What Has Merit Management Changed?

the trustee may not avoid a transfer that is a margin payment … or settlement payment … 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 … commodity contract … or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) ….

The Merit Management Decision

In Merit Management, the Supreme Court addressed one aspect of the qualifying institution requirement: the conduit rule, adopted in several circuits, and held that the qualifying institution rule could be satisfied even if the only qualifying institution was involved in the transaction merely as a conduit. The case arose from efforts by a trustee to avoid as a constructive intent fraudulent conveyance prepetition payments that had been made to acquire stock of a competitor of the debtor. The purchase price had been escrowed, and was subsequently paid to the shareholder/sellers by the escrow agent. The complaint alleged that the debtor had been insolvent when the transaction took place, and that it had “significantly overpaid” for the stock such that the payment was for less than reasonably equivalent value.

The district court granted defendants' motion to dismiss, holding the safe harbor applicable. Critical to this ruling was a determination that 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 Seventh Circuit reversed, reasoning that the escrow agent was a mere conduit, and that in determining the scope of the safe harbor conduits should be ignored.

The Supreme Court unanimously affirmed. It held that the qualifying institution requirement had to be satisfied by one of the parties to the transfer that the avoidance action seeks to avoid. Thus, in Merit Management, where the complaint sought to avoid a transfer from the original payor (the debtor company) to the ultimate payee (the shareholders), those entities were the only relevant actors for safe harbor purposes. As neither entity was a protected institution, the safe harbor was held inapplicable.

The decision was expressly based on an analysis of the plain language of the statute and the contextual use of the safe harbor as it relates to the avoidance provisions of the Bankruptcy Code. The Court stated that the defendants' arguments based on statutory purpose were inconsistent with the plain language of the statute.

The Merit Management rule regarding conduits has yet to be applied in a subsequent reported decision. But the Tribune fraudulent conveyance litigation, which began before Merit Management and is still ongoing, illustrates both the consequences of what an application of Merit Management rule might look, as well as some of the practical issues that will now be faced in safe harbor litigation.

Tribune

The Tribune litigation arose from the 2008 bankruptcy of the Tribune Company. In 2007, the Tribune employee stock ownership plan acquired all of Tribune's outstanding shares through a leveraged buyout, pursuant to which Tribune's shareholders were paid a total of approximately $8.3 billion. In December 2008, Tribune and its subsidiaries filed for bankruptcy. Bondholders argued that the leveraged buyout was a fraudulent conveyance in favor of shareholders, and that shareholders had been paid with funds that could otherwise have gone to unsecured creditors. Many complaints were filed, and those cases were consolidated, as multi-district litigation, in the Southern District of New York. The shareholder defendants moved to dismiss the constructive fraud claims based upon the safe harbor.

The Second Circuit (before Merit Management) had adopted the conduit rule, so that rule was not at issue in the first rounds of the Tribune litigation. Based on the conduit rule, there was no real question that the payments had flowed through qualifying institutions. Instead, the crucial issue was whether the plaintiffs had properly structured the litigation to bypass the safe harbor by having the action brought by creditors under state fraudulent conveyance laws rather than by the bankruptcy trustee. In In re Tribune Company Fraudulent Conveyance Litigation, 818 F. 3d 98 (2d Cir. 2016), the Second Circuit ruled that even though section 546(e) expressly bars only actions by “a trustee” it impliedly also bars such actions when brought by creditors. The court reasoned that the purpose of the safe harbor would be eviscerated if the safe harbor applied only to actions brought by a trustee and not to actions brought by creditors.

Plaintiffs filed a petition for a writ of certiorari from the Supreme Court in 2016. The Court did not act on the Tribune petition, even as it granted the Merit Management certiorari petition and then subsequently decided Merit Management. On April 3, 2018, slightly more than a month after Merit Management was handed down, a filing was made that suggested that a majority of the Court was conflicted and that no Supreme Court ruling was forthcoming. Specifically, Justices Kennedy and Thomas issued a “statement” referencing 28 U. S. C. §2109 and stating that “given the possibility that there might not be a quorum in this Court … consideration of the petition for certiorari will be deferred for an additional period of time, [thereby allowing] the Court of Appeals or the District Court to consider whether to recall the mandate … in light of this Court's decision in Merit Management….”

On May 15, 2018, the Second Circuit recalled the mandate “in anticipation of further panel review.” There has not been further panel review since. But safe harbor defenses were addressed all the same before the district court, where the Tribune litigation trustee filed a motion seeking to amend his complaint to add a constructive fraud count.

The trustee contended that Merit Management overturned the Second Circuit's prior conduit rule, and that the blanket application of the safe harbor to all shareholder defendants is inappropriate. Rather, he argued, qualifying institution status would have to be established for each defendant individually. Many would undoubtedly assert that they are Financial Participants as defined by Bankruptcy Code section 101(22A):

(A) an entity that, at the time it enters into a securities contract, commodity contract, swap agreement, repurchase agreement, or forward contract, or at the time of the date of the filing of the petition, has one or more agreements or transactions described in paragraph (1), (2), (3), (4), (5), or (6) of section 561(a) with the debtor or any other entity (other than an affiliate) of a total gross dollar value of not less than $ 1,000,000,000 in notional or actual principal amount outstanding (aggregated across counterparties) at such time or on any day during the 15-month period preceding the date of the filing of the petition, or has gross mark-to-market positions of not less than $ 100,000,000 (aggregated across counterparties) in one or more such agreements or transactions with the debtor or any other entity (other than an affiliate) at such time or on any day during the 15-month period preceding the date of the filing of the petition.

