United States: Seventh Circuit Deepens Circuit Split On Applicability Of Section 546(e) Safe Harbor To Transactions Involving Financial Institution Acting As Mere Conduit

Last Updated: September 28 2016
Article by Brad B. Erens and Mark G. Douglas

In FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677 (7th Cir. July 28, 2016), a three-judge panel of the U.S. Court of Appeals for the Seventh Circuit ruled that the "safe harbor" under section 546(e) of the Bankruptcy Code for settlement payments made in connection with securities contracts does not protect "transfers that are simply conducted through financial institutions (or the other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit." The ruling deepens a split among the circuit courts of appeal on the issue and may be a candidate for review by the U.S. Supreme Court to resolve the dispute.

The Section 546(e) Safe Harbor

Section 546 of the Bankruptcy Code imposes a number of limitations on a bankruptcy trustee's avoidance powers, including the power to avoid certain preferential and/or fraudulent transfers. In 1982, Congress broadened a limited safe harbor for securities transactions then set forth in section 764(c) of the Bankruptcy Code, which applied only in commodity broker liquidation cases under chapter 7, by replacing the provision with section 546(e) (then designated as section 546(d), until renumbering in 1984).

Section 546(e) provides:


Notwithstanding sections 544, 545, 547, 548(a)(1)(B), and 548(b) of [the Bankruptcy Code], the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of [the Bankruptcy Code], or settlement payment as defined in section 101 or 741 of [the Bankruptcy Code], made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7) [of the Bankruptcy Code], commodity contract, as defined in section 761(4) [of the Bankruptcy Code], or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of [the Bankruptcy Code].

The purpose of section 546(e) is to prevent "the insolvency of one commodity or security firm from spreading to other firms and possibly threatening the collapse of the affected market." H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583, 1982 WL 25042. The provision was "intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries." Id. With the enactment of section 546(e), Congress also sought to promote customer confidence in the markets by protecting market stability. See Kaiser Steel Corp. v. Charles Schwab & Co., 913 F.2d 846 (10th Cir. 1990) (citing Sen. Rep. No. 989, at 8 (1978)).

If a transaction falls within the scope of section 546(e), it may not be avoided unless the transfer is avoidable under section 548(a)(1)(A) of the Bankruptcy Code—that is, because it was made with actual intent to hinder, delay, or defraud creditors. In determining whether a "constructively" fraudulent transfer (a transfer for which an insolvent debtor did not receive reasonably equivalent value in exchange) is shielded from avoidance under section 546(e), key issues are often whether the transfer qualifies as a "settlement payment" and whether the transfer is made under a "securities contract." In addition, to be within the scope of the safe harbor, a transfer must have been "made by or to (or for the benefit of)" a commodity broker, a forward contract merchant, a stockbroker, a financial institution, a financial participant, or a securities clearing agency.

Five circuit courts of appeal have ruled that the section 546(e) safe harbor extends to transactions even where one of the entities named in the provision is merely a "conduit" for the transfer of funds from the debtor to the ultimate transferee. See In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013) (safe harbor applicable where financial institution was trustee and actual exchange was between two private entities); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009) (safe harbor applied even though financial institution involved in leveraged buyout ("LBO") was only an exchange agent); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009) (section 546(e) not limited to public securities transactions and protects from avoidance debtor's payments deposited in national bank in exchange for shareholders' privately held stock during LBO); In re Resorts Int'l, Inc., 181 F.3d 505, 516 (3d Cir. 1999) (noting that "the requirement that the 'commodity brokers, forward contract merchants, stockbrokers, financial institutions, and securities clearing agencies' obtain a 'beneficial interest' in the funds they handle . . . is not explicit in section 546"); In re Kaiser Steel Corp., 952 F.2d 1230, 1240 (10th Cir. 1991) (rejecting argument that "even if the payments were settlement payments, § 546(e) does not protect a settlement payment 'by' a stockbroker, financial institution, or clearing agency, unless that payment is to another participant in the clearance and settlement system and not to an equity security holder").

The Eleventh Circuit ruled to the contrary in In re Munford, Inc., 98 F.3d 604 (11th Cir. 1996). In Munford, the court held that section 546(e) did not shield from avoidance payments made by the debtor to shareholders in an LBO because the "financial institution" involved was only a conduit for the transfer of funds and securities—the bank never had a "beneficial interest" sufficient to qualify as a "transferee" in the LBO. In so ruling, the Eleventh Circuit wrote:


None of the entities listed in section 546(e)—i.e., a commodity broker, forward contract merchant, stockbroker, financial institution, or a securities clearing agency—made or received a transfer/payment. Thus, section 546(e) is not applicable. . . . True, a section 546(e) financial institution was presumptively involved in this transaction. But the bank here was nothing more than an intermediary or conduit. Funds were deposited with the bank and when the bank received the shares from the selling shareholders, it sent funds to them in exchange. The bank never acquired a beneficial interest in either the funds or the shares. . . . Importantly, a trustee may only avoid a transfer to a "transferee." See 11 U.S.C. § 550. Since the bank never acquired a beneficial interest in the funds, it was not a "transferee" in the LBO transaction.

