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By Prashant M. Rai
Prashant M. Rai is an associate based in the New York office of Weil, Gotshal & Manges LLP. He is a member of the Firm's Business Finance & Restructuring practice group. He received a B.A. from the University Of California, Los Angeles in 2010, and a J.D. from Columbia Law School in 2014. He is admitted to practice in California. He can be reached at email@example.com.
Leveraged buy-outs (or “LBOs”) are fundamental to the distressed debt ecosystem. As one court once described, “In a typical LBO, a target company is acquired with a significant portion of the purchase price being paid through a loan secured by the target company's assets.” In re Tribune Co. Fraudulent Conveyance Litigation, 2016 BL 96098, 818 F.3d 98, 105 n.1 (2d Cir. 2016). LBOs are by design high-risk gambits. In order to realize the higher returns that potentially follow from increasing leverage, a post-LBO company must generate cash in-flows that outpace its heightened debt repayment obligations. When the strategy fails, a deleveraging transaction becomes necessary to preserve the company as a going concern, which often takes the form of a Chapter 11 filing. Thus, one can often source a corporate bankruptcy to an LBO that fell short of aspirations.
If the company files for Chapter 11 relief, the company's creditors will conduct a close examination of the LBO (particularly the price point) to determine whether, pursuant to Bankruptcy Code Section 548(a)(1)(B) (and/or Section 544), they may bring additional value into the estate by avoiding the transaction as a constructive fraudulent conveyance. Jurisdictions split over the limits of this avoidance power with respect to LBOs, particularly over the applicability of the safe harbor contained in Bankruptcy Code Section 546(e) for certain kinds of securities transactions.
In FTI Consulting, Inc. v. Merit Management Group, LP, No. 15-3388, 2016 BL 243677 (7th Cir. July 28, 2016), the Seventh Circuit brought fresh attention to the issue by adopting a narrower view of the safe harbor than that of certain other circuits. That is, the Seventh Circuit's position aligns with the minority view, reflected in the law of the Eleventh Circuit, but lies in opposition to the law in the Second Circuit, Third Circuit, and others. In the view of this author, the Merit Management interpretation squares well with the purpose of the safe harbor and the structure of the Bankruptcy Code. Nevertheless, by rejecting the reasoning of the Second and Third Circuits, Metro Management reinforces the divide between jurisdictions, and could have significant ramifications on forum selection for LBO-related corporate bankruptcies.
Section 548 of the Bankruptcy Code provides, among other things, that a debtor may avoid as a “constructive” fraudulent conveyance any transfer of the debtor's interest in property that was made or incurred on or within two years before the filing of the petition where the debtor (i) received less than a reasonably equivalent value in exchange for such transfer or obligation and (ii) either was insolvent on the date of the transaction or became insolvent as a result of such transfer. See11 U.S.C. §548(a)(1)(B). A court may find that a failed LBO that drives a company into bankruptcy fits within this description. Therefore, without some provision that safe harbors such a transaction, the debtor (and in some instances, the debtor's creditors) may avoid the LBO and unwind the transaction.
Section 546(e) of the Bankruptcy Code potentially provides such a safe harbor. Although Section 546(e) does not extend to transactions that a debtor executes with actual fraudulent intent, it shields transactions from assertions of “constructive” fraudulence due to their failing to provide the debtor with reasonably equivalent value. Under Section 546(e), a debtor may not avoid as constructively fraudulent a transfer that is (i) a “settlement payment” or a “transfer … in connection with a securities contract,” and (ii) “made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency … .” In connection with (i), courts have stated that a “settlement” is “the ‘completion of a securities transaction,’” meaning that “payments to shareholders as part of an LBO [are] ‘settlement payments' under the statute.” In re Resorts Intern., Inc., 181 F.3d 505, 515–16 (3d Cir. 1999) (quoting Kaiser Steel Corp. v. Pearl Brewing Co., 952 F.2d 1230, 1239–40 (10th Cir. 1991). With respect to (ii), the statute lists a number of qualifying entities whose participation may safe harbor a transaction. Notwithstanding that there are significant differences between the various listed entities, for ease of reference this article will refer to all of them using the single term “financial institution,” except where expressly stated to the contrary.
