On July 28, 2016, the Seventh Circuit rendered an opinion in FTI Consulting, Inc. v. Merit Management Group, LP,1 holding that a transfer is not protected by the safe harbor provision of section 546(e) when a financial institution or other named entity acts merely as a conduit for the transferred funds. The decision, which sides with the Eleventh Circuit in Munford v. Valuation Research Corp. (In re Munford, Inc.),2 and strikes a further divide with five other circuits that have interpreted 546(e) to include a conduit situation, has practical implications for parties to securities transactions, and in particular shareholders that cashed out as part of a leveraged buyout.
Background
In 2003, Valley View Downs, a racetrack operator, acquired all of the shares of Bedford Downs for $55 million. Valley View borrowed the money to purchase Bedford Downs from Credit Suisse (and other lenders) and placed the funds with Citizens Bank, as escrow agent. Citizens Bank, in turn, transferred the funds upon the closing. After the closing, Valley View failed to obtain its gambling license and filed for bankruptcy under chapter 11.
FTI Consulting, Inc., as trustee, brought suit against Merit Management Group, a 30% shareholder in Bedford Downs, alleging that Valley View's transfer ultimately to Merit Management of approximately $16.5 million was avoidable under sections 544, 548(a)(1)(B), and 550 of the Bankruptcy Code as a constructive fraudulent transfer. Merit Management argued that that transfer was "made by or to (or for the benefit of)" an entity named in section 546(e) (namely, a financial institution) and therefore was protected by the safe harbor. The district court agreed with Merit Management that the transfer was "made by or to" a financial institution because the funds passed through Citizens Bank and Credit Suisse. FTI then appealed.
The Seventh Circuit Decision
The Seventh Circuit considered one question on appeal, whether the section 546(e) safe harbor protects transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), when the entity is neither the debtor nor the transferee but only the conduit. The Seventh Circuit held it did not and reversed the district court.
In arriving at its decision, the Seventh Circuit found that the phrases "by or to" and "for the benefit of" were ambiguous and it was unclear from the plain language of the statute whether the safe harbor was meant to include intermediaries. As a result, the court examined the statute's purpose and context for guidance. In doing so, the court agreed with FTI's arguments that (i) since the other sections of chapter 5 of the Bankruptcy Code established that only transfers made by the debtor prior to the bankruptcy petition are avoidable, transfers made by a named entity in section 546(e) should also refer to a transfer of property by the debtor, and (ii) because sections 544, 547, and 548 of the Bankruptcy Code refer to avoidance of transfers to or for the benefit of entities subject to fraudulent transfer liability, section 546(e)'s safe harbor must refer only to transfers made to a named entity that is a creditor. The court also relied on its prior decision in Bonded Financial Services, Inc. v. European American Bank,3 in which it found that a bank that acted as a financial intermediary and received no benefit was not a transferee under chapter 5 of the Bankruptcy Code. The court stressed that Merit Management's alternative interpretation of the safe harbor "would be so broad as to render any transfer non-avoidable unless it were done in cold hard cash, ... ."4
The Seventh Circuit also examined the legislative history of section 546(e) and concluded that none of the actions taken by Congress indicated that the safe harbor applied to covered institutions in their capacity as intermediaries. According to the court, "[a]lthough we have said that section 546(e) is to be understood broadly, ... that does not mean that there are no limits. While Valley View's settlement with Bedford resembled a leveraged buyout, and in that way touched on the securities market, neither Valley View nor Merit were 'parties in the securities industry.' They are simply corporations that wanted to exchange money for privately held stock."5 Recognizing that the purpose of the safe harbor was to reduce systemic risk in the financial markets, the court was not troubled that there would be any ripple effect from the return of the funds to FTI.
Finally, the court disagreed with Merit Management's argument that Congress disapproved the Eleventh Circuit's opinion in Munford finding 546(e) inapplicable to conduits by passing the 2006 Amendment adding "(or for the benefit of)" to the statute. The Seventh Circuit reasoned that Congress would not have jettisoned the ruling in such a subtle and circuitous manner, but would have instead provided that acting as a conduit qualified.
Practical Considerations
The decision represents a win for bankrupt estates seeking to avoid transfers made to shareholders as part of a leveraged buyout, particularly with respect to shares held privately. Shareholders may now be at risk (at least in the Seventh and Eleventh Circuits) that trustees may seek to recover transfers under a constructive fraudulent transfer theory. As a practical matter, given the split in authority and the potential for forum shopping, disputes among stakeholders regarding where a company should file for bankruptcy may arise. The circuit split in authority also makes this an issue to monitor closely since a decision by the Supreme Court would have profound ramifications on the scope of the safe harbor and leverage buyouts.
Footnotes
1 No. 15-3388, 2016 U.S. App. LEXIS 13705 (7th Cir. July 28, 2016).
2 98 F.3d 604 (11th Cir. 1996).
3 838 F.2d 890, 893 (7th Cir. 1988).
4 2016 U.S. App. LEXIS 13705, at *11.
5 Id . at * 15-16.
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