Alerts and Updates

Supreme Court Limits Safe Harbor; May Increase Challenges to LBOs in Chapter 11

March 5, 2018

The Supreme Court’s decision in Merit Management Group has immediate implications in the bankruptcy proceedings of companies acquired in prepetition leveraged buyouts.

In Merit Management Group, LP v. FTI Consulting, Inc., the United States Supreme Court held that the securities “safe harbor” provision in the bankruptcy code, 11 U.S.C. § 546(e), does not protect transfers to a financial institution that acted as a mere conduit or intermediary. The unanimous decision, which resolved a circuit court split, may unsettle market participants and increase challenges to leveraged buyout transactions (LBOs) in bankruptcy.

Facts and Procedural History

Valley View Downs, LP entered into an agreement with Bedford Downs Management Corp., pursuant to which Valley View would purchase all of Bedford Down’s stock for $55 million if Valley View obtained the last available harness-racing license in the commonwealth of Pennsylvania. Valley View did obtain the license, and instructed the Cayman Islands branch of Credit Suisse to wire the purchase price to Citizens Bank of Pennsylvania, which had agreed to serve as the third-party escrow agent for the transaction. At closing, the purchase price was disbursed from Citizens Bank to Bedford Down’s shareholders, including to Merit Management, LP, which received a total of $16.5 million in exchange for its stock.

Valley View and its parent company, Centaur, LLC, subsequently filed for protection under chapter 11 of the Bankruptcy Code. The Bankruptcy Court approved a plan of reorganization that provided for a litigation trust with FTI Consulting Inc. as trustee. FTI Consulting filed suit against Merit Management seeking to avoid the $16.5 million transfer as a constructively fraudulent conveyance under § 548(a)(1)(B) of the Bankruptcy Code. Merit Management responded that the transfer was exempt from avoidance under the safe harbor of § 546(e) of the Bankruptcy Code because the transfer was a “settlement payment… made by or to (or for the benefit of) a financial institution[s],” being Credit Suisse and Citizens Bank.

The District Court agreed with Merit Management’s contentions and granted its motion for judgment on the pleadings, reasoning that the safe harbor applied because a financial institution did in fact receive or transfer funds in connection with a “settlement payment” or “securities contract.” See 541 B.R. 850, 858 (N.D. Ill. 2015). On appeal, however, the Seventh Circuit Appellate Court reversed, holding that the safe harbor did not protect transfers in which financial institutions acted as a mere conduit. See 830 F.3d 690, 691 (7th Cir. 2016). In so ruling, the Seventh Circuit Court of Appeals split from contrary holdings issued by the Second, Third, Sixth, Eighth and Tenth Circuit Courts of Appeals.

The Supreme Court’s Reasoning

Central to the Supreme Court’s analysis was the text of § 546(e) of the Bankruptcy Code, which provides, inter alia, that “the trustee may not avoid a transfer that is a… settlement payment… made by or to (or for the benefit of) a… financial institution… or that is a transfer made by or to (or for the benefit of) a…  financial institution… in connection with a securities contract.” The Court concluded that “the plain meaning of § 546(e) dictates that the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid.” FTI Consulting was seeking to avoid and recover the $16.5 million transfer from Valley View to Merit Management. Neither Valley View nor Merit Management was a “financial institution” and so it did not matter that Credit Suisse and Citizens Banks may have acted as conduits or intermediaries in the overall transaction. Instead, as the Court said, “the Credit Suisse and Citizens Bank component parts are simply irrelevant to the analysis under § 546(e).”

Commentary and Takeaways

The Supreme Court’s decision in Merit Management Group has immediate implications in the bankruptcy proceedings of companies acquired in prepetition leveraged buyouts. Selling stockholders that are not financial institutions are now subject to greater risk that a creditors’ committee, trustee or other estate fiduciary will seek to “claw back” the sale proceeds. There is also a potential for inconsistent and inequitable results, with selling stockholders that are financial institutions enjoying the benefit of the safe harbor while nonfinancial institution stockholders are subject to avoidance actions and disgorgement. 

At the same time, the decision benefits official committees of unsecured creditors, which may have a greater ability to challenge prepetition LBO transactions and to obtain recoveries for unsecured creditors.

For More Information

If you have any questions about this Alert, please contact Christopher M. Winter, Drew S. McGehrin, any of the attorneys in our Business Reorganization and Financial Restructuring Practice Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.