In Merit Management, debtor Valley View Downs, LP applied for Pennsylvania's last available harness-racing license in order to develop a “racino” (a race track with a casino). Another company, Bedford Downs Management Company, also applied for the license. To eliminate its competition, Valley View agreed to purchase all of Bedford Downs' stock for $55 million. Merit Management Group, LP was an approximate 30% holder of Bedford Downs' stock. As part of the transaction, Credit Suisse lent Valley View certain funds to finance the transaction, and Credit Suisse and Citizens Bank served as escrow agents to facilitate the transfer of funds between Valley View and Bedford Downs' shareholders (including Merit Management).
After Valley View's purchase of Bedford Downs, the racing commission granted Valley View the harness-racing license. However, Valley View was ultimately unable to procure the gaming license needed to operate the casino portion of the establishment. The purpose of the acquisition having been frustrated, Valley View filed for Chapter 11 relief. Pursuant to Valley View's plan of reorganization, a litigation trust was formed and FTI Consulting, Inc. was selected as the litigation trustee. FTI filed an action against Merit Management pursuant to Section 548(a)(1)(B) seeking to avoid the Bedford Downs acquisition as a constructive fraudulent transfer and recover the funds paid to Merit Management in connection with the transaction. Merit Management responded that Section 546(e) protected the transaction from avoidance. First, according to Merit Management, the transaction was either a “settlement payment” or a transfer made “in connection with a securities contract.” Second, the payment was made by or to a financial institution because Valley View transferred the funds to the shareholders through Credit Suisse and Citizens Bank, which are financial institutions within the meaning of the statute.
FTI did not dispute that the transfer of funds from Valley View to Merit Management (through Credit Suisse and Citizens Bank) constituted a “settlement payment” or a transfer “in connection with a securities contract,” or that Credit Suisse and Citizens Bank were financial institutions. Instead, FTI argued that the transfer of funds was not “made by or to (or for the benefit of) … a financial institution,” because the transaction was in substance between Valley View and the shareholders of Bedford Downs, neither of which were financial institutions. Therefore, the dispute centered on whether the transfer of funds from Valley View to Bedford Downs through Credit Suisse and Citizens Bank as escrow agents was made “by or to (or for the benefit of)” those institutions.
Against this backdrop, a brief digression is appropriate to discuss the analysis of the previous courts to address this section of the statutory language.
Prior to Merit Management, the Eleventh Circuit was the only court of appeal to take the position that Section 546(e) does not safe harbor LBOs like the one at issue in Merit Management. In Matter of Munford, Inc., 98 F.3d 604 (11th Cir. 1996), the court considered the applicability of Section 546(e) to the following transaction. The Panfida Group offered to purchase all of the stock of Munford, Inc., an operator of specialty retail stores. Munford agreed to the transaction, and Panfida partnered with Citigroup for financing. Pursuant to the merger agreement, Panfida would deposit the funds to purchase Munford's stock with Citizens & Southern Trust Company, a financial institution. Citizens & Southern would distribute the funds to Munford's shareholders, and the shareholders' ownership interest in Munford would be extinguished. Munford and Panfida would then merge into one corporation. Panfida and Munford completed the LBO in the form described, and thirteen months after the transaction, the post-merger corporation filed for Chapter 11 relief.
The debtor filed an adversary proceeding in the Bankruptcy Court seeking to avoid the transfer of funds to certain of Munford's shareholders as a constructive fraudulent conveyance. Those shareholders defended on the theory that Section 546(e) safe-harbored the LBO because Panfida transferred the funds to, and the shareholders received the funds from, Citizen & Southern, undisputedly a financial institution. The debtor did not deny that the transfer of funds was a settlement payment, and did not deny that Citizens & Southern was a financial institution. Nevertheless, the debtor contended that the transfer of funds was not “made by or to a … financial institution,” because Citizens & Southern was merely a conduit to effectuate a transaction that was in substance between Panfida and Munford's shareholders.
