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FTI Consulting, Inc. v. Merit Management Group, LP: Seventh Circuit Rejects 546(e) Safe Harbor Protection for Transfers that Involve Financial Institutions that Act Only as Conduits
Practical Law Legal Update w-002-9213 (Approx. 7 pages)
FTI Consulting, Inc. v. Merit Management Group, LP: Seventh Circuit Rejects 546(e) Safe Harbor Protection for Transfers that Involve Financial Institutions that Act Only as Conduits
by Practical Law Bankruptcy & Restructuring
| Published on 15 Aug 2016 • USA (National/Federal) |
In FTI Consulting, Inc. v. Merit Management Group, LP, the US Court of Appeals for the Seventh Circuit held that safe harbor protections for transfers made "by or to (or for the benefit of)" certain financial institutions identified in section 546(e) of the Bankruptcy Code do not apply where the transaction is merely conducted through such institutions but the financial institution is neither the debtor nor the transferee.
On July 28, 2016, the US Court of Appeals for the Seventh Circuit (Seventh Circuit), in FTI Consulting, Inc. v. Merit Management Group, LP, held that safe harbor protections of section 546(e) of the Bankruptcy Code provided for transfers made "by or to (or for the benefit of)" certain financial institutions do not apply where the transaction is merely conducted through such institutions but the financial institution is neither the debtor nor the transferee ( (7th Cir. July 28, 2016)).
Background
In 2007, Valley View Downs, LP (Debtors), owner of a Pennsylvania racetrack, acquired another racetrack, Bedford Downs, in an effort to eliminate its competition to acquire Pennsylvania's last harness-racing license, and to establish a combination racetrack and gambling operation. Valley View purchased 100% of Bedford Downs' shares in exchange for $55 million. To finance the transaction, Valley View utilized Credit Suisse as a lender and Citizens Bank of Pennsylvania as escrow agent. After the sale, Valley View failed to secure a gambling license, leading them to file a Chapter 11 petition on March 6, 2010.
Under the confirmed plan of reorganization, FTI Consulting, Inc. was selected as litigation trustee. In an adversary proceeding in the US Court for the Northern District of Illinois (District Court), the litigation trustee sought to avoid the transfer made to Merit Management Group, LP (Merit), 30% shareholder of Bedford Downs, as a fraudulent transfer. Merit argued that the transaction fell under the safe harbor of section 546(e) of the Bankruptcy Code and should not be avoided because the transfers were made "by or to" a financial institution when they were financed by Credit Suisse and held in escrow by Citizen's Bank of Pennsylvania.
The District Court granted Merit's motion for judgment on the pleadings, holding that the safe harbor under section 546(e) of the Bankruptcy Code applied. Even if the involvement of the financial institutions was as a mere intermediary or conduit, the 546(e) safe harbor barred avoidance of these transfers (FTI Consulting, Inc. v. Merit Management Group, LP, 541 B.R. 850 (N.D. Ill. October 2, 2015)).
The litigation trustee appealed to the Seventh Circuit, which reviewed whether the 546(e) safe harbor provision protects transfers that are conducted through financial institutions where the institutions are neither the debtor nor transferee and act only as conduits.
Outcome
The Seventh Circuit reversed the District Court decision, and held that the safe harbor provision of section 546(e) of the Bankruptcy Code does not protect transfers that involve financial institutions that act merely as a conduit.
In reaching this decision, the Seventh Circuit analyzed:
- The language of section 546(e).
- The Congressional purpose of creating section 546(e).
- Section 546(e)'s limitation of the trustee's avoidance power.
- The division among the US circuit courts on the issue.
The Language of Section 546(e) is Ambiguous
The Seventh Circuit held the language of section 546(e) of the Bankruptcy Code, "settlement payment…made by or to (or for the benefit of)," was ambiguous as to whether or not it included transfers involving a financial institution as a mere conduit. The Seventh Circuit held the language was ambiguous because:
- "By or to" could mean any transfer where an owner of a bank account used the bank's services to transfer funds.
- "For the benefit of" could mean a transaction made on the behalf of an entity, or one involving an entity receiving a financial or beneficial interest.
Because of these ambiguities, the Seventh Circuit looked beyond the plain language of the statute for guidance as to the function of the safe harbor, including the congressional context of the enactment of the statute.
