New York Decision Shows that Merit Management Is a Dead Letter

Despite the Supreme Court’s Merit Management decision, a bald-faced fraudulent transfer can still be immune from attack, at least in the Second Circuit, if the transaction was structured to use a financial institution as an agent for the defendant.

Merit Management was the landmark decision in February 2018, where the Supreme Court held that the presence of a financial institution as a conduit in the chain of payments in a leveraged buyout was insufficient to invoke the so-called safe harbor in Section 546(e). That section provides that a trustee may not avoid a “settlement payment . . . made by or to (or for the benefit of) . . . a financial institution.” In Section 101(22)(A), a financial institution includes a bank.

Merit Management held that Section 546(e) only applies to “the transfer that the trustee seeks to avoid.” More particularly, Justice Sotomayor said that “the relevant transfer for purposes of the Section 546(e) safe-harbor inquiry is the overarching transfer that the trustee seeks to avoid.” Merit Management Group LP v. FTI Consulting Inc., 138 S. Ct. 883, 888, 893 (Sup. Ct. Feb. 27, 2018).

Merit Management’s Effect on Tribune I

Merit Management had the effect of abrogating one of the Second Circuit’s principal holdings in Note Holders v. Large Private Beneficial Owners (In re Tribune Co. Fraudulent Conveyance Litigation), 818 F.3d 98 (2d Cir. 2016), which we shall refer to as Tribune I. After what amounted to a remand from the Supreme Court following Merit Management, the Second Circuit amended its Tribune I opinion in what we shall refer to as Tribune II: In re Tribune Co. Fraudulent Conveyance Litigation, 946 F.3d 66 (2d Cir. Dec. 19, 2019).

Tribune I included two rulings by the Second Circuit that precluded creditors of a bankrupt company from bringing suit on their own behalf based on state fraudulent transfer law. First, the circuit court ruled that the safe harbor in Section 546(e) applied even if a bank only served as a conduit for money paid to selling shareholders in a leveraged buyout that turns out to be a fraudulent transfer. The appeals court said that the safe harbor protects transactions, not just financial institutions.

Merit Management had the effect of overturning the Second Circuit’s holding that the safe harbor applies even if a bank only serves as a conduit for money paid to selling shareholders in a leveraged buyout that was a fraudulent transfer.

Tribune I had a second ground for dismissal: The Section 546(e) safe harbor impliedly preempts state law on fraudulent transfers anytime there is a bankruptcy of a company that was the subject of a leveraged buyout. As a result of federal preemption, the Second Circuit said that individual creditors cannot mount a fraudulent transfer suit on their own behalf.

The Loophole in Merit Management

In Tribune II, the Second Circuit in substance found a loophole in Merit Management: A defendant in a fraudulent transfer suit who cannot invoke the Section 546(e) safe harbor after Merit Management can still immunize the transaction from attack as a constructive fraudulent transfer under Section 548(a)(1)(B) by employing a “financial institution” as its “agent.”  

Bankruptcy Judge Robert E. Grossman of Central Islip, N.Y., was assigned to preside over a case in Manhattan under New York law alleging that a leveraged refinancing was a fraudulent transfer with “actual intent.” Where the Tribune opinions involved constructively fraudulent transfers, Judge Grossman was dealt a case alleging “actual intent.”

Leveraged transactions are always complex, and the case before Judge Grossman was no exception. Basically, a company took down $2.1 billion in new financing to pay its owners. Three years later, the company was in bankruptcy. Subordinate lenders in the leveraged financing received nothing in the resulting chapter 11 plan. All they got was the right to receive whatever a liquidating trustee might recover in lawsuits.

The creditors assigned their New York fraudulent transfer claims to the liquidating trustee, who sued defendants that were paid with proceeds from the leveraged refinancing. In his 82-page opinion on June 18, Judge Grossman granted the defendants’ motion to dismiss.

Judge Grossman Follows Tribune II

Judge Grossman’s opinion is “must reading” for anyone structuring a leveraged buyout or a leveraged refinancing. His decision highlights the structuring devices blessed by Tribune II that make a transaction immune from attack under the Section 546(e) safe harbor. Significantly also, Judge Grossman dissected Merit Management to explain why Tribune II based dismissal on principles not addressed by the Supreme Court.

