Bankruptcy Safe Harbor Provisions Don't Protect Mere ‘Conduits'

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By Diane Davis

Aug. 1 — The safe harbor protection in Section 546(e) of the Bankruptcy Code doesn't protect transfers made via a financial institution when that entity is merely a conduit, the Seventh Circuit held July 28 ( FTI Consulting, Inc. v. Merit Mgmt. Grp., LP, 2016 BL 243677, 7th Cir., No. 15-3388, 7/28/16 ).

Chief Judge Diane P. Wood of the U.S. Court of Appeals for the Seventh Circuit reversed the judgment of the district court and remanded the case for a determination on the merits.

Bankruptcy Code Section 546(e) provides a safe harbor for three types of transfers — margin payments, settlement payments, and transfers in connection with certain types of contracts, according to Bloomberg Law: Bankruptcy Treatise, pt. II, ch. 74 (D. Michael Lynn et al. eds., 2016).

The Second, Third, Sixth, Eighth, and Tenth Circuits apply the safe harbor when a financial institution is nothing more than a conduit, but the Seventh Circuit rejected that approach and sided with the Eleventh Circuit in Munford v. Valuation Research Corp. (In re Munford, Inc.), 98 F.3d 604 (11th Cir. 1996).

“We will not interpret the safe harbor so expansively that it covers any transaction involving securities that uses a financial institution or other named entity as a conduit for funds,” the court said.

Two bankruptcy scholars told Bloomberg BNA that they agreed with the Seventh Circuit that there wouldn't be any “ripple effects” in the financial markets as a result of this decision.

‘Real World' Statutory Interpretation

“I think the case is extremely significant and it is the right outcome,” Robert M. Fishman of Shaw Fishman Glantz & Towbin, Chicago, told Bloomberg BNA July 29. Fishman is a member of the advisory board of Bloomberg BNA's Bankruptcy Law Reporter.

“The court elected not to take the easy way out and say ‘unambiguous language, clear meaning,'” Fishman said. “It recognized that the purpose of the statute was to protect particular parties to particular transactions, not every party to every transaction that happened to utilize a bank in some way to facilitate a transaction (which means every party to every transaction),” he said.

Right Result

“This is the right result,” because the Seventh Circuit looked to the policy behind Section 546(e), Associate Professor of Law Samir Parikh, Lewis & Clark Law School, Portland, Ore., told Bloomberg BNA Aug. 1. The other courts looked at the statute, and after determining that the language was unambiguous, they didn't look to the legislative history behind Section 546(e), Parikh said. Parikh is an editor of Bloomberg Law: Bankruptcy Treatise.

“The Seventh Circuit reasoned that since the financial institution ‘never acquired a beneficial interest in either the funds or the shares,’ it was not a ‘transferee’ as that term is used in the Bankruptcy Code, and Section 546(e) was inapplicable,” Parikh said. “That argument has been roundly criticized,” he said.

“With this ruling, the Seventh Circuit joins the Eleventh Circuit and presents a meaningful circuit split that will hopefully encourage the Supreme Court to resolve the dispute,” Parikh said.

No ‘Ripple Effects.'

Fishman agreed with the Seventh Circuit that there wouldn't be any “ripple effects” in the financial markets as a result of this decision. “The parties that Congress intended to protect in order to assure the stability of financial markets are still protected,” Fishman told Bloomberg BNA. “Now, private parties, who were never intended to be protected by Congress, are outside of the safe harbor,” he said.

“Section 546(e) was designed to protect system integrity,” Parikh told Bloomberg BNA. “But leveraged buyouts and other similar transactions present no risk to the securities markets because courts are attempting to unwind a transaction after it has successfully cleared,” he said.

“The debtor’s formers shareholders are the only affected parties,” according to Parikh. “The securities clearing system is not implicated and there is no risk that the insolvency of one firm will spread and threaten to collapse the securities industry,” Parikh told Bloomberg BNA. “The policy basis supporting Section 546(e) persuaded the Seventh Circuit to exclude the transaction at issue from protection,” Parikh said.

Lead to More Forum Shopping

“Circuit splits like this just encourage more forum shopping within a system that has almost no restrictions on the practice,” according to Parikh.