The court agreed with the debtor. Conceding that a “financial institution was presumptively involved in this transaction,” the court noted that “the bank here was nothing more than an intermediary or conduit.” Id. at 610. Therefore, the court held that Section 546(e) did not safe harbor the transaction because “the bank never acquired a beneficial interest in either the funds or the shares.” Id.
Since the Eleventh Circuit rendered its opinion in Munford, both the Second and the Third Circuit repeatedly addressed the same issue. Both took the opposite view of the Eleventh Circuit.
In In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013), the Second Circuit considered a company's prepayment of certain of its outstanding notes. To execute the transaction, the company transferred funds to CIBC Mellon Trust Co., a financial institution within the meaning of Section 546(e), which received the funds and then distributed them to the company's noteholders. Less than 90 days after making the payment, the company filed for Chapter 11 relief. After the company entered into Chapter 11, the unsecured creditors' committee sought to avoid the transactions as preferential payments under Section 547 of the Bankruptcy Code. The power to avoid transfers as preferences under Section 547, like the constructive fraudulent transfer avoidance power under Section 548(a)(1)(B), is subject to the Section 546(e) safe harbor.
The company asserted that Section 546(e) protected the prepayments from avoidance. As an initial matter, the court noted that the payment constituted a “transfer … in connection with a securities contract.” Therefore, the question was, like in Merit Management and in Munford, whether the debtor's transfer of funds to the noteholders through a financial institution was “made by or to (or for the benefit of) a … financial institution.” Unlike the Eleventh Circuit in Munford, the Second Circuit answered this question in the affirmative, and held that the transaction was within the scope of the safe harbor.
First, the court noted that the statute explicitly phrases its participation requirement for financial institutions in the disjunctive (“made by or to ( or for the benefit of) … a financial institution”). From this, the court inferred that a transaction made “by” a financial institution need not also be “for the benefit of” that financial institution to warrant protection under the safe harbor.
Second, the court discussed the purpose of Section 546(e). Quoting its earlier decision in In re Enron Creditors Recovery Corp., 651 F.3d 329 (2d Cir. 2011), the court stated:
Quebecor World, 719 F.3d at 100 (quoting Enron, 651 F.3d at 334 (internal citations omitted)).
Similar to Quebecor, in Enron, the court held that the safe harbor applied to certain of Enron's redemption payments to noteholders prior to the notes' maturity date on the theory that Enron conducted the transactions through a financial institution. The court so held notwithstanding that the financial institution merely “acted as a conduit and record keeper” and did not take title to the securities during the transaction. In analogizing to the LBO cases, the Enron court reasoned that unwinding the redemption payments would have a “substantial impact on the stability of the financial markets … even though only private securities were involved and no financial intermediary took a beneficial interest in the exchanged securities . . . .” Enron, 651 F.3d at 338. Similarly, the Quebecor court observed, “A transaction involving one of these financial intermediaries, even as a conduit, necessarily touches upon these at-risk markets.” Quebecor, 719 F.3d at 100. Therefore, the Second Circuit, both in Enron and Quebecor, concluded that Section 546(e)’s purpose calls for it to safe harbor transactions even where a financial institution lacks a beneficial interest in the transaction.
The Second Circuit has continued to develop its view since its rulings in Enron and Quebecor. Just one day prior to the Seventh Circuit's decision in Merit Management, the Second Circuit further opined on the purpose behind Section 546(e) in In re Tribune Company Fraudulent Conveyance Litigation, 818 F.3d 98 (2d Cir. 2016). In Tribune, the procedural posture differed from that of Merit Management and the other cases previously discussed herein, and a federal avoidance action was not before the court. Nevertheless, the court suggested that “[s]ection 546(e)’s language clearly covers payments … by commercial firms to financial intermediaries to purchase shares from … shareholders.” Id. at 120.
