Safe Harbor Resource Center

FEATURED PUBLICATION | March 23, 2021 | Creditors’ Rights and Bankruptcy Litigation

Elements of the Safe Harbor Defense

Section 546(e) of the Bankruptcy Code provides a safe harbor that bars certain avoidance actions/clawback actions (described below – “What types of actions are barred?”) regarding Qualifying Transactions (described below) that involve Qualifying Entities (described below).

What types of actions are barred?

Section 546(e) bars preference actions and constructive fraudulent conveyance actions. It also bars actual intent fraudulent conveyance actions that are based on state fraudulent conveyance statutes. It does not protect transfers avoidable under the federal actual intent fraudulent conveyance statute, that is, those made within two years before the petition date that are proven to have been made with actual intent to hinder, delay, or defraud creditors, although in those cases certain defendants may still be able to raise safe harbor defenses.

By its terms section 546(e) bars actions brought by bankruptcy trustees or debtors-in-possession. Caselaw has applied section 546(e) to also bar actions brought by creditors under state fraudulent conveyance laws post-bankruptcy (see Tribune, described below). In addition, caselaw has  interpreted section 546(e) to bar actions based on legal theories that are analogous to barred actions, such as unjust enrichment claims.

Qualifying Transaction

For section 546(e) to apply, the avoidance action must seek to avoid a Qualifying Transaction, such as a settlement payment or a transfer made in connection with a securities contract. Caselaw has interpreted “securities contract” and “in connection with a securities contract” very broadly.

Qualifying Entity

For section 546(e) to apply, the challenged transfer must have been made by, to, or for the benefit of a Qualifying Entity, such as a stockbroker, Financial Institution, Financial Participant, or securities clearing agency. A Financial Participant is an entity that holds sizable positions in certain designated securities contracts and derivatives. A Financial Institution is a bank or a bank customer, if the bank is serving as agent or custodian for such customer in connection with a securities contract.

Leading Cases

Merit Management Group LP v. FTI Consulting, Inc., __U.S. __, 138 S. Ct. 883, 200 L.Ed.2d 183 (2017)

Merit is the leading Supreme Court case on the Safe Harbor. It concerns the Qualifying Entity requirement.

Merit involved efforts by a bankruptcy trustee to avoid as fraudulent conveyances payments 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 Qualifying Transfer requirement had been met, as the transfers were either “Settlement Payments” or Payments made in connection with securities contracts, so the only Safe Harbor issue presented concerned the Qualifying Entity requirement.

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 purposes of the Qualifying Entity requirement were the original payor and the ultimate payee, neither of which was a Financial Institution.

The Supreme Court, in a unanimous decision, affirmed the ruling of the Seventh Circuit. It held that the Qualifying Entity requirement is determined by the status of the parties of the overarching transfer that the clawback action seeks to avoid. Thus, in Merit, 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 Qualifying Entity purposes. As neither of those entities was a Qualifying Entity, the Safe Harbor was held inapplicable.

In re Tribune Company Fraudulent Conveyance Litigation
818 F.3d 98 (2d Cir. 2016) (Tribune I)
2019 Westlaw 1771786 (S.D.N.Y. April 23, 2019) (Tribune II)
946 F.3d (2d Cir. 2019) (Tribune III)
10 F.4th 147 (2d Cir. 2021) (Tribune IV)

The Tribune litigation arose from the 2008 bankruptcy of the Tribune Company. In 2007, the Tribune employee stock ownership plan had acquired all of Tribune’s outstanding shares through a leveraged buyout, pursuant to which Tribune’s shareholders were paid a total of approximately $8.2 billion. In December 2008, Tribune and its subsidiaries filed for bankruptcy.

In April 2011, the Bankruptcy Court modified the automatic stay to permit creditors of Tribune to file state law constructive fraudulent conveyance complaints against former Tribune shareholders. Beginning in June 2011, various creditors of Tribune initiated 44 actions against thousands of former Tribune shareholders in 21 state and federal courts around the country, asserting state law constructive fraudulent conveyance claims and seeking to avoid billions of dollars in payments that the shareholders received in the LBO.

The 2012 Tribune plan of reorganization provided for a litigation trust to prosecute certain actions on behalf of the bankruptcy estate (including actual intent fraudulent conveyance actions against the former shareholders) (the “Trustee Action”), and also provided that state law constructive fraudulent conveyance claims were to be disclaimed by the bankruptcy estate and could continue to be prosecuted by the creditors themselves. Those actions were consolidated, and the actions (the “Creditor Actions”) proceeded before the District Court for the Southern District of New York.