According to Parikh, “forum shopping is rampant in bankruptcy.” “Many companies acquired through leveraged buyouts (LBO) find themselves in bankruptcy,” and “more companies like them will follow,” he said. “For these companies, prior to filing, key constituencies are going to determine in which district to file their case. Many of these constituencies are invariably former shareholders (or affiliated with former shareholders) who seized a significant premium because of the LBO. You can bet they are going to ensure that their case does not get filed in the Seventh or Eleventh Circuits,” Parikh said.

“Experienced bankruptcy attorneys are going to direct these cases into the Second Circuit (most likely the SDNY), which has adopted an extremely broad reading of Section 546(e), and recently issued Deutsche Bank Trust Co. Ams. v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litig. , 2016 BL 96098, 818 F.3d 98 (2d Cir. 2016) (affirming district court ruling that Section 546(e) barred bankruptcy trustee from avoiding allegedly fraudulent transfers and estate creditors were not entitled to pursue state-law constructive fraudulent conveyance claim because such claims did not revert to them),” Parikh said.

“I don’t see a ripple effect through the financial markets from the ruling because sophisticated parties (and those are the only ones with influence in the financial markets) who could be disadvantaged by this ruling will ensure they don’t wind up in the Seventh Circuit,” Parikh said. “I can’t imagine financial institutions being overly concerned with this ruling because the money is being disgorged from former shareholders,” he said.

Avoidable Transfers?

Debtor Valley View Downs, which owned a Pennsylvania racetrack, was competing with Bedford Downs for the last harness-racing license in the state so they could operate a combination horse track and casino. Valley View and Bedford agreed to a deal in which Valley View would acquire all Bedford shares in exchange for $55 million. The $55 million transfer was to take place through escrow agent Citizens Bank of Pennsylvania. Valley View borrowed money from Credit Suisse and other lenders to pay for the shares.

After the transfer, Valley View obtained the harness-racing license, but it didn't secure the gambling license, which ultimately led it to file for Chapter 11 bankruptcy. Chapter 11 allows companies (or individuals) to enjoy protections from creditors while they seek to reorganize their debt or liquidate under a plan that must be approved by the bankruptcy court.

Plaintiff/appellant FTI Consulting, Inc., as trustee, sued defendant Merit Management Group, a 30 percent shareholder in Bedford Downs, to recover $16.5 million as an avoidable transfer under Bankruptcy Code Sections 544, 548(a)(1)(b), and 550.

The transfer at issue is either a “settlement payment” or a payment made “in connection with a securities contract,” according to the court.

Merit Management Group argued that the transfer was “made by or to (or for the benefit of)” an entity named in Section 546(e) and therefore protected under the safe harbor.

The district court agreed with Merit Management Group and prevented FTI Consulting Inc. from avoiding the transfer and recovering $16.5 million.

Statute Is Unclear

The Seventh Circuit found Section 546(e) to be unclear whether the safe harbor was meant to include intermediaries, or if it is limited to what we might think of as the “real parties in interest” — the “first and final party possessing the thing transferred.”

The court agreed with FTI Consulting Inc. that it's the economic substance of the transaction that matters.

The court rejected Merit Management Group's argument that Congress disapproved of the Eleventh Circuit's Munford by passing the 2006 amendment adding “(or for the benefit of)” language to the statute.

Congress wouldn't have “jettisoned Munford's rule by such a subtle and circuitous route,” the court said. “If Congress had wanted to say that acting as a conduit for a transaction between non-named entities is enough to qualify for the safe harbor, it would have been easy to do that. But it did not,” the court said.

Judges Richard A. Posner and Ilana Diamond Rovner joined the opinion.

Gregory S. Schwegmann, Reid Collins & Tsai LLP, Austin, Texas, represented plaintiff/appellant FTI Consulting, Inc.; Jason J. DeJonker and James B. Sowka, Seyfarth Shaw LLP, Chicago, represented defendant/appellee Merit Management Group, LP.

To contact the reporter on this story: Diane Davis in Washington at

To contact the editor responsible for this story: Jay Horowitz at

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