As a general matter, in line with Quebecor and Enron, the court observed that the purpose of the safe harbor was to provide for the stability of the financial markets. The court noted that in the “narrowest” of senses, this means protecting financial institutions from avoidance claims. Id. at 119. However, the court also stated that Congress meant for the safe harbor to extend to protect transactions where a financial institution served no other purpose than as an intermediary.
The appellants (the defendants in the underlying fraudulent transfer actions) observed that avoidance actions that seek the return of funds from shareholders do not expose a financial intermediary to any avoidance risk. Thus, where a financial institution's role is merely as an intermediary, the main purpose of Section 546(e), to protect financial institutions from avoidance risk, is not implicated.
The court disagreed. The court conceded that there is evidence in the legislative record that Congress' initial concern was the effect that one financial institution filing for bankruptcy could have on other financial institutions. However, the court noted that the legislative history also “reflects a concern over the use of avoidance powers not only after the bankruptcy of an intermediary, but also after a ‘customer’ or ‘other participant’ in the securities markets enters bankruptcy.” Id. at 120. From this, the court inferred that Section 546(e) should apply even where an avoidance action seeks the return of funds only from shareholders.
With respect to the court's position in this regard, it is not clear why it follows from the legislative record's references to the bankruptcies of customers that Section 546(e) should apply even to transactions that do not expose financial institutions avoidance risk. The record could mean that Congress intended for the safe harbor to apply to circumstances when the customer of a financial institution transacts directly with the financial institution (and not merely with some other party, using the financial institution a conduit), and the customer files for bankruptcy, thus exposing the financial institution to avoidance risk. The court did not address this consideration.
The court also reasoned that Section 546(e)’s language reflects a purpose of “enhancing the efficiency of securities markets in order to reduce the cost of capital to the American economy.” Id. at 121. To allow the avoidance of securities transactions “would create substantial deterrents … to investing in the securities market.” Id. Investors “would have to confront a higher degree of uncertainty … as to the consummation of securities transfers,” and would have to set aside reserves when they sell stock in a company in case that company ultimately enters bankruptcy. Id. On these grounds, the Tribune court implied that Section 546(e) may safe harbor securities transactions that use financial intermediaries.
The court may have overstated this risk. As a matter of accounting principles, a firm must only set aside a reserve for avoidance claims if the risk of loss reaches a certain probability threshold. Thus, assuming that the firm is not also a creditor of the bankrupt entity, the firm must only set aside reserves if there is a certain probability that the firm engaged in a fraudulent conveyance with the bankrupt entity, and that too, only for the statutory time period. Moreover, the court may not be correct that the appellant's view of the statute, if adopted, would increase the cost of capital to investing in the securities markets. One could argue that expanding the safe harbor to transactions that use financial intermediaries only shifts the cost of capital from participants in the equity markets to participants in the debt markets. The broader the safe harbor, the more potential debt investors must account for the risk that the debt issuer will engage in preference payments or fraudulent transfers prior to filing for Chapter 11 relief.
Notwithstanding these concerns, the Third Circuit has adopted the same view as the Second Circuit and has rejected the Eleventh Circuit's reasoning in Munford. In In re Resorts Intern., Inc., 181 F.3d 505 (3d Cir. 1999), the debtor corporation merged with another entity as part of an LBO and then subsequently filed for bankruptcy. The debtor sued former shareholders of the other merger party to recover its losses in connection with the transaction. One of the theories that the debtor advanced was that the transaction was avoidable as a constructive fraudulent conveyance. The shareholders argued that Section 546(e) safe-harbored the transaction because the debtor transferred the funds to the shareholders through Chase Manhattan Bank and Merrill Lynch. There was no dispute that the financial institutions lacked a beneficial interest in the transaction and served merely as intermediaries.
The debtor urged the court to adopt the Munford reading of the statute. The court, however, was persuaded by the Munford dissent. To the court, the statute's language was plain, and did not require that a financial institution be the ultimate buyer or seller in an LBO in order to safe harbor the LBO from avoidance. The court therefore applied the safe harbor, and did not avoid the transaction.
