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The Bankruptcy Protector

February 28, 2018

Substance Over Form: Supreme Court Ruling Strengthens Avoidance Powers of Bankruptcy Trustees

By Dylan Trache

On February 27, 2018, the Supreme Court of the United States decided Merit Management Group, LP v. FTI Consulting, Inc.   The key issue in the case was the scope of Section 546(e) of the bankruptcy code which insulates certain transactions from a bankruptcy trustee’s statutory avoidance powers.  A bankruptcy trustee may avoid many types of pre-petition transfers, including preferential payments made to creditors within 90 days of a bankruptcy petition and transfers made for less than reasonably equivalent value completed within two years of a bankruptcy filing.  In FTI, the trustee sought to avoid a constructively fraudulent transfer under Section 548 of the Bankruptcy Code.  However, the defendant defended the action by raising Section 546(e) of the Bankruptcy Code, which provides that the trustee may not avoid any transfer that is a “settlement payment … made by or to (or for the benefit of) a financial institution … in connection with a securities contract.”

The transfer at issue involved an agreement to purchase the stock of a proposed harness racing business for $55 million.  The funds necessary to complete the transaction were placed in escrow at Citizens Bank, and later disbursed to the sellers’ equity holders, including Merit Management, which received $16.5 million pursuant to the terms of the sale contract.  The buyer quickly failed and filed for Chapter 11 bankruptcy.  FTI Consulting was appointed as trustee under a litigation trust established pursuant to a Chapter 11 plan.  FTI sued Merit to recover the payment made, arguing that the value of the stock received by the debtor in the transaction was not reasonably equivalent to the amounts paid.  In defense, Merit asserted that Section 546(e) provided a safe harbor because it received funds, not from the debtor, but from Citizens Bank – a financial institution.

The District Court concluded that Section 546(e) barred recovery of the transfer, but the Seventh Circuit reversed and the Supreme Court granted certiorari to determine the scope of the limitation and unanimously ruled that Section 546(e) did not shield Merit.

Crucial to the Supreme Court’s opinion was the ruling that courts should look to the overall substance of a transfer, not its component parts in determining whether Section 546(e) would bar recovery.  The Court held that simply because one portion of the transaction involved a payment out of escrow from a financial institution did not change the fact that the overarching transfer was between the debtor and Merit.  The Court also rejected an argument advanced by Merit that certain amendments to the statute had been intended to abrogate a prior decision which held that Section 546(e) did not apply to transfers in which a financial institution was simply an intermediary. The Court did not find any evidence in the statutory language or legislative history to support that argument. Applying its ruling regarding the scope of Section 546(e), the Court concluded that the applicable transfer at issue was the debtor’s transfer to Merit and that since neither was a financial institution or other covered entity under the statute, the safe harbor did not apply.

The Court’s ruling resolves a circuit split and helps clarify that a recipient of a pre-bankruptcy transfer will not avoid liability to the trustee simply because a bank or other financial institution played a minor role in the transfer.  Rather, courts will look to the substance of the entire transaction to determine whether the transfer sought to be avoided is covered by the safe harbor.   The decision will benefit trustees and debtors in possession which will have one less defense to overcome when seeking to avoid a constructively fraudulent transfer.

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