This definition provides protection to institutions that have entered into, during the relevant time period, securities contracts, commodity contracts, swap agreements, repurchase agreements, or forward contracts that either: 1) have a gross notional or actual principal amount in excess of $1 billion; or 2) a mark to market valuation in excess of $100 million. The availability of this defense to any defendant can only be determined by a careful review of the entity's assets and liabilities. The result would be a bifurcation of the defense pool, in which generally smaller defendants might be forced to stay in the case while larger defendants could get out.

The district court denied the trustee's motion, ruling that blanket application of the safe harbor to all shareholder defendants is still appropriate notwithstanding Merit Management, based upon the structure of the Tribune leveraged buyout and an unusual aspect of the definition of Financial Institution (in italics below) in Bankruptcy Code section 101(22):

(A) a Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity and, when any such Federal reserve bank, receiver, liquidating agent, conservator or entity is acting as agent or custodian for a customer … in connection with a securities contract … such customer.

(Emphasis added.)

The court determined that Tribune was a customer of Computershare, which acted as agent and custodian for the leveraged buyout stock transactions, and hence Tribune was deemed to be a Financial Institution.

It is likely that this decision will be appealed to the Second Circuit.

In addition to the specific arguments regarding the qualified institution requirement, the district court also rejected the trustee's argument that the spirit of Merit Management dictates that the scope of the safe harbor should be generally pared back. A similar argument was rejected in Lehman, the other subsequent reported case to apply Merit Management to an avoidance action.

Lehman

The Lehman litigation concerned 44 synthetic collateralized debt obligation (CDO) transactions set up by Lehman and marketed by Lehman to investors who were interested in taking synthetic long positions on credit default swaps opposite Lehman's LBSF subsidiary. The investors bought notes issued by trusts established by Lehman, and the indenture trustees invested the note proceeds in securities to be held as collateral. The transaction documents provided that the collateral would be held and used to make payments under the swap agreements unless there was a termination event. Lehman's parent (LBHI) provided credit enhancement.

The transaction documents contained provisions that specified different waterfall priorities following a default depending upon who was the defaulting party. If there was a default by the noteholders or the trusts the collateral would be liquidated and paid to Lehman ahead of the noteholders. If there was a default by LBHI or LBSF the collateral would be liquidated and paid to the noteholders ahead of Lehman.

When LBHI (but not LBSF) filed for bankruptcy the indenture trustees terminated the swap agreements, liquidated the collateral and after paying expenses paid the balance of the proceeds to the noteholders. There was nothing left for Lehman.

After LBSF subsequently filed for bankruptcy, LBSF brought several suits against noteholders from those CDOs, seeking to recover from the noteholders the payments the noteholders had received from the trustees. At the heart of Lehman's legal theory was the assertion that the waterfall provisions were invalid ipso facto clauses. Lehman argued that when the trustees followed these priority provisions, which Lehman labeled “flip clauses,” the result was that the interests of LBSF had been forfeited.

Bankruptcy Court Decision

A group of 77 noteholder defendants filed a joint motion to dismiss the complaint. The Bankruptcy Court granted the motion and dismissed Lehman's complaint as against the moving noteholders in a decision dated June 28, 2016. The decision rested upon three independent bases, one of which, of significance here, was the safe harbor. Specifically, the court ruled that the transactions were protected by the safe harbor of section 560, which provides an exception to the ipso facto prohibitions for “the exercise of a contractual right of any swap participant or financial participant to cause the liquidation, termination or acceleration” of a swap agreement. The court rejected Lehman's argument that the provision should be read narrowly such that the sale of collateral and payment of noteholders was not considered a “liquidation” of the swaps. It cited several decisions by the Second Circuit (including the Tribune decision) as endorsing a “broad and literal interpretation” of the related safe harbor provisions of section 546.

Lehman appealed the decision to the district court, urging that the safe harbor should be read narrowly. While that appeal was pending, and after the briefing had been completed, the Supreme Court decided Merit Management. Lehman then added an argument that inasmuch as the Merit Management decision was in favor of plaintiffs it not only dictated a ruling in favor of clawback plaintiffs but also invalidated the decisions of the Second Circuit upon which the bankruptcy court had relied.

Lehman District Court Decision

The district court affirmed the bankruptcy court's decision on March 18, 2018, based solely upon the safe harbor. It found that Lehman's proffered narrow interpretation was inconsistent with both the plain language of the safe harbor and its legislative history. The district court further cited Merit Management in support of its decision, noting its directive to “look to both the language [of a statute] itself and the specific context in which that language is used.” Based on the language of the safe harbor and context in which it is used, the District Court found Lehman's proposed narrow interpretation of the safe harbor to be “nonsensical.”

Lehman's appeal of this decision to the Second Circuit has been briefed but oral argument has not yet taken place.

 *****

Matthew Gold is a partner with Kleinberg Kaplan in New York. He has extensive experience representing secured and unsecured creditors, creditors' committees, debtors, landlords, trustees and acquirers of assets in chapter 11 reorganizations, chapter 7 liquidations, voluntary and involuntary cases, SIPA proceedings, and out-of-court workouts and restructurings. He has prosecuted and defended preference and fraudulent conveyance actions, negotiated and confirmed plans of reorganization and disclosure statements, drafted and negotiated asset sales, and given non-consolidation opinions. Kleinberg Kaplan represents certain defendants in the Lehman and Tribune adversary proceedings.