Id.

at 610.

The Seventh Circuit weighed in on this issue in FTI Consulting.

FTI Consulting

In 2007, Valley View Downs, LP ("Valley View"), the owner of a Pennsylvania racetrack, acquired all of the stock of a competitor, Bedford Downs ("Bedford"), in a $55 million LBO transaction styled as a "settlement agreement" because Bedford and Valley View were competing for "racino" licenses. Citizens Bank of Pennsylvania ("Citizens") acted as escrow agent for the exchange. After the LBO, Valley View filed for chapter 11 protection in 2009 in the Northern District of Illinois because the Illinois gaming commission denied Valley View's application for the gambling license.

The trustee of a litigation trust created under Valley View's chapter 11 plan sued a 30 percent shareholder in Bedford, alleging that Valley View's transfer to Bedford and thence to the shareholder of approximately $16.5 million (30 percent of the $55 million) was constructively fraudulent and therefore avoidable under sections 544 and 548(a)(1)(B) of the Bankruptcy Code. The bankruptcy court and, on appeal, the district court ruled that the transfer to the shareholder was protected by the section 546(e) safe harbor.

The Seventh Circuit's Ruling

The Seventh Circuit reversed. "Although we have said that section 546(e) is to be understood broadly," the court wrote, "that does not mean that there are no limits." Here, the court explained, although the transaction resembled an LBO and "in that way touched on the securities market," Valley View and the shareholder were not "parties in the securities industry," but simply "corporations that wanted to exchange money for privately held stock." Citizens, the "financial institution" involved as escrow agent, was merely a conduit.

In Bonded Financial Services, Inc. v. European American Bank, 838 F.2d 890, 893 (7th Cir. 1988), the Seventh Circuit explained, it had previously defined "transferee" as an entity with "dominion over the money" or "the right to put the money to one's own purposes." In Bonded Financial, the court ruled that a bank which "acted as a financial intermediary" and "received no benefit" was not a "transferee" for purposes of chapter 5 of the Bankruptcy Code. Id. In FTI Consulting, the Seventh Circuit extended that reasoning to the section 546(e) safe harbor. It accordingly ruled that transfers "made by or to (or for the benefit of)" in the context of 546(e) refer to transfers made to "transferees."

Examining the history of section 546(e), the Seventh Circuit explained that nothing Congress did in originally enacting the safe harbor, or in later expanding its scope to other types of actors in the securities industry, including financial institutions, indicates "that the safe harbor applie[s] to those institutions in their capacity as intermediaries." According to the court, "the safe harbor has ample work to do when an entity involved in the commodities trade is a debtor or actual recipient of a transfer, rather than simply a conduit for funds."

The Seventh Circuit rejected the argument that Congress effectively overruled Munford by adding the phrase "(or for the benefit of)" to section 546(e) as part of the Financial Netting Improvements Act of 2006, Pub. L. No. 109-390 § 5(b)(1) (2006), in response to the Eleventh Circuit's statement in Munford that "[t]he bank never acquired a beneficial interest in either the funds or the shares." Munford, 98 F.3d at 610. The Seventh Circuit acknowledged that, in Quebecor, the Second Circuit construed the 2006 amendment to mean that section 546(e) was satisfied if one of the designated entities made a transfer, received a transfer, or acquired a beneficial interest in the transferred assets. See Quebecor, 719 F.3d at 100 n.3. Even so, the Seventh Circuit wrote that "[w]e do not believe that Congress would have jettisoned Munford's rule by such a subtle and circuitous route." According to the court, "If Congress had wanted to say that acting as a conduit for a transaction between non-named entities is enough to qualify for the safe harbor, it would have been easy to do that . . . [b]ut it did not."

Outlook

FTI Consulting effectively rekindles a two-decade-long circuit split that had largely faded into obscurity before the Seventh Circuit chose to resurrect the minority approach articulated in Munford but rejected by five other circuits. On August 11, 2016, the shareholder defendant filed a petition asking the Seventh Circuit to rehear the case en banc, claiming that the panel ruling conflicts with those of five other circuits, as well as with decisions within the Seventh Circuit, and that the panel's decision would lead to inequitable results which Congress could not have intended. The Seventh Circuit denied the motion on August 30, 2016. It remains to be seen whether FTI Consulting will be overturned by the U.S. Supreme Court, should it grant a petition for certiorari to resolve the circuit split.

In the meantime, the ruling means that participants, such as selling shareholders, in LBO transactions involving companies whose solvency is questionable face different levels of exposure depending on the law on this issue in the circuit in which the LBO could later be challenged as a fraudulent transfer.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Mark G. Douglas
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.