Congress Created the Safe Harbor to Protect Financial Markets
Relying on their previous ruling in Grede, the Seventh Circuit determined, after analyzing the Congressional intent of creating the safe harbor protections under section 546(e) of the Bankruptcy Code in 1982, its purpose was to protect the securities market from systemic risk and prevent a "bankruptcy from rippling through the securities industry." (Grede v. FCStone, LLC, 746 F.3d 244, 252 (7th Cir. 2014)). The Seventh Circuit held that here there was no risk of a ripple effect from returning the funds to the litigation trustee. The Seventh Circuit noted that the transfer between the Debtors and Merit resembled a leveraged buyout. While the transaction did involve the securities market, it dealt with privately held stock for an exchange of money, and neither the Debtors nor Merit were parties in the securities industry.
The Safe Harbor Limits on Avoidance Powers
The Seventh Circuit held that financial intermediaries that received no benefit from a transfer are not included as transferees under 546(e) of the Bankruptcy Code. To determine the meaning of "transferee," the Seventh Circuit analyzed the limitation that section 546(e) places on a trustee's avoidance power in the context of sections 544, 547, and 548 of the Bankruptcy Code, that describe the types of transfers a trustee has the power to avoid, as well as section 550 of the Bankruptcy Code, that describes how a trustee recovers avoidance transfers to determine the meaning of "transferee." The Seventh Circuit determined:
- Sections 544, 547, and 548 of the Bankruptcy Code permit the trustee to avoid transfers only where the debtor has an obligation to a specified entity within each section. This also applies to the safe harbor in section 546(e) and limits the avoidance power only to transfers where the debtor has incurred an obligation to a named financial institution in section 546(e).
- Section 548(c) of the Bankruptcy Code protects transferees identified in 548(d)(2)(B) who take for value and in good faith. The Seventh Circuit posited that Congress could not have intended to protect just any transfer that deposited money in a bank account. Rather, the intent was to protect a transferee who specifically takes for value. Similarly, the safe harbor protection of section 546(e) of the Bankruptcy Code protects someone who takes for value. The Seventh Circuit noted that if 548(c) merely created a transferee specific defense, any transfer that was not "done in cold hard cash" would not be avoidable.
- The charitable contribution safe harbor of section 548(a)(2) of the Bankruptcy Code, and the safe harbor from the enforcement of the automatic stay in section 555 of the Bankruptcy Code, also refer to economic transfers that are protected due to the substance of the transfers, not merely the involvement of the named entities within the sections.
- Section 550 of the Bankruptcy Code describes how a trustee can recover transfers from initial or mediate transferees. As interpreted by the Seventh Circuit in Bonded Financial, a "transferee" in section 550 is an entity with "dominion over the money." (Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890, 893 (7th Cir. 1988)). The Seventh Circuit held this definition of transferee also applies here to section 546(e).
The Seventh Circuit Disagrees with the Position of Five Other Circuits
The Seventh Circuit recognized that its opinion differed from those given by a majority of other circuit courts including the Second, Eighth, Sixth, Third, and Tenth Circuits (see In re Quebecor World (USA) Inc., 719 F.3d 94 (2nd Cir. 2013); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009); In re Resorts Int'l, Inc., 181 F.3d 505 (3rd Cir. 1999); and, In re Kaiser Steel Corp., 952 F.2d 1230 (10th Cir. 1991); also, see Legal Update, In re Quebecor World (USA) Inc.: Second Circuit Broadly Applies Section 546(e) "Securities Contract" Safe Harbor).
The Seventh Circuit noted, however, that its opinion did align with the Eleventh Circuit. In Munford, the Eleventh Circuit held that the 546(e) safe harbor did not apply when Munford made payments to its shareholders using financial institutions as conduits (Matter of Munford, Inc., 98 F.3d 604, 610 (11th Cir. 1996)). Merit argued that Congress disapproved of the Munford decision, as evidenced by their amending section 546(e) to include "(or for the benefit of)" in 2006, and the Second Circuit agreed in Quebecor. The Seventh Circuit rejected this argument, and noted that if Congress wanted to include financial institutions that were involved in these transfers as conduits it could have easily done so, and the Seventh Circuit did not believe Congress "jettisoned Munford's rule by such a subtle and circuitous route."
Practical Implications
This decision puts forward a narrower view of safe harbor protections under section 546(e) of the Bankruptcy Code than has been interpreted by the majority of other circuit courts. Without further clarification, the conflict may require the US Supreme Court to ultimately resolve the matter. Circuit courts with no existing opinion on this issue may be confronted with making the decision of whether to align with the more permissive majority of courts or the more restrictive minority in future decisions. Transferees should be wary, as this decision increases the likelihood that courts may permit avoidance of their prepetition transferred funds that use financial institutions merely as conduits.