In sum, both the Second and the Third Circuits, two circuits where many of the largest corporate bankruptcies are filed, have rejected the Munford view and have suggested that securities transactions like LBOs that use financial intermediaries may enjoy avoidance protection under Section 546(e).
Several other circuits concur with the Second and Third Circuits on this issue. See, e.g., In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); Kaiser Steel Corp. v. Pearl Brewing Co., 952 F.2d 1230 (10th Cir. 1991). The arguments advanced in those opinions are similar to those made by the Second and Third Circuits and discussed herein. For brevity, this article does not discuss those opinions separately.
To refresh, there was no dispute in Merit Management regarding whether Valley View's payment to Merit Management, as former shareholder of Bedford Downs, was a “settlement payment” or was a transfer “in connection with a securities contract.” The only issue was whether the use of Citizens Bank and Credit Suisse as conduits for the transfer of funds qualified the transaction as one “made by or to (or for the benefit of) a … financial institution.”
In analyzing the issue, the district court first acknowledged the existence of a split of authority, noting that the Seventh Circuit had yet to adopt a view on the proper construction of this particular statutory phrase. However, the court was able to point to its previous decision in Grede v. FCStone, LLC, in which it opined on the purpose behind Section 546(e):
FTI Consulting, Inc. v. Merit Management Group, LP , 541 B.R. 850, 855 (N.D. Ill. 2015) (quoting Grede v. FCStone, LLC, 746 F.3d 244, 253 (7th Cir. 2014)).
With this purpose in mind, the district court ultimately rejected the Munford line of reasoning. Although the court eschewed applying a “wooden textualism to the issue,” the court nevertheless noted that “the text is what it is and must be applied whether or not the result seems equitable.” Id. at 854–55. According to the court, the conclusion was inescapable that the transfers were made “by or to” a financial institution because Credit Suisse and Citizens Bank transferred or received funds in connection with the transaction.
FTI argued to the district court that this interpretation would render a nullity Section 546(e)’s requirement that a transaction involve a financial institution, because “it is difficult to imagine circumstances where a ‘settlement payment’ or ‘a transfer in connection with a securities contract’ does not somehow involve … the debtor's or transferee's bank.” Id. at 859. The court found this unpersuasive because a “court cannot use its own assessment of Congressional intention to rewrite the words in” the statute. Id. The district did not appear to assign much weight to the portion of the above-quoted language in Grede that emphasized the problems that a liquidity shortfall can create for a commodity broker or other securities business. It would seem that an avoidance suit aimed at a common shareholder, not at a financial intermediary, would not implicate this concern. Nevertheless, the district court ultimately concluded that Section 546(e) safe-harbored the transaction.
After the district court ruled in favor of Merit Management, FTI appealed to the Seventh Circuit. The gateway issue for the court was whether the statutory language was unambiguous. The district court assumed that it was plain that the transaction at issue constituted a transaction made either “by or to” Credit Suisse and Citizens Bank. The district court, in fact, rejected FTI's arguments regarding legislative history on the theory that when a statute's language is plain, it must be followed, equities be damned. The Seventh Circuit disagreed. The court reasoned that “[i]t is impossible to say in the abstract what the … words ‘by or to,’ mean here … a postcard sent through the U.S. Postal Service could be said to have been sent ‘by’ the Postal Service or ‘by’ the sender who filled it out.” FTI Consulting, Inc. v. Merit Management Group, LP, No. 15-3388, 2016 BL 243677 (7th Cir. July 28, 2016). Thus, unlike the district court, the Seventh Circuit did not feel bound to disregard FTI's arguments regarding the context, structure, and purposes behind the Bankruptcy Code because the existence of “multiple plausible interpretations require[s] us to search beyond the statute's plain language.” Id.
