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Merit Mgmt. Group LP v. FTI Consulting Inc.

posted by Adam Levitin

The Supreme Court weighed in today on one of the the most important circuit splits in the bankruptcy world, namely the scope of one of the section 546(e) safe harbors from avoidance actions in bankruptcy.  Section 546(e) has two safe harbors, one for "settlement payments" and the other for transfers "made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract … commodity contract… or forward contract…”. This latter safe harbor had been read (ridiculously) broadly by some of the courts of appeals, as every non-cash transaction has to go through some sort of financial institution.  Specifically, imagine a transaction in which funds are moving from A to D, but go through intermediary financial institutions B and C:  A-->B-->C-->D.  Can D shelter in the fact that the transfer went through financial institutions B and C?  

The Supreme Court unanimously said no, and I think they clearly got the right result, although I fear the methodology the court used may ultimately be unhelpful for those who think that fraudulent transfer law has an important role to play in policing the fairness of financial markets and preventing against excessively risky heads-I-win, tails-you-lose gambles.  

The Supreme Court's approach in Merit was, unsurprisingly one of uninspired statutory interpretation.  I guess that's to be expected when you have a court filled with con law/admin types who aren't really comfortable on the policy issues, but it's a notable contrast to say, W.O. Douglas's bankruptcy opinions (whatever one thinks of them). The Court saw the case as really being decided by the plain language of the statute, but the Court itself was playing games with the statutory language.  Consider this language from the opinion:  

The transfer that the “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.” §546(e) (emphasis added). Not a transfer that involves. Not a transfer that comprises. But a transfer that is a securities transaction covered under §546(e). The provision explicitly equates the transfer that the trustee may otherwise avoid with the transfer that, under the safe harbor, the trustee may not avoid. In other words, to qualify for protection under the securities safe harbor, §546(e) provides that the otherwise avoidable transfer itself be a transfer that meets the safe-harbor criteria.

Notice the legerdemain here:  Justice Sotomayor goes from talking about "a transfer that is...made in connection with a securities contract" to talking about "a transfer that is a securities contract."  The words "in connection with" just disappeared!  Those are key words that mean something like "a transfer that involves," but the Court just read them out of the statute.  That's kind of astounding because literally the transaction at issue was a transfer not from A-->D, but from C-->D, and that is a transfer from a financial institution made in connection with a securities contract.  In short, I think the plain language approach here just doesn't work unless one disregards whole words from the statute...as the Court did.

A better approach would have been to disregard financial institutions and as agents of or mere conduits. That's the economic reality of the transaction.  and are only transferring on funds from to because they have been engaged by to do so.  They are acting on A's behalf and are not the meaningfully independent actors.  When viewed that way, the transaction really is to D, and then there's no financial institution involved in its own capacity.  I wish the Supreme Court had approached the problem that way because the overly literal (although incorrectly applied) reliance on statutory language creates problems elsewhere in fraudulent transfer land.  

An agency or conduit approach to the problem would also have mad sense from a policy perspective.  The policy argument for the section 546(e) safe harbors has always been that it is necessary to protect financial institutions from the uncertainty of clawback actions, lest there be spillover effects that roil financial markets generally.  Even if one buys that policy argument, it is only an argument for protecting and C, not the end-recipient D.  And if it were otherwise, than any competently advised recipient of a fraudulent transfer or preference would just make sure that the payment went through a financial institution (as it always would with a wire transfer or check), such that constructive fraudulent transfer law would have no purchase in securities, commodities or forward contract transactions.  

The Merit Management Group decision means that the selling shareholders in an LBO cannot shelter in fact the payment to them went through a financial institution. But it's worth noting what was not addressed in Merit.  First, Merit does not prevent the selling shareholders in an LBO from raising the settlement payment safe harbor of section 546(e).  I haven't followed the case closely enough to know why that argument isn't at issue also, but it certainly seems like a viable one.  Indeed, under the block quoted language above, it would seem pretty clear that the payment to the selling shareholders is a settlement payment.  