The reason behind the split of the fraudulent conveyance causes of action was the plaintiffs’ concern that the Safe Harbor would prevent a bankruptcy trustee from bringing constructive fraudulent conveyance actions against the former shareholders. The strategy to try to work around the Safe Harbor was to structure the litigation so that the named plaintiff in the constructive fraud cases was not a bankruptcy trustee but instead a creditor or a representative of creditors. The point was that the language of section 546(e) appears to limit only actions brought by “the trustee,” and thus an action brought by a creditor arguably is outside of the scope of the Safe Harbor. Pursuant to the workaround strategy, the bankruptcy estate disclaimed any right to avoid transactions under the state fraudulent conveyance statutes, and instead the same transactions became the subject of avoidance actions brought by creditors under state fraudulent conveyance laws.

In 2016 (Tribune I), the Second Circuit approved the dismissal of the Creditor Actions, holding that section 546(e) blocked the workaround. It based its decision on the doctrine of implied preemption, holding that the purpose of the protections of the Safe Harbor would be eviscerated if the Safe Harbor applied to only actions brought by a trustee and not to substantively identical actions brought by creditors. It further held that the Safe Harbor requirements were satisfied, following current Second Circuit precedent that financial institutions that the Qualifying Entity requirement was satisfied because the funds flowed through Financial Institutions that were “mere conduits,” that is, entities without a substantial stake in the transaction.

Following the Supreme Court’s subsequent 2018 decision in Merit Management (above), the Tribune litigation trustee and the creditor plaintiffs took the position that Merit Management invalidated the Tribune I ruling. Based on this position, (1) the trustee filed a motion in the Trustee Action seeking to amend his complaint to add a count alleging that the payments to shareholder defendants could be avoided as constructively fraudulent conveyances, and (2) the creditor plaintiffs asked, in the Creditor Actions, for the Second Circuit to reverse Tribune I in light of Merit Management.

In the Trustee Action the district court (Tribune II) denied the trustee’s motion to amend, reasoning that the amendment would be “futile” because all of the shareholder defendants would be able to successfully assert a Safe Harbor defense in a motion to dismiss. (The court also relied on a separate determination that permitting the amendment would result in undue prejudice to shareholder defendants, “whose only involvement in this transaction was receiving payment for their shares.”) The Safe Harbor conclusion was based on a ruling that Tribune itself fits within the definition of a Financial Institution, due to the terms by which the term statutorily defined. As the court explained, “The Bankruptcy Code [in section 101(22)(A)] defines a ‘financial institution’ to include not only traditional financial institutions, but also, in defined circumstances, the customers of traditional financial institutions.”

Tribune had engaged Computershare Trust Company to act as depositary in connection with the 2007 leveraged buyout. Computershare itself was a Financial Institution, which made Tribune, as Computershare’s customer, also a Financial Institution. Accordingly, the Qualifying Entity requirement was deemed satisfied.

The court further determined that this application of the Safe Harbor is consistent with Merit Management. It reasoned that under Merit Management it is irrelevant, for Qualifying Entity requirement purposes, that Computerserve, as a Financial Institution, served as a conduit for the flow of funds from Tribune to shareholders. Merit Management requires that the Qualifying Entity be the payor or the payee. Computerserve was not only a conduit but also an agent of Tribune. Thus, the payor, Tribune, was determined to be a Qualifying Entity itself. And the Merit Management decision expressly disclaimed any ruling on the “customer as Financial Institution” portion of the Financial Institution definition that was critical in Tribune.

Tribune II was appealed to the Second Circuit. While that appeal was pending a separate panel (Tribune III), acting in the Creditor Actions, ruled for the defendants. While the appellate panel did not cite to or discuss the Tribune II decision it reached the same conclusion – that Tribune itself fit within the definition of a Financial Institution, due to the way in which the term is statutorily defined, and that as a result the Safe Harbor is applicable to protect the Tribune defendants.

The Tribune III panel also reaffirmed the Tribune I 2016 conclusion, based on the doctrine of implied preemption that the plaintiffs could not work around the Safe Harbor by framing the action as one brought by creditors of Tribune rather than by a bankruptcy trustee. It rejected the plaintiffs’ arguments that Merit Management, which was based on a strict interpretation of the plain meaning of a statutory provision, should be interpreted to supply a policy rationale for allowing the workaround and making the Safe Harbor inapplicable.

The Second Circuit then affirmed the Tribune II decision in Tribune IV.

A Selection of Our Thought Leadership on Safe Harbor