Against this backdrop, the court pointed out a number of other provisions that would either be rendered superfluous or absurd under the district court's reading of Section 546(e). The court also discussed the legislative history behind the provision. The court observed that “the safe harbor's purpose is to ‘protect the market from systemic risk and allow parties in the securities industry to enter into transactions with greater confidence’—to prevent ‘one large bankruptcy from rippling through the securities industry.’” Id. at *5 (quoting Grede, 746 F.3d at 244). However, the court did not view the function of Section 546(e) as protecting all securities transactions that are executed through financial intermediaries. “The safe harbor has ample work to do when an entity involved in the commodities trade is a debtor or actual recipient of a transfer, rather than simply a conduit of funds.” Id. at *5.
The court also reasoned that the facts of the case before it demonstrated that their interpretation would not expose the financial markets to the potential domino effect that worried Congress. “Valley View's bankruptcy will not trigger bankruptcies of any commodity or securities firms … there is no evidence that it would have any impact on Credit Suisse, Citizens Bank, or any other bank or entity named in section 546(e).” Id. at *6.
Therefore, the court reversed the district court and held that Section 546(e) does not safe harbor securities transactions in which a financial institution's only role is that of a conduit of funds. “Valley View [and] Merit were … simply corporations that wanted to exchange money for privately held stock … . We will not interpret [section 546(e)] so expansively that it covers any transaction involving securities that uses a financial institution … as a conduit … .” Id.
Given the stakes, it is important to try to account for why courts disagree so strongly regarding the scope of Section 546(e). One explanation might point to the various courts' disparate views on the policy behind the provision. In Merit Management, the court described Section 546(e) as aimed at minimizing a narrow, specific risk. That is, financial institutions engage in thousands of securities transactions with an innumerable number of parties, including one another, on a daily basis. If a market participant files for bankruptcy, a financial institution that conducts business with the debtor becomes exposed to the risk that the debtor may avoid their transactions. The size of the impact on the financial institution could magnify if the debtor's financial distress is tied to a larger market trend that affects multiple parties in the market. Such a phenomenon could push the financial institution to enter bankruptcy itself. If the financial institution files for bankruptcy, then it may file avoidance actions against the other financial institutions that it trades with, potentially causing a domino effect of bankruptcies, and risking the collapse of the financial markets.
The Merit Management court viewed Section 546(e) as responsive to this risk in two ways: (1) by protecting a financial institution from avoidance actions filed by its securities transaction counterparties when the counterparties file for bankruptcy, and (2) protecting a financial institution's counterparties from such avoidance actions when the financial institution files for bankruptcy, in order to encourage market participants to continue to transact with such financial institutions in times of financial uncertainty. However, the avoidance of a transaction between two non-financial institutions, where a financial institution served only as an intermediary, would not expose the financial institution to the same risk. Therefore, the Merit Management court did not view Section 546(e) as protecting transactions between two non-financial institutions where the financial institution's only role is that of an intermediary, because such transactions do not implicate the policy behind Section 546(e), as viewed by the court.
In contrast, the Second and Third Circuit seem to assign a broader purpose to Section 546(e). According to these circuits, as best articulated in the Second Circuit's decision in Tribune, the purpose of Section 546(e) is not just to protect against one bankruptcy in the financial services industry from causing a ripple effect of additional bankruptcies in the sector, but also generally to promote certainty and stability in the financial markets. That is, the financial markets depend upon the certainty and finality of securities transactions. Exposing market participants to the risk that their trades may be unwound increases the cost of capital associated with investing in the securities markets and deters market participation.
Thus, for the Second and Third Circuits, it may not be enough to safe harbor transactions where a financial institution is one of the transacting parties. It seems as though these circuits would safe-harbor certain securities transactions that use financial intermediaries as well. The Tribune court observed that the financial markets rely on the use of financial intermediaries to efficiently broker transactions between market participants, so the rule should encourage the use of financial intermediaries rather than deter it. See Tribune, 818 F.3d at 119.
Ultimately, although the Second and Third Circuit's suggestions regarding the proper construction of Section 546(e) are well-reasoned, this author's view is that both the statutory text and the Bankruptcy Code's structure support the Merit Management construction.
