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
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
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
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

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 or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq 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 of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions