Seventh Circuit Rules That Certain Transfers Involving Financial Institution Intermediaries Not Immune From Recovery by Bankruptcy Trustee
By Shane G. Ramsey
On January 28, 2016, the Seventh Circuit rendered its decision in FTI Consulting, Inc. v. Merit Management Group, LP, holding that a transfer is not protected by the safe harbor provision of section 546(e) of the Bankruptcy Code when a financial institution or other entity acts merely as a conduit for the transferred funds. This decision has wide reaching implications for parties to securities transactions.
The Seventh Circuit's opinion arose out of the bankruptcy proceeding of Valley View Downs, LP ("Valley"), the owner of a Pennsylvania racetrack. Valley was in competition with another racetrack, Bedford Downs ("Bedford"), for the last racing license in the state. Rather than compete with one another to obtain the sole license, Valley and Bedford agreed to combine their businesses. In so doing, Valley was to acquire all Bedford shares in exchange for $55 million. Credit Suisse extended a loan to Valley to pay for the Bedford shares. The exchange of the $55 million for the shares was to take place through Citizens Bank, acting as escrow agent. After the transfer, Valley obtained the racing license, but it failed to secure its gambling license (another license necessary in order to operate the proposed business). As a result of its failure to obtain the gambling license, Valley filed for relief under Chapter 11 of the Bankruptcy Code.
After the filing of the petition for relief, FTI Consulting, Inc. ("FTI"), as litigation trustee, brought suit against Merit Management Group ("Merit"), a 30% shareholder of Bedford. FTI alleged that Bedford's transfer to Valley, and then to Merit, of approximately $16.5 million (30% of the $55 million), was avoidable under sections 544, 548(a)(1)(b), and 550 of the Bankruptcy Code.
Merit maintained that the transfer was "made by or to (or for the benefit of)" an entity named in section 546(e) and therefore protected under the safe harbor because the funds passed through Citizens Bank and Credit Suisse (Merit could not rely on its own status for this argument, because it was not a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency (the entities named in section 546(e)).
FTI argued that because Chapter 5 causes of action establish that only transfers "made by the debtor" prior to the bankruptcy petition are avoidable, transfers "made by" a named entity in section 546(e) ought also to refer to a transfer of property by the debtor. FTI further argued that because sections 544, 547, and 548 refer to avoidance of transfers to or for the benefit of entities subject to fraudulent-transfer liability, section 546(e)'s safe harbor must refer only to transfers made to a named entity that is a creditor.
The Seventh Circuit agreed with FTI. In so doing, the Seventh Circuit sided with the Eleventh Circuit's decision on this issue and departed from the positions adopted by five other Circuit Courts of Appeal.
As a result of this decision, shareholders may now be at risk that trustee in a bankruptcy proceeding will seek to recover transfers under a constructive fraudulent transfer theory. Given the split in authority at the Circuit Court of Appeals level, disputes among stakeholders regarding where a company should file for bankruptcy are likely to arise, especially if the debtor has recently completed a leveraged buyout that might come under scrutiny in the debtor’s bankruptcy case. The circuit split in authority also makes this an issue to monitor closely inasmuch as a decision by the Supreme Court would, once and for all, clarify the scope of Section 546(e)'s safe harbor.
To discuss how the Merit opinion might affect your business practices, contact Shane Ramsey, 615-664-5315, or any member of Nelson Mullin’s Bankruptcy and Financial Restructuring Practice Group.
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