First, as a matter of statutory construction, it is canonical that courts should read a statute so as not to render any statutory language superfluous. See Quebecor, 719 F.3d at 99–100 (citing Marx v. Gen. Revenue Corp., 133 S.Ct. 1166, 1177–78 (2013)). Applying this rule, it does not seem as though the Second and Third Circuit assign much weight to the list of qualifying entities in the statute. As discussed previously, virtually all securities transactions between sophisticated parties use a financial intermediary of some sort. And, for those rare securities transactions that do not, in most cases it would not add significant cost for the parties to include one. Therefore, if extended to logical conclusion, the Second and Third Circuit view in effect may protect (or offers the opportunity for protection to) substantially all securities transactions, regardless of whether the transacting parties are financial institutions. However, it seems as though if Congress wished to protect all securities transactions, they could have written the statute in a much simpler way. The fact that Congress included in the statute a lengthy list of qualifying entities suggests that it wanted the list to have some effect, which is a notion for which the Second and Third Circuits have failed to adequately account.
The Second and Third Circuits have argued that the Merit Management view ignores the plain language of the statute because of the use of the word “or” preceding the phrase “for the benefit of.” Put differently, these courts have argued that if Congress wanted to require that a financial institution have a beneficial interest in the transaction for the safe harbor to apply, it would have used the word “and” instead of “or.” There are two problems with this argument.
First, the words “by or to,” as they are used in the statute, are ambiguous. The Seventh Circuit correctly pointed out in Merit Management that it is impossible to know the meaning of “by or to” without additional context. To use the court's example, consider the transmission of a piece of mail. One could say that the piece of mail is sent “by or to” the sender and the recipient. However, it is just as easy to say that the same piece of mail is sent “by or to” the Post Office. The former interpretation looks at where the piece of mail's journey begins and ends. The latter looks at who physically exchanges the piece of mail. Neither interpretation is more or less consistent with the plain language of the phrase. Thus, it is reasonable to believe that for a payment to be made “by or to” a financial institution, the financial institution must be one of the transacting parties and cannot simply be an intermediary. See Merit Management (“The . . . transfer … was not a transfer made on behalf of a debtor by a third party; rather, it was one made by the debtor using a bank as a conduit.”).
Second, the Merit Management view is consistent with Congress' use of the disjunctive preceding the phrase “for the benefit of.” Congress could have meant the phrase “for the benefit of” to encompass situations where a non-financial institution makes a payment on behalf of a financial institution where the financial institution has a vested interest in the transaction. Congress would have wanted to include such transactions under the safe harbor. If a third-party payor transfers funds to a payee for the benefit of a financial institution, then in most cases the payee will provide or have provided the financial institution with some consideration in exchange (and the financial institution will provide or have provided consideration to the third-party payor). If the third-party payor then files for bankruptcy and seeks to avoid the payment, then it seems likely that the payee will attempt to recover its consideration from the financial institution. Therefore, including these types of transactions within the ambit of the safe harbor is consistent with the statute's purpose of protecting financial institutions from the financial costs that accompany avoidance actions. In addition, transactions of the type just described are transactions where Congress would want counterparties to have confidence in their certainty because they are in effect transactions with the financial institution itself, and there is no disagreement that one of the purposes of Section 546(e) is to encourage market participants to continue to transact with financial institutions in times of financial uncertainty.
In sum, the Merit Management view appropriately accounts for the disjunctive preceding the phrase “for the benefit of,” and assigns independent significance to each of the statute's clauses.
In addition to the internal structure of Section 546(e), the structure and purposes of the Bankruptcy Code as a whole lend support to the Merit Management interpretation. As a matter of statutory construction, “courts must interpret a ‘statute as a symmetrical and coherent regulatory scheme, and fit, if possible, all parts into an harmonious whole.”’ Merit Management (quoting Davis v. Michigan Dep't of Treasury, 489 U.S. 803, 809 (1989)). Thus, courts must account for the effect that their construction of Section 546(e) will have on the other provisions in the Bankruptcy Code.
