Bankruptcy trustees have tested the limits of the § 546(e) safe harbor since its enactment. In case after case, the courts, with few exceptions, have expanded those limits — that is, perhaps, until now. On Monday, Nov. 6, 2017, the U.S. Supreme Court heard argument in the case of Merit Management Group LP v. FTI Consulting Inc. to resolve the 5-2 circuit split concerning the proper scope of the § 546(e) safe harbor.[1]
Section 546(e) acts as an exception to a trustee’s chapter 5 avoidance powers by protecting certain transfers from avoidance. Whether a transfer is protected from avoidance turns on the answers to two questions. First, was the transfer at issue a settlement payment or a transfer made in connection with a securities contract? If yes, as was undisputed in Merit, the second question must be answered: Was the transfer made “by or to (or for the benefit of)” a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant or securities clearing agency?
This second question lies at the heart of the dispute in Merit and the 5-2 circuit split. Five circuit courts of appeals have taken a mechanistic view of the statutory language “by or to” and have held that where an entity listed in the statute, like a bank, is involved in the transfer, even when only acting as a conduit, the transfer falls within the safe harbor.[2] In Merit, the Supreme Court is reviewing the Seventh Circuit’s opinion that staked out an opposing view that focused on the economic substance of the relevant transaction and not the manner in which it was executed.[3]
We will have to wait to find out which view the Court adopts, but even if the Court affirms the Seventh Circuit’s opinion, the war over the scope § 546(e) will not be over. Rather, the battleground will shift away from the language of § 546(e) itself to the definition of “financial institution” as set forth in 11 U.S.C. § 101(22). The definition of financial institution includes not only an assortment of banks, but also a customer of a bank when the bank “act[s] as agent or custodian for a customer ... in connection with a securities contract.”[4]
Thus, even if the bank involved in a securities transaction acted only as a conduit, § 546(e) may still protect the transfer from avoidance if the bank acted as an “agent or custodian” for the recipient of the transfer “in connection with a securities contract.” In that case, the transferee would fall under the definition of financial institution and the safe harbor would apply. As Justice Breyer pointedly asked counsel during argument in the Merit case (referring to this definition), “So, why doesn’t that cover it?”
The short answer is that no one knows because it does not appear that anyone has ever raised this argument before.[5] Despite decades of litigation over the scope of § 546(e), no court has ever addressed the argument that either the transferor or the transferee is a financial institution under § 101(22) as a result of their status as a customer of a financial institution, even in cases where a cursory reading of the definition would seem to resolve the dispute in the defendant’s favor.[6]
Moreover, the definition of “financial institution” is less than clear and raises several questions with which trustees, fraudulent-transfer defendants and the courts will have to grapple, most critically, what does it mean to act as an “agent or custodian” in connection with a securities contract? Is it limited to situations where the bank is acting in the role of a stockbroker, buying and selling securities on behalf of its customer? Or, on the other end of the spectrum, does a bank act as a custodian or agent in connection with a securities contract when it simply wires or receives funds on behalf of the purchaser or seller of securities? Or is the line somewhere in between? Then, there is also the question of how courts should apply the definition in a manner that does not render large sections of the safe harbor completely superfluous. For example, if the definition of financial institution is to be read broadly, why did Congress include financial participants among its list of entities enumerated in § 546(e)? Indeed, it is difficult to imagine a situation where a financial participant that is engaging in a securities transaction is not using a bank to execute the transaction.
It will likely take years of litigation to answer these questions, and the answers will likely generate even more questions. In sum, even if the Supreme Court affirms the Seventh Circuit’s decision in Merit, the battle over the scope of § 546(e) will be far from over.
[1] Merit Management Group LP v. FTI Consulting Inc., No. 16-748. The transcript of the oral argument can be accessed at https://www.supremecourt.gov/oral_arguments/argument_transcripts/2017/1….
[2] See, e.g., Official Committee of Unsecured Creditors of Quebecor World (USA) Inc. v. American United Life Insurance Co. (In re Quebecor World USA Inc.), 719 F.3d 94 (2d Cir. 2013); Contemporary Industries Corp v. Frost, 564 F.3d 981 (8th Cir. 2009); Quality Stores Inc. v. Alford (In re QSI Holdings Inc.), 571 F.3d 545 (6th Cir. 2009); Lowenschuss v. Resorts Int’l Inc. (In re Resorts Int’l Inc.), 181 F.3d 505 (3d Cir 1999).
[3] FTI Consulting Inc. v. Merit Mgmt. Group LP, 830 F.3d 690, 694-97 (7th Cir. 2016), cert. granted, 137 S. Ct. 2092, 197 L. Ed. 2d 894 (2017).
[4] 11 U.S.C. § 101(22).
[5] Merit took the position in the case that it was not a financial institution under the Bankruptcy Code, stating in its Petition for Review: “Neither [Valley View Downs] ... nor [Merit] is itself a financial institution or one of the other types of entities discussed in Section 546(e).”
[6] See, e.g., Munford v. Valuation Research Corp. (Matter of Munford Inc.), 98 F.3d 604 (11th Cir. 1996). In Munford, the relevant transfers were first deposited into a financial institution pursuant to the terms of the securities contract before they were transferred to the shareholders. The court held that the transfers were not made by the financial institution, but rather by the debtor because the financial institution acted as a conduit and not a transferee. Nevertheless, the defendant chose not to argue that the debtor was also a financial institution because it was the customer of a financial institution that was acting as its agent or custodian in connection with a securities contract.