Storm Warning: Supreme Court to Rule on Safe Harbor

Kleinberg Kaplan, partner Matthew Gold

A case currently before the United States Supreme Court could significantly restrict the scope of an important defense to clawback actions, limiting its usefulness for entities that are not major financial institutions or large funds. Based on recent oral argument, the Bankruptcy Code safe harbor for clawbacks may be given a narrow interpretation, leaving it available for most practical purposes only to banks, large funds, and other large financial institutions. The case, Merit Management Group LP v. FTI Consulting, Inc., constitutes the first Supreme Court test of the increasingly important Safe Harbor. While the direction of oral argument is not a definitive guide to the Court’s ultimate ruling, the oral argument on the case suggests that the Court will not adopt the current majority rule that Safe Harbor protections can be triggered even when the only involvement of a financial institution in the transaction is that it forwards funds to the ultimate beneficiary.

The Safe Harbor

The Safe Harbor has become increasingly important to clawback action defendants, providing defenses where none might otherwise exist and facilitating the dismissal of cases before trial. It generally precludes trustees (and others representing the bankruptcy estate) from bringing actions alleging preferences or constructive fraudulent transfers based on federal bankruptcy law. From a plaintiff’s perspective, constructive fraudulent transfer actions, which generally require the plaintiff to prove only that the transfer was made for less than reasonably equivalent value while the transferor was insolvent, are easier to establish than are actual intent actions. The Safe Harbor also generally precludes trustees (and others representing the bankruptcy estate) from bringing fraudulent conveyance actions based on state law, which often provides a reach-back period that is significantly longer than the two year reach-back period established under the Bankruptcy Code.

For the Safe Harbor to be applicable, the transaction must be of a type specified in the statute, and be “by or to or for the benefit of” one of several designated entities, such as brokers and Financial Institutions (a defined term in the Bankruptcy Code). (A discussion of the different types of transfers and entities protected by the Safe Harbor is beyond the scope of this Alert; those issues were discussed in our prior Alert.)

The Merit issue

Merit involves efforts by the bankruptcy trustee to avoid as a fraudulent conveyance payment made to the debtor’s shareholders from the proceeds of a sale of real estate. The proceeds had been escrowed following the sale and were paid to the shareholders by the escrow agent (a bank) following an indemnity holdback period. The defendants asserted the Safe Harbor as a defense. There was no dispute that the transfers were either “settlement payments” or “payments made in connection with securities contracts,” two of the relevant types of transactions, so the only Safe Harbor issue presented concerned the role of the Financial Institution in the transaction.

The district court granted defendants’ motion to dismiss, holding the Safe Harbor applicable because the escrow agent, a bank, was a Financial Institution, and that the payment that the trustee sought to avoid had been made by the escrow agent to the defendants. The Court of Appeals for the Seventh Circuit reversed, reasoning that the escrow agent was a mere conduit, and that the relevant entities for the purpose of Safe Harbor are the original payor and the ultimate payee, neither of which was a Financial Institution.

Several circuits, including the Second Circuit, have held that the predicates of the Safe Harbor are satisfied if one of the entities in a multi-step transaction is one of the statutorily designated entities, even if that entity is a conduit with no economic stake in the transaction. The Supreme Court took Merit, likely in light of the circuit split. Oral argument was held in November.

Potential effect on other cases

A decision that affirms the Seventh Circuit ruling could have significant effects on other cases. At a minimum it would significantly cut back the number of clawback defendants that could make use of the Safe Harbor. For example, in In re Tribune Company Fraudulent Conveyance Litigation, the Second Circuit ruled that the Safe Harbor applies to shield tens of thousands of defendants from fraudulent conveyance liability, based in part on the existing Second Circuit precedent regarding the conduit issue. (see prior alert).

The Supreme Court has held in abeyance the certiorari petition filed by the Tribune plaintiffs, presumably awaiting the disposition of Merit. Under the Seventh Circuit rule, the Tribune case might be remanded for separate determinations for each defendant regarding whether it is an eligible entity under the Safe Harbor. Defendants that are banks or large funds could still come within the Safe Harbor protections, but other defendants might have to defend the case on the merits.

Conversely, a reversal of the Seventh Circuit ruling could keep the Safe Harbor available to a broad range of participants in securities-related transactions. And another possible result, which was suggested during oral argument, would be a ruling that turns on certain case-specific facts and that leaves unresolved the circuit split.

More broadly, the past decade has seen a series of appellate court decisions endorsing an increasingly broad interpretation of the Safe Harbor. Depending on the scope and breadth of the Supreme Court’s decision, many of those decisions may have to be revisited.

Kleinberg Kaplan represents certain defendants in the Tribune adversary proceedings.

