The 'Customer' Argument: An Expansion Of The Section 546(e) Safe Harbor?

Introduction

In February 2018, the U.S. Supreme Court issued an opinion that, at first blush, appeared to severely curtail the scope of the transferee protections provided by Section 546(e) of the Bankruptcy Code, the “safe harbor” provision that shields specified types of payments from a bankruptcy trustee's avoidance powers, including transfers “made by or to (or for the benefit of)” a “financial institution” in connection with a “securities contract.” A recent decision from the Second Circuit breathes fresh life into the defense.

Before 2018, courts of appeal had long been divided over whether the Section 546(e) safe harbor applied to protect transfers made in connection with a securities contract when neither the debtor/transferor nor the ultimate transferee was a qualifying financial institution — that is, when the only financial institutions involved in the transaction were banks, brokers, or other entities serving only as intermediaries or conduits. In Merit Management Group, L.P. v. FTI Consulting, Inc., 138 S.Ct. 883 (2018), the Supreme Court construed the safe harbor narrowly, holding that “the relevant transfer for purposes of the § 546(e) safe harbor is the overarching transfer that the trustee seeks to avoid.” Thus, if the trustee sought to avoid a transfer from a debtor, “A,” to an entity that was not a financial institution, “D,” it did not matter that the transfer may have passed through the hands of intermediaries, “B” and “C,” that were financial institutions — the transfer would not be safe-harbored.

The Supreme Court's decision in Merit threatened to eliminate a defense frequently asserted by, among others, cashed-out shareholders in leveraged buyouts (LBOs), who will often both tender their shares and receive their distributions through financial institutions, e.g., banks. Left unaddressed by Merit, however, was a lingering argument that the shareholders themselves might qualify as financial institutions by virtue of a quirk of the statutory language, which appeared to leave room for treating nonfinancial institutions as financial institutions so long as they were customers of financial institutions in connection with a securities contract.

The Second Circuit, in its recent decision in the long-running fraudulent transfer litigation arising out of the failed LBO and ultimate bankruptcy of Tribune Company, becomes the first circuit court to address that argument. In In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019) (Tribune II), the Second Circuit, adopting a plain-language analysis, held that a customer of a financial institution in connection with a securities contract is, indeed, a financial institution...