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January 21, 2020

When is a “Mere Conduit” More Than A “Mere Conduit”? The Second Circuit Has a Clue

By Shane G. Ramsey, John T. Baxter

Section 546(e) of the Bankruptcy Code is a safe harbor provision that establishes that a trustee or debtor-in-possession may not avoid a transfer “by or to... a financial institution.. in connection with a securities contract” other than under an intentional fraudulent conveyance theory.  On December 19, 2019, the Second Circuit in Note Holders v. Large Private Beneficial Owners (In re Tribune Company Fraudulent Conveyance Litigation)[1] (hereinafter “Tribune II”), found a loophole in the Supreme Court’s recent decision in Merit Management Group LP v. FTI Consulting Inc.[2] regarding this safe harbor provision.  As a result, creditors in the Second Circuit can continue to sanitize certain securities transactions from constructive fraudulent transfer claims through utilizing a “financial institution” as a broker. 

The history leading up to the Tribune II decision is somewhat convoluted, but provides a good overview of the section 546(e) safe harbor provision and how it functions.  The case at issue in Tribune II is an offshoot of the chapter 11 bankruptcy case of publishing company Tribune Company.  Faced with deteriorating financial conditions in 2007, Tribune was the target of a leveraged buyout (“LBO”) which included paying out over $8 billion to shareholders at a premium price above the shares’ trading range.  In cashing out these shares, Tribune utilized a securities clearing agency to act as an intermediary between the company and the shareholders.  Shortly after the LBO was consummated, Tribune filed for chapter 11 protection.

An official committee of unsecured creditors (“UCC”) was appointed in Tribune’s bankruptcy case and commenced fraudulent transfer litigation against the shareholders under an “actual intent” theory.  The UCC did not, however, bring constructive fraudulent transfer claims, which claims are governed by state law.  Under section 546(a) of the Bankruptcy Code, the UCC had a two-year statute of limitations in which to bring any and all fraudulent transfer claims beginning from the petition date.

Just prior to the expiration of the two-year statute of limitations, certain Tribune creditors sought and received relief from the automatic stay to initiate constructive fraudulent transfer claims against the shareholders arising from the LBO.  The bankruptcy court modified the stay and allowed the creditors to seek state law constructive fraudulent transfer litigation outside the bankruptcy court.  It is this litigation that gave rise to the Second Circuit’s two holdings in this case, with the Supreme Court’s Merit decision sandwiched in between.

The case was first before the Second Circuit after the United States District Court for the Southern District of New York dismissed the creditors’ claims for lack of statutory standing, citing the automatic stay in the bankruptcy case.  On appeal in Tribune I, the Second Circuit held that the creditors did have standing, but that the case should be dismissed for two separate reasons: (1) the use of the clearing agency in the LBO shielded the transaction from constructive fraudulent transfer claims under section 546(e); and (2) section 546(e) preempted state law fraudulent transfer claims where the company at the heart of the LBO payments being avoided is in bankruptcy.   

After Tribune I was decided and cert was pending, the Supreme Court issued its opinion in Merit, which held, in pertinent part, that section 546(e) only applies to protect financial institutions, as opposed to the transactions to which they are a part, and that the existence of a financial institution as a “mere conduit” was insufficient to cleanse the transaction from attack.  Based on this decision, the Supreme Court issued a “Statement” to the Second Circuit with respect to Tribune I, indicating that the mandate should be recalled.

Upon what amounted to a remand from the Supreme Court, the Second Circuit in Tribune II essentially doubled-down on its previous holding.  But in light of Merit, it had some explaining to do.  Accordingly, the Second Circuit explained that the financial clearing agent that Tribune utilized in the LBO was its agent.  Because this clearing agent was a “financial institution” within the definition of section 546(e), Tribune, as its principal, was also a “financial institution” and, thus, within the safe harbor’s protection.

By shifting the focus from the financial institution as a “mere conduit” to an “agent,” the Second Circuit functionally avoided the Merit decision from impacting its previous holding.  As such, companies in the Second Circuit can still shield themselves from constructive fraudulent transfer claims in securities transfers by utilizing financial institutions as their agents.  But they may want to avoid calling them “conduits”... just in case.

[1] Nos. 13-3992-cv, 13-3875-cv, 13-4178-cv, 13-4196-cv, 2019 WL 6971499 (2d Cir. Dec. 19, 2019)
[2] 138 S. Ct. 883 (2018)