Kleinberg Kaplan, partner Matthew Gold

A case currently before the United States Supreme Court could significantly restrict the scope of an important defense to clawback actions, limiting its usefulness for entities that are not major financial institutions or large funds. Based on recent oral argument, the Bankruptcy Code safe harbor for clawbacks may be given a narrow interpretation, leaving it available for most practical purposes only to banks, large funds, and other large financial institutions. The case, Merit Management Group LP v. FTI Consulting, Inc., constitutes the first Supreme Court test of the increasingly important Safe Harbor. While the direction of oral argument is not a definitive guide to the Court’s ultimate ruling, the oral argument on the case suggests that the Court will not adopt the current majority rule that Safe Harbor protections can be triggered even when the only involvement of a financial institution in the transaction is that it forwards funds to the ultimate beneficiary.

The Safe Harbor

The Safe Harbor has become increasingly important to clawback action defendants, providing defenses where none might otherwise exist and facilitating the dismissal of cases before trial. It generally precludes trustees (and others representing the bankruptcy estate) from bringing actions alleging preferences or constructive fraudulent transfers based on federal bankruptcy law. From a plaintiff’s perspective, constructive fraudulent transfer actions, which generally require the plaintiff to prove only that the transfer was made for less than reasonably equivalent value while the transferor was insolvent, are easier to establish than are actual intent actions. The Safe Harbor also generally precludes trustees (and others representing the bankruptcy estate) from bringing fraudulent conveyance actions based on state law, which often provides a reach-back period that is significantly longer than the two year reach-back period established under the Bankruptcy Code.

For the Safe Harbor to be applicable, the transaction must be of a type specified in the statute, and be “by or to or for the benefit of” one of several designated entities, such as brokers and Financial Institutions (a defined term in the Bankruptcy Code). (A discussion of the different types of transfers and entities protected by the Safe Harbor is beyond the scope of this Alert; those issues were discussed in our prior Alert.)

The Merit issue

Merit involves efforts by the bankruptcy trustee to avoid as a fraudulent conveyance payment made to the debtor’s shareholders from the proceeds of a sale of real estate. The proceeds had been escrowed following the sale and were paid to the shareholders by the escrow agent (a bank) following an indemnity holdback period. The defendants asserted the Safe Harbor as a defense. There was no dispute that the transfers were either “settlement payments” or “payments made in connection with securities contracts,” two of the relevant types of transactions, so the only Safe Harbor issue presented concerned the role of the Financial Institution in the transaction.

The district court granted defendants’ motion to dismiss, holding the Safe Harbor applicable because the escrow agent, a bank, was a Financial Institution, and that the payment that the trustee sought to avoid had been made by the escrow agent to the defendants. The Court of Appeals for the Seventh Circuit reversed, reasoning that the escrow agent was a mere conduit, and that the relevant entities for the purpose of Safe Harbor are the original payor and the ultimate payee, neither of which was a Financial Institution.

Several circuits, including the Second Circuit, have held that the predicates of the Safe Harbor are satisfied if one of the entities in a multi-step transaction is one of the statutorily designated entities, even if that entity is a conduit with no economic stake in the transaction. The Supreme Court took Merit, likely in light of the circuit split. Oral argument was held in November.

Potential effect on other cases

A decision that affirms the Seventh Circuit ruling could have significant effects on other cases. At a minimum it would significantly cut back the number of clawback defendants that could make use of the Safe Harbor. For example, in In re Tribune Company Fraudulent Conveyance Litigation, the Second Circuit ruled that the Safe Harbor applies to shield tens of thousands of defendants from fraudulent conveyance liability, based in part on the existing Second Circuit precedent regarding the conduit issue. (see prior alert).

The Supreme Court has held in abeyance the certiorari petition filed by the Tribune plaintiffs, presumably awaiting the disposition of Merit. Under the Seventh Circuit rule, the Tribune case might be remanded for separate determinations for each defendant regarding whether it is an eligible entity under the Safe Harbor. Defendants that are banks or large funds could still come within the Safe Harbor protections, but other defendants might have to defend the case on the merits.

Conversely, a reversal of the Seventh Circuit ruling could keep the Safe Harbor available to a broad range of participants in securities-related transactions. And another possible result, which was suggested during oral argument, would be a ruling that turns on certain case-specific facts and that leaves unresolved the circuit split.

More broadly, the past decade has seen a series of appellate court decisions endorsing an increasingly broad interpretation of the Safe Harbor. Depending on the scope and breadth of the Supreme Court’s decision, many of those decisions may have to be revisited.

Kleinberg Kaplan represents certain defendants in the Tribune adversary proceedings.