Web Analytics

Supreme Court Makes Bankruptcy Claw-Backs Easier While Protecting Financial Institutions

Newsletter

In a unanimous ruling, the Supreme Court in Merit Management Group, LP v. FTI Consulting, Inc., 2018 WL 1054879 (Feb. 27, 2018) has made it easier for bankruptcy trustees to claw back money received as part of certain transactions, while emphasizing that bankruptcy law still protects the financial institutions that facilitate those transactions. The transfers at issue in Merit Management were not a debtor’s ordinary loan payments to a lender. Rather, at issue were payments that are often made as part of shareholder buy-outs or stock redemptions, involving many millions of dollars. The Supreme Court’s decision overturns law going back over a quarter century. As a result, this decision means substantial new risks for shareholders or others receiving payments as part of a corporate restructuring, if it results in bankruptcy.

Fraudulent Transfers and the “Safe Harbor”

The Bankruptcy Code allows trustees to “avoid” – that is, undo – various types of payments by a debtor that deplete the debtor’s assets for its creditors as a whole. Among these are “constructively fraudulent transfers” – transfers of property made while the debtor was insolvent and for less than the transferred property was worth. Trustees often target payments to shareholders, which are seen to create little or no value for the company, while depleting its assets available to pay creditors.

But shareholders have often defended against avoidance actions by invoking a “safe harbor” provision of the Bankruptcy Code: Section 546(e), which prevents the claw-back of transfers “made by or to (or for the benefit of)” a financial institution. Five federal courts of appeals have interpreted this language to protect otherwise avoidable transfers that merely pass through a bank or financial institution – for example, as an escrow agent – even if the institution itself had no beneficial interest in the funds transferred.

Under this reading, many large financial transactions would find shelter in the safe harbor. However, two other courts of appeal, disagreeing with the majority view, have held that the Section 546(e) safe harbor does not protect a transfer between a debtor and a third-party merely because a financial institution served as a conduit for funds that moved between them. The Supreme Court stepped in to resolve the issue.

Favoring Bankruptcy Trustees, the Court Limits the Safe Harbor

In Merit Management, a racetrack owner agreed to buy all the shares of its competitor. The racetrack owner borrowed the purchase price from a bank, using another bank as escrow agent for the exchange. When the racetrack business failed, its owner filed for bankruptcy.

A bankruptcy trustee sued one of the competitor’s shareholders to recover $16.5 million that the shareholder had received in the sale as a constructively fraudulent transfer. In response, the shareholder argued that the safe harbor protected the transfer, because the funds passed from the lender, through the escrow agent, to the shareholder.

Grounding its analysis on the “plain meaning” of the text of Section 546(e), the Supreme Court sided with the trustee. The Court held that funds that simply pass through a financial institution on their way to another entity, such as a shareholder, do not constitute a transfer – as stated in the text of Section 546(e) – “made by or to … a financial institution.” After analyzing the text of Section 546(e) and the overall structure of the Bankruptcy Code’s avoidance provisions, the Court concluded that the safe harbor applies only “to the overarching transfer that the trustee seeks to avoid” – in this case, the transfer between the debtor racetrack owner and the shareholder – and not to intermediate “component part[s] of that transfer.” In other words, any intermediate transfers may be disregarded, and the fact that funds may have passed through one or more banks along the way to the final recipient sued by the bankruptcy trustee does not insulate the transfer to that final recipient from avoidance.

Safe Harbor Remains Safe for Financial Institutions

The Court also stressed that the safe harbor still applies to protect financial institutions targeted by a trustee. A bank’s deep pockets would be a tempting target for a trustee’s claw-back action, especially if the ultimate recipient no longer had the money to return.

However, because the safe harbor precludes avoidance of any transfer “by or to (or for the benefit of)” certain financial institutions, a trustee could not seek to recover funds from the institutions that acted as conduits or escrow agents for a challenged transfer.

Additional Risks for Corporate Restructuring

As part of its decision in Merit Management, the Court overruled contrary rulings from federal courts of appeal across the country. And as a result, this ruling changes some longstanding assumptions and introduces additional risks for those receiving payments in corporate restructurings that eventually fail and result in bankruptcy. Shareholders, purchasers of companies, and their advisors will need to assess those risks and consider other potential ways to structure transactions to reduce the risk of having to return payments made as part of a restructuring.

Follow Quarles

Subscribe Media Contact
Back to Main Content

We use cookies to provide you with the best user experience on our website and to analyze statistics related to our website. To understand more about how we use cookies, or for instructions to change your preference and browser settings, please see our Privacy Notice. Please note that if you choose to reject cookies, doing so may impair some of our website's functionality.