The avoidance power is an essential tool of a debtor in possession to protect its various creditor constituencies. Section 547, for example, allows a debtor in possession to avoid prepetition payments to creditors that, if left untouched, could potentially undermine the equal treatment of similarly situated creditors and/or the priority that senior creditors enjoy over junior creditors. Section 548(a)(1)(B) allows a debtor in possession to avoid certain transfers where the debtor received less than reasonably equivalent value and the debtor was either insolvent on the date of the transaction or became insolvent as a result of the transaction. When a corporation is insolvent or is contemplating a transaction that may result in insolvency, the debtor owes a duty to preserve value for its creditors. Therefore, the Bankruptcy Code contemplates that the debtor should be able to unwind transactions that allow value to escape the estate to the detriment of the debtor's creditors.
Section 546(e) should not be read so broadly so as to allow the debtor and its prepetition securities contract counterparties to easily structure transactions so as to escape the avoidance power. The Second and Third Circuit view seems to imply that these parties need only include two elements in order to safe-harbor a transaction. First, the transfer must be in connection with a securities contract ( e.g., cash for stock, rather than cash for assets such as real or intellectual property). Second, the transfer must be made through a financial intermediary such as a paying agent or a depository. Generally, neither of these elements will be cost-prohibitive, and to the extent there are associated costs, it will be uncommon that they will exceed the costs associated with the unwinding of the transaction altogether that would result from a successful avoidance action.
Therefore, the Second and Third Circuit view of Section 546(e), if extended, may allow the safe harbor to swallow the rule itself. This occurs across two dimensions. First, virtually every securities transaction can be accomplished through a financial intermediary. It is not difficult to include a financial intermediary as part of the structure of a transaction. The Seventh Circuit alluded to this fact in Merit Management, stating, “Merit's preferred interpretation would be so broad as to render any transfer [in connection with a securities contract] non-avoidable unless it were done in cold hard cash … .” Merit Management. Second, many transactions that are not at their core securities-related can be structured using securities. Consider, for example, a debtor purchasing real estate for cash. Without Section 546(e) protection, this transaction might be avoidable as a constructive fraudulent conveyance if the real estate was not reasonably equivalent in value to the cash that the debtor paid, and the parties consummated the transaction while the debtor was insolvent (or the debtor became insolvent as a result of the transaction). If Section 546(e) does not require that a financial institution enjoy a beneficial interest in the transaction, a seller can easily demand a structure that will minimize avoidance risk. Instead of transferring title to the real estate directly to the debtor, the seller can create a NewCo, transfer the real estate to the NewCo tax-free, and then transfer the stock in the NewCo to the debtor. Then, if the debtor uses a paying agent to transfer the cash in exchange for the NewCo stock, the transaction becomes unavoidable, even though the economic substance of the transaction remains unchanged. There is nothing in the legislative history to suggest that Congress intended Section 546(e) to protect such transactions, or to encourage contract counterparties to structure transactions in this way.
It is important to recognize that, regardless of the merits of the competing positions, the court's ruling in Merit Management creates a significant difference in law between the circuits that in certain cases may serve as one of the primary deciding factors in selecting a forum for a Chapter 11 filing. A debtor that wants to file an avoidance action against its LBO counterparties may wish to file in the Seventh or Eleventh Circuits. As a corollary, if a debtor is in discussions with a set of creditors regarding a potential deleveraging transaction, and those creditors would like the LBO avoided, those creditors may pressure the debtor to file in the Seventh or Eleventh Circuit. Conversely, if the debtor is in discussions with a set of creditors that want to protect the LBO ( e.g., because they were the debtor's counterparties in that transaction), those creditors may require that the debtor steer clear of the Seventh and Eleventh Circuit in favor of circuits with a broader view of the Section 546(e) safe harbor. From the perspective of uniformity of law and minimization of forum selection, this is an issue at which the United States Supreme Court may want to take a close look.
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