By Daniel Gill
Bankruptcy trustees may have more opportunities to challenge leveraged buyouts. That after the Supreme Court ruled Feb. 27 defendants of fraudulent conveyance actions in bankruptcy involving transfers of securities can’t hide behind a safe harbor rule merely because banks or other financial institutions were involved in the transaction.
The unanimous decision written by Justice Sonia Sotomayor resolves a circuit split. It affirms the Seventh Circuit’s ruling that 11 U.S.C. §546(e) doesn’t apply if the banks were mere conduits to the transaction, as opposed to the original transferor or ultimate recipient.
At the same time, the decision overrules precedent set by a number of other circuits, including the Second and Third Circuits, which includes New York and Delaware, where the bulk of large business bankruptcies are filed.
“The decision has far-reaching import and makes it much more likely that a trustee will be able to successfully avoid securities transfers, including leveraged buyouts,” Charles J. Tabb, of counsel, Foley & Lardner LLP and Mildred Van Voorhis Jones Chair in Law at the University of Illinois in Champaign, Ill., told Bloomberg Law.
The decision may have profound implications in challenges to leveraged buyouts. Until now, courts in the Second and Third Circuits have cited 546(e) as a defense to challenges that LBO’s weren’t made for good consideration.
The court’s decision “will lead to new results in LBO litigation,” Samir Parikh told Bloomberg Law. Parikh is a professor of law at Lewis & Clark Law School in Portland, Ore., and an editor of Bloomberg Law: Bankruptcy Treatise.
“The court got this one right,” Robert M. Fishman told Bloomberg Law. Fishman is a bankruptcy attorney with Shaw Fishman Glantz & Towbin LLC in Chicago, and serves on the advisory board to Bloomberg BNA’s Bankruptcy Law Reporter.
“Over the years, too many ‘avoidable’ transactions have hidden behind this false defense,” he said.
FTI Consulting Inc. was the trustee of a litigating trust created by the Chapter 11 bankruptcy plan of Valley View Downs LP. Before filing bankruptcy, Valley View bought the shares of a competitor, including those held by Merit Management Group LP.
The litigation trust sued Merit to claw back the purchase price of Merit’s shares of the competitor bought by Valley View. The suit alleged that Valley View paid Merit more than the shares were worth, asserting a constructive fraud claim.
Merit asserted that it was protected by the safe harbor rule, because the transfer passed through two separate banks—one serving as the purchaser’s lender and the other operating as an escrow for the transaction.
The lower courts said that the safe harbor applied by the plain language of the statute, but the Seventh Circuit looked at the overarching transaction, which was between a non-institutional buyer and seller of stock. Because the banks were only conduits to the transaction, the safe harbor didn’t apply, it said.
The Supreme Court agreed with the Seventh Circuit. "[T]he plain meaning of §546(e) dictates that the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid,” Sotomayor wrote.
The court described the transfer here as one that went through four steps: A▸B▸C▸D, with A being the seller of the shares and D being the purchaser, and B and C being the lending bank and the escrow bank.
Ultimately the subject transfer which the trustee sought to avoid was A ▸ D, the court said. Since that transfer was not “made by or to (or for the benefit of)" an entity covered by the safe harbor exceptions of §546(e), the safe harbor did not apply.
“This is the right result looking into the legislative history behind Section 546(e),” Parikh said.
“This kind of transaction doesn’t threaten to destabilize the securities markets, the goal of 546(e),” he said.
A contrary ruling by the court could create a barrier to fraudulent transfer or preference litigation in general.
“Every transaction, almost without exception, utilizes a financial institution to move money between parties. If the section 546(e) defense were valid as attempted here, it would mean that Congress intended to shield literally every transaction from attack as a fraudulent conveyance,” Fishman said.
“If the Court had held the other way, challenged transfers involving securities transactions would have been effectively unavoidable unless made in cash,” Tabb said.
“The Court’s holding restores a semblance of sanity to the scope of the securities safe harbor,” he said.
Merit Management was represented by Brian C. Walsh, of Bryan Cave LLP, St. Louis, Mo. FTI Consulting was represented by Paul D. Clement, of Kirkland & Ellis LLP, Washington.
The case is Merit Mgmt. Grp., LP v FTI Consulting, Inc. , U.S., No. 16-784, affirmed 2/27/18 .
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