The Supreme Court’s recent decision in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018), held that transfers made by or to entities that are not “financial institutions” or other covered entities fall outside the scope of 11 U.S.C. § 546(e)’s “safe harbor” from a trustee’s avoidance powers under the Bankruptcy Code, even if those transfers are made through financial institutions or other covered entities. In a unanimous decision, the Supreme Court jettisoned the majority view adopted by the Second, Third, Sixth, Eighth and Tenth Circuits, all of which applied the “safe harbor” to transactions made through covered entities.

Merit Management involved fraudulent transfer claims brought by FTI Consulting, as trustee of a bankruptcy litigation trust, against Merit Management Group, LP to recover approximately $16.5 million paid to Merit in connection with a cash-for-stock agreement involving the sale of Bedford Downs Management Corp. to Valley View Downs, LP.

As part of its bid to secure a license to operate a “racino” in Pennsylvania, Valley View entered into a transaction to acquire Bedford Downs. This multistep transaction involved Valley View borrowing funds from Credit Suisse and other lenders, with Credit Suisse then wiring $55 million to Citizens Bank of Pennsylvania as third-party escrow agent. Bedford Downs’ shareholders, including Merit, deposited their stock certificates into escrow with Citizens and, at closing, Valley View received the Bedford Downs stock certificates from escrow, while Citizens disbursed the funds to the shareholders. Valley View and its parent company, Centaur, LLC, were later forced to file bankruptcy, and FTI, as trustee of the litigation trust created under Valley View’s and Centaur’s confirmed bankruptcy plan, sought to avoid the $16.5 million transfer that Merit received for its stock in Bedford Downs.

Merit moved for judgment on the pleadings and asserted that the $16.5 million transfer fell within the “safe harbor” of § 546(e), which exempts a “settlement payment … made by or to (or for the benefit of)” a covered “financial institution … in connection with a securities contract” from a bankruptcy trustee’s avoidance powers. Merit argued that the $16.5 million transfer was made by or to (or for the benefit of) Credit Suisse and Citizens Bank and could not be avoided even if the transfer was constructively fraudulent.

In response, FTI argued that Credit Suisse and Citizens Bank (which are “financial institutions” subject to the “safe harbor”) were mere conduits with no beneficial interest in the funds and that the transfer being avoided was really made by Valley View and to or for the benefit of Merit, entities to which § 546(e)’s safe harbor did not apply.

The District Court ruled in favor of Merit, adopting what it termed the “Majority Position” that § 546(e) barred avoidance of the $16.5 million transfer even if Credit Suisse and Citizens Bank had merely acted as an “intermediary or conduit.” See FTI Consulting, Inc. v. Merit Mgmt. Group, LP, 541 B.R. 850, 855 (N.D. Ill. 2015). On appeal, the Seventh Circuit reversed and held that § 546(e) does not protect “transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit.” FTI Consulting, Inc. v. Merit Mgmt. Group, LP, 830 F.3d 690, 691 (7th Cir. 2016). The Seventh Circuit recognized that it was adopting a “different position from the one adopted by” the Second, Third, Sixth, Eighth and Tenth Circuits, which “interpreted section 546(e) to include the conduit situation.” Id. at 697.

The Supreme Court granted certiorari to resolve the circuit split and affirmed the Seventh Circuit’s decision, finding that § 546(e)’s safe harbor did not apply to FTI’s attempt to avoid the $16.5 million transfer from Valley View to Merit for the Bedford Downs stock. Merit Mgmt. Group, 138 S.Ct. at 883. The Supreme Court’s analysis focused heavily on the text of § 546(e), which language the Court interpreted as applying “to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.” Id. at 893. The Court emphasized that § 546(e)’s reference to “a transfer that is” either a “settlement payment” or made “in connection with a securities contract” “dispels [any] doubt” that § 546(e)’s focus is on the overall transfer and not a component transfer that “involves” or “comprises” such payment. Id. at 894.

The Merit Management decision has significant potential implications for financial institutions and other parties to qualified financial contracts. In its wake, a bankruptcy trustee’s ability to avoid the overall transaction may not be precluded simply because a leg of the transaction involved a transfer to or by a financial institution or other entity covered by § 546(e). To that end, careful analysis may be warranted when parties structure a securities transaction, in order to evaluate and maximize the potential for protection under § 546(e).