Merit Management did not deal with whether the defendants were subsumed within the definition of a “financial institution” as defined in Section 101(22)(A). The Tribune II court ruled on the issue, and Judge Grossman naturally followed the Second Circuit.

A “financial institution” in Section 101(22)(A) is defined as a bank or “trust company, . . . and when any such . . . entity is acting as agent . . . for a customer . . . in connection with a securities contract . . . such customer.” In the opinion of the Second Circuit, a customer of a financial institution itself becomes a “financial institution” if the financial institution is acting as the customer’s agent. That’s what Judge Grossman held, invoking Tribune II as binding authority.

Ruling that the defendants were financial institutions was not enough by itself to invoke the safe harbor, because the liquidating trustee argued that his suit was based on state law, not Section 548. However, the Tribune decisions foreclosed the argument because the Second Circuit held that Section 546(e) preempts state law as to companies that end up in bankruptcy.

Judge Grossman held that federal preemption applies as much to fraudulent transfers with “actual intent” as it does to constructively fraudulent transfers. He therefore dismissed the trustee’s complaint because the Section 546(e) safe harbor made the defendants immune.

Judge Grossman’s opinion covered several other topics that arise in leveraged buyout and refinancing litigation. He dealt with statutes of limitations and a Delaware statute of repose, the pleading standard when defrauded institutions were sophisticated creditors, and whether a “critical mass” of directors must have acted with fraudulent intent. On those other issues, Judge Grossman upheld the trustee’s pleading, but to no avail, because the defendants drew a get-out-of-jail-free card called Section 546(e).

To read’s ABI’s reports on Merit Management and Tribune II, click here and here.

Observations

Even with Merit Management on the books, there may never be liability for receipt of a fraudulent transfer clothed as a leveraged buyout or leveraged refinancing.

The definition of “financial institution” in Section 101(22)(A) suggests that no one will ever be held liable unless those who structured the transaction were asleep at the switch.

A financial institution is defined a “commercial . . . bank , . . . and when any [bank] is acting as agent . . . for a customer . . . in connection with a securities contract . . . such customer.” Translated into plain English, as the Second Circuit said, a customer of a financial institution itself becomes a “financial institution” if the financial institution is acting as the customer’s agent in a leveraged transaction.

Consequently, the nonbank customer (i.e., recipient of a fraudulent transfer) magically becomes a financial institution and may then raise Section 546(e) as a complete defense to fraudulent transfer liability.

Collier recognizes the shortcomings in Merit Management in light of the definition of “financial institution.” The treatise says:

On its face, Merit Management appears to narrow meaningfully the application of section 546(e) to distributions to nonfinancial institution shareholders in connection with leveraged buyouts and similar transactions. However, a couple of factors may yet affect the significance of the result. First, the parties did not argue that the initial transferor or ultimate transferee itself qualified as a “financial institution” under the Code by virtue of being a “customer” of a financial institution that acted as its agent or custodian in connection with a securities contract — a powerful argument that may allow future defendant transferees to avail themselves of section 546(e)’s safe harbor protections notwithstanding the Merit Management decision. Second, the market may adapt to obtain the benefit of the section 546(e) safe harbor notwithstanding the Merit Management holding. For example, prior to receiving distributions on their stock in connection with LBOs, larger stockholders may (a) sell their stock to financial institutions that are eligible for the section 546(e) safe harbor or (b) move their stock into custodial accounts with financial institutions and thereby be treated as financial institutions by virtue of the definition of “financial institution” in section 101(22)(A).

5 Collier on Bankruptcy ¶ 555.06 (16th rev. ed. 2020). [Citations omitted; emphasis added.]

This writer questions whether Congress intended for all recipients of fraudulent transfers in LOBs to be immune from liability. Such broad exculpation goes far beyond the need for protecting the securities markets, but that’s what the statutory language says.

The definition in Section 101(22)(A) applies to more than Section 546(e). The definition plays its most important role in provisions like Section 555 and 556, which allow immediate liquidation of securities contracts after a bankruptcy filing. In those circumstances, it makes sense for a nonbank to have the status of a bank or broker, otherwise there would be gaps in the right to liquidate.

Although the broad definition makes sense in the context of Sections 555 and 556, the same cannot be said for Section 546(e). This writer submits that Congress should give “financial institution” a separate and more narrow definition for use with Section 546(e). Otherwise, the Bankruptcy Code will be read as explicitly condoning (if not promoting) fraudulent transfers.