Supreme Court Set for Argument in ‘High Stakes’ Bankruptcy Case

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By Daniel Gill

The U.S. Supreme Court will hear arguments Nov. 6 in a “high stakes” case that may affect whether financial transactions that underpin corporate buyouts that are mostly debt financed can be challenged later if the acquisition fails and winds up in bankruptcy court.

The question that has produced a deep circuit split is whether the “safe harbor” rule, 11 U.S.C. §546(e), prevents a bankruptcy trustee from suing to “claw back” or undo the pre-bankruptcy sale of stock deemed fraudulent when the transfers were made through banks even if they acted simply as conduits ( Merit Mgmt. Grp., LP, v. FTI Consulting, Inc. , U.S., 16-784, Review Granted 5/1/17 ).

The court will decide if the section prohibits those kinds of avoidance actions by trustees even when the financial institutions are not defendants or at risk of any order for recovery, or when they don’t have a beneficial interest in the transfer.

The Seventh Circuit said that trustees can go after the money in those cases. Some bankruptcy law scholars predict high-court reversal of that decision based on a “misguided” plain language reading of the statute. But they warn that such a ruling would be contrary to the purpose of the section in play here and the overall Bankruptcy Code.

Important Question

“The case is very important for bankruptcy practitioners, as it raises the larger question of whether securities buyouts can ever be avoided,” Charles J. Tabb, of counsel, Foley & Lardner LLP and Mildred Van Voorhis Jones Chair in Law at the University of Illinois, Champaign, Ill., told Bloomberg Law in an Oct. 22 email.

The National Association of Bankruptcy Trustees emphasized in an amicus brief the significance of the ruling for creditors.

“A trustee’s ability to recover a constructively fraudulent transfer is often the creditors’ only hope for a meaningful recovery, and the Court’s decision will have a dramatic effect on the ability of amicus’ members to achieve that central objective of the Bankruptcy Code,” the association wrote in its brief.

The issue is prominent in leveraged buyout cases, where the purchase of a company is basically financed by the assets of the purchased company.

Reversal by the justices “would prevent a trustee from attempting to unwind a failed leveraged buyout, even when it is a purely private transaction, as most are,” the trustees association said.

“Encumbering a company’s assets to finance its own acquisition poses a unique hazard to unsecured creditors,” it said.

“The stakes are high,” Prashant M. Rai told Bloomberg Law in an Oct. 20 email. Rai is a restructuring attorney at Weil, Gotshal & Manges LLP, New York. He’s written a Bloomberg Law Insights article on the issue.

“The Supreme Court needs to resolve the split of authority to discourage forum-shopping,” he said.

“An affirmance of the Seventh Circuit by the Supreme Court certainly will cause a stir with the New York and Delaware bankruptcy bars,” where most large commercial cases are heard, he said.

The Transfer in Question

The case stems from a dispute between two companies hoping to create a “racino"—a race track and casino—in Pennsylvania.

Valley View Downs L.P. and Bedford Downs Management Corporation both sought the last state license available for harness racing. They each opposed the granting of the license to the other.

Valley View Downs eventually agreed to buy Bedford Downs stock so it could pursue the license unopposed. Merit Management Group L.P., the petitioner in this case, owned about 30 percent of Bedford Downs.

In a transaction that originated with Credit Suisse, as a lender to Valley View, about $16.5 million passed through an escrow held by Citizens Bank of Pennsylvania to Merit Management for its shares in Bedford Downs.

Valley View got the harness racing license, but it couldn’t secure a gaming license for the casino and wound up filing Chapter 11.

A reorganization plan was confirmed, and FTI Consulting Inc. became trustee of a litigation trust. That trust sued Merit Management to recover the $16.5 million it received as a constructive fraudulent conveyance.

The legal theory was that Merit didn’t give reasonably equivalent value for the payment, and that the transfer occurred when Valley View was insolvent, or it was rendered insolvent by the transfer.

The Safe Harbor

Merit Management answered that Section 546(e) of the Bankruptcy Code was a defense to the action. That section provides that a settlement payment made “by or to (or for the benefit of)" certain protected financial institutions can’t be sued for constructive fraudulent conveyances (as opposed to cases of intentional fraud).

Even though the parties to the transfer were Valley View as the purchaser of the Bedford Downs stock and Merit Management as the seller, Merit Management argued that because both Citizens and Credit Suisse are protected financial institutions, the Section 546(e) safe harbor applies to bar the action.

The Seventh Circuit disagreed and held that where the financial institutions are mere conduits of the transaction, the safe harbor would not bar the action against the defendant.

That decision put the circuit at odds with other circuits considering the question, including the Second, Third, Sixth, Eighth and Tenth Circuits. The Eleventh Circuit agreed with the Seventh.

“The Second and Third Circuits house many of the largest corporate bankruptcies. Therefore, if the Supreme Court adopts the minority view of the statute, many noteworthy transactions will come under scrutiny that previously would have fallen within the safe harbor,” Rai said.

A Plain Language Analysis

“I think that the Supreme Court will reverse the Seventh Circuit, based on a misguided plain language reading of Section 546(e),” Tabb said.

“The problem is, this reading makes absolutely no sense whatsoever,” he said. “The qualifying financial entities for whom the safe harbor is written are dissociated entirely from the transfer sought to be avoided. None of those financial entities is a target of the avoidance or subject to any risk of recovery,” he said.

“To give a private non-financial party (like Merit), who is not in any way an intended beneficiary of the safe harbor, immunity under that safe harbor because of the happenstance that a qualifying entity was somewhere in the chain of transfers, is absurd,” Tabb said.

But apparently such an absurd result is likely, as experts expect the Supreme Court to favor a plain reading of the language.

The court should reverse the Seventh Circuit because the language is clear and unambiguous, Samir Parikh told Bloomberg Law Oct. 24. Parikh is a professor of law at Lewis & Clark Law School, Portland Ore. There’s nothing in the statute that suggests that the financial institution has to have a beneficial interest in the transfer, he said.

Unfortunately, the clear language doesn’t comport with what the legislative history suggests the law was designed to do, Parikh said. Parikh is an editor of Bloomberg Law: Bankruptcy Treatise.

Purpose of the Safe Harbor

Congress enacted the section to protect the nation’s financial markets from the instability caused by the reversal of settled securities transactions. It was intended to minimize the displacement caused in commodities and securities markets in the event of a major bankruptcy affecting the industries and to prevent the ripple effects created by the insolvency of a commodities or securities firm from spreading to others and possibly threatening the collapse of the affected industry, according to Bloomberg Law: Bankruptcy Treatise, pt. II, ch. 74 (D. Michael Lynn et al. eds., 2017).

And significantly, there’s nothing to suggest that the law was intended to protect shareholders enriched by failed leveraged buyouts.

“LBO’s should be subject to fraudulent transfer law, but I don’t think the court can get there,” Parikh said. “The language of the statute is too clear; there are no grounds to look at the legislative history,” he said.

Merit Management is represented by Brian C. Walsh, of Bryan Cave LLP, St. Louis, Mo. FTI Consulting is represented by Paul D. Clement, of Kirkland & Ellis LLP, Washington.

To contact the reporter on this story: Daniel Gill in Washington at

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

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