to avoid is the relevant transfer for consideration of the Section 546(e) safe harbor.” It reached this conclusion based on a close reading of the applicable statutes. In doing so, the court reviewed other sections of the Bankruptcy Code which detailed what transfers could be avoided and reasoned that it had to be those same transfers that could fall within the safe harbor provisions. “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.”

The Supreme Court did not find convincing Merit's argument that the 2006 Congressional addition of the parenthetical “or for the benefit of” to the statute meant that financial institutions which acted as intermediaries without beneficial interest could still trigger safe harbor protection. The court noted that the same, or similar language, was included in other substantive avoidance statutes, and that “by adding the same language to the Section 546(e) safe harbor, Congress ensured that the scope of the safe harbor matched the scope of the avoiding powers.” Nor was it convinced by Merit's argument as to congressional intent, that the safe harbor provision was enacted as a “comprehensive approach to securities and commodities transactions' that was 'prophylactic, not surgical' and meant to 'advance the interests of parties in the finality of transactions.'” Rather, the court said that Congressional intent suggested the opposite—the statutory language was “by or to (or for the benefit of)” and not “through.” Thus, because the transfer that the trustee sought to invalidate was the transfer from the debtor to Merit, and neither of those parties contended that either was a financial institution, the transfer could not fall within the safe harbor afforded under Section 546(e).

Some practitioners suggest that Merit is one of the more important bankruptcy-related decisions to come out of the Supreme Court in the last several years. No longer can failed LBO transactions which result in a subsequent bankruptcy be insulated from review simply because the sale proceeds were run through a bank. Creditors of the bankrupt companies will applaud this outcome as providing a possible source of recovery where none may have existed before. Others however, worry that the Supreme Court's narrow reading of the safe harbor provisions may have a negative impact on commerce in areas where to date, they have been heavily relied upon to create confidence that an intervening bankruptcy would not cause the unwinding of deals already consummated. Only time will tell whether that occurs as well as what other impact this decision may have.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Kate A. Mahoney is an associate in the firm's Philadelphia office, where she concentrates her practice on commercial litigation matters.