Second, Merit doesn't address the situation of a financial institution that is the ultimate recipient of a transfer, that is a financial institution that is in the position of D.  In particular, consider a bank that provides the financing for an LBO and receives a security interest for that financing, even though the loan proceeds are not going to the target company, at least in any material way (they might be routed through the target company, but it's window dressing).  That bank is not acting as a conduit between the ultimate parties in the transfer; it is one of the ultimate parties in the transfer.  Yet, the security interest is being transferred to a financial institution in a transaction that is in connection with a securities contract (the LBO).  It's hard to see any policy justification for letting a financial institution benefit from a safe harbor in that situation--if you finance an LBO you shouldn't be surprised if there's subsequently fraudulent transfer litigation against you, and it's hardly going to bring down financial markets (the risk might just make lenders insist on more sustainable LBOs).

This issue remains unresolved by Merit, but the opinion's penultimate sentence is worrisome:  "Because the parties do not contend that either Valley View or Merit is a “financial institution” or other covered entity, the transfer falls outside of the §546(e) safe harbor."  The implication here is that if the ultimate recipient of a transfer is a financial institution, then no matter whether it was a mere conduit or the end recipient it is protected by 546(e).  My approach to disregarding financial institutions from 546(e) when they act as mere conduits wouldn't solve this problem; here they're not mere conduits.  Given the Supreme Court's plain language approach in Merit, I'm guessing that is how the court would ultimately rule if it ever confronted the issue, and this is what makes me feel that Merit isn't really a win for those who think fraudulent transfer law plays a critical role in ensuring fairness and constraining excessively risky gambles in financial transactions.     

Addendum:  I don't have a good response to the section 101(22)(A) definition that Jason Kilborn has highlighted. 


Curious. I thought, perhaps mistakenly, that the main reason to watch this decision was that we would get a resolution as to whether selling shareholders in an LBO can use the settlement payment safe harbor.

To me, that is the part of this situation that really gets to the core of whether fraudulent transfer law should yield to the public interest in the finality of securities transactions. The financial institution issue was an interesting sidelight, but I agree that one way or another (either as conduits or under the more esoteric reasoning the Court adopted), that issue was going to go away.

I assume that when I disagree with Adam, I'm wrong, but ... I just looked at 546(e) again, and it does NOT seem to read as I understand the opening para of Adam's post to suggest. The safe harbor applies only if the payment is BOTH a settlement payment AND is "made by or to ... a financial institution." No?

I see that there is a second safe harbor ("or that is a transfer made by or to ... [a] financial institution ... in connection with a securities contract"), but again, this safe harbor ALSO requires a connection to a financial institution.

If the selling shareholders ARE financial institutions, then I agree that they might be able to raise the defense (and perhaps always if we read the "plain language" of the definition in 101(22)(A) raised by Henry Kevane of Pachulski Stang--I can't take credit for this brilliant find). But an ordinary stockholder, without that odd definition characterizing a human as a financial institution, could not raise the 546(e) defense. What am I missing?

Jason's right. While the issue in Merit was the second safe harbor, the logic of the opinion is such that it would preclude application of the settlement payment safe harbor as well if (1) the financial intermediaries are disregarded and (2) the recipient is not itself a financial institution.

So the selling shareholders are still on the hook, but there remains the problem that the financiers of the LBOs are not.

The way I read Merit, Sotomayor intuited it as a conduit decision, and then did whatever statutory construction was needed to arrive at the chosen result. Her colleagues felt the same way: hence no concurring or dissenting opinions.

I think that the Supremes have decided that not every safe harbor is sacred, but don't want to go any further than the easiest cases. I think that they need more help from the Adam Levitins and Mark Roes and David Skeels of the world. There has been a fair amount of literature on repo safe harbors, but not enough on derivatives and oddballs like 546(e).

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