The U.S. Supreme Court decision in Merit Management v. FTI Consulting may prove important to distressed asset managers, who need to know when defendants can assert the protection of the “safe harbor” provision of federal bankruptcy law, thus avoiding clawbacks.
Section 546(e) of the statute says that a debtor may not avoid a transfer that is “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 a securities contract.” The idea is to protect the securities and commodities markets from the disruptions that clawbacks could otherwise create there.
The language can be interpreted either broadly or narrowly, especially in the context of private securities transactions. The broader reading is the more literal, the narrower reading is the more contextual. Most of the circuits that have looked at this have decided to understand the language broadly, so the safe harbor has been growing in importance over time.
The Seventh Circuit
Yet not all circuits agreed. The Seventh Circuit, in particular, found that the pass through of a security through a financial institution not not trigger 546(e). So it allowed an avoidance action to proceed.
The case involved a racetrack operator, Valley View Downs LP. Before seeking bankruptcy court protection, Valley bought some of the equity of another racetrack, Bedford Downs, through a leveraged buyout ($55 million) arranged by Credit Suisse.
Citizens Bank of Pennsylvania, escrow agent, held the Bedford Downs shares.
After the bankruptcy, FTI, as litigation trustee, initiated a fraudulent transfer action against Merit, which held a 30% stake in Bedford Downs. The trustee sought Merit’s portion of the proceeds from the equity purchase. Merit claimed the safe harbor, on the grounds that the transaction was made “by or to:” financial institutions, in this case both Credit Suisse and Citizens Bank, and thus the transaction qualified for safe harbor treatment under a broad (and literal) reading of the statutory language. That meant the Seventh Circuit–which takes in the federal districts in Wisconsin, Indiana, and Illinois–was at odds with the other circuits, adopting a narrow reading of the language.
The Court of Appeals’ decision in Merit looked to the purpose of the statute to define its meaning. The purpose, it said, was 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.” The involvement of the financial institutions in this transaction, it thought, was incidental to the private exchange of cash for stock, which consequently must take its chances in the storm outside of the safety of harbor.
A Unanimous SCOTUS
In the face of this conflict among the circuits the Supreme Court agreed to hear Merit. Its decision, in late February upheld the Seventh Circuit, and it suggests that it thinks the safe harbor has gotten too large, and safe, at the hands of the other Circuits.
Kleinberg Kaplan, in a memorandum on Merit emailed to clients, has summarized the likely effect of the decision this way: “clawback plaintiffs will likely look to structure their complaints with an eye to whether prospective defendants are safe harbor protected entities. Parties to transactions involving securities will look to structure their transactions to maximize the likelihood that the safe harbor will provide protection against prospective clawback attack.”
The Supreme Court was impressively united on this, 9-0. Justice Sotomayor writing for the court.
Big Picture Readings?
In jurisprudential terms the decision might be seen as an adverse comment on literalism. Words don’t necessarily meant precisely what they say. Not only is context important, but the word “context” as it is so often used in such assertions is itself multi-faceted. A transfer, Sotomayor tells us, is not made “by” a financial institution if the institution in question is a mere conduit.
In policy terms, the SCOTUS decision may make it easier for trustees to challenge LBOs that then end up in the bankruptcy courts, a fairly common event. But some time will have to pass, the courts below will have to develop a track record in applying Merit, before one will really have a sense of whether this is a watershed or a footnote.