On February 27, 2018, the United States Supreme Court issued its opinion in Merit Management Group, LP v. FTI Consulting, Inc. to resolve conflicting Circuit Court interpretations of Bankruptcy Code Section 546(e). Although the Merit opinion is unanimous and appears straightforward on first reading, fertile grounds for future litigation remain.
Section 546(e) is commonly referred to as the “safe harbor” provision that insulates certain kinds of transactions from avoidance by bankruptcy trustees as preferential transfers under Bankruptcy Code Section 547 or fraudulent conveyances under Bankruptcy Code Section 548. Section 546(e) provides in parts pertinent to the Merit case that:
Notwithstanding sections 544, 545, 547, 548(a)(1)(B),and 548(b) of this title, the trustee may not avoid a transfer…made by or to (or for the benefit of) a… financial institution… in connection with a securities contract … that is made before the commencement of the case, except under section 548(a)(1)(A) of this title [which provides for avoidance of transfers made with actual intent to hinder, delay or defraud creditors].
For reasons discussed below, it is noteworthy that the “notwithstanding” clause of Section 546(e) does not refer to Bankruptcy Code Section 550(a).
In the case before it, the District Court, agreeing with the Second, Third, Sixth, Eighth, Tenth, and Eleventh Circuits, had held that FTI, the trustee for Valley View Downs, LP could not recover funds paid by Valley View to Merit Management for Merit’s stock in Bedford Downs Management Corp. under a securities contract as a fraudulent conveyance because the funds had flowed from Credit Suisse, as the financial institution that had financed the stock purchase, through Citizens Bank of Pennsylvania, another financial institution, as escrow agent. However, the Seventh Circuit reversed, holding that Section 546(e) does not prevent avoidance of a transfer when a financial institution serves as a “mere conduit.”
Although the Supreme Court affirmed the Seventh Circuit’s decision, it said that the inquiry as to whether Citizens Bank was a “mere conduit” or had “a beneficial interest in or dominion and control over the transferred property” “put the proverbial cart before the horse.” According to the Supreme Court, “Before a court can determine whether a transfer was made by or to or for the benefit of a covered entity, the court must first identify the relevant transfer to test in that inquiry.” After examining the language of Section 546(e) and its history, the Supreme Court said, “the statutory language and the context in which it is used all point to the transfer that the trustee seeks to avoid as the relevant transfer for consideration of the §546(e) safe-harbor criteria.”
FTI had identified the transfer of the purchase price by Valley View to FTI, not the transfer of the purchase price by Valley View to Citizens as escrow agent, as the transfer it was seeking to avoid. After noting that “after a trustee files an avoidance action identifying the transfer it seeks to set aside, a defendant in that action is free to argue that the trustee failed to properly identify an avoidable transfer under the Code, including any available arguments concerning the role of component parts of the transfer,” the Supreme Court said:
Merit does not contend that FTI improperly identified the Valley View-to-Merit transfer as the transfer to be avoided, focusing instead on whether FTI can “ignore” the component parts at the safe-harbor inquiry. Absent that argument, however, the Credit Suisse and Citizens Bank component parts are simply irrelevant to the analysis under §546(e). The focus must remain on the transfer the trustee sought to avoid. (Emphasis added).
The problem with the Court’s analysis that intervening transfers from A to B, from B to C, and from C to D are “simply irrelevant if the trustee alleges that he is only seeking to avoid a transfer from A to D is that it does not address the effect of Bankruptcy Code Section 550(a), even though the Court quotes Section 550(a) in its opinion. That Section provides:
[T]o the extent that a transfer is avoided under section. . 547 [or] 548…. the trustee may recover . . . the property transferred, or, if the court so orders, the value of such property… from…the initial transferee of such transfer or the entity for whose benefit such transfer was made, …or from any immediate or mediate transferee of such initial transferee.
Section 550(a) expressly makes the “component parts of the transfer” relevant because it allows a trustee to recover the transferred property or its value not only from the ultimate recipient of the transfer, but from intervening transferees. By operation of Section 500(a), even though FTI could not have avoided the transfer of Valley View’s funds under a securities contract to financial institutions Credit Suisse or Citizens if it had alleged that was what it was trying to accomplish, FTI set the stage for recovering from Credit Suisse or Citizens by instead identifying the transfer from Valley View to Merit as the avoidable transfer.
The Supreme Court’s recitation that Merit missed its opportunity “argue that the trustee failed to properly identify an avoidable transfer under the Code, including any available arguments concerning the role of component parts of the transfer,” and its focus on the allegations in the trustee’s complaint as defining the relevant transfer make it essential for any party sued by a trustee in an action to avoid a preferential transfer or fraudulent conveyance to raise early and often any inconsistencies between what the trustee alleges he or she is seeking to accomplish and what the trustee’s real goal is.