Troubled Waters Ahead: Supreme Court Narrows Safe Harbor
Client Alerts | March 6, 2018 | Hedge Funds
The United States Supreme Court has narrowed the scope of section 546(e), the Bankruptcy Code securities safe harbor for clawbacks, such that it may be available in many cases to only banks, large funds, and other large financial institutions. The case, Merit Management Group LP v. FTI Consulting, Inc., is the first Supreme Court test of the increasingly important safe harbor, but provides relatively little guidance regarding other contentious safe harbor issues.
The past decade has seen a series of appellate court decisions endorsing an increasingly broad interpretation of the safe harbor, progressively increasing the situations in which defendants could assert protection. (Some of these rulings have been discussed in prior alerts here and here.) Merit constitutes a reversal of that trend, and thus is good news for bankruptcy trustees and unsecured creditors (who typically are the beneficiaries of clawback actions) in bankruptcy cases.
What is unclear is whether the Merit ruling will provide an effective basis for bankruptcy trustees (and other bankruptcy plaintiffs) to chip away at some of these other rulings. The reasoning of Merit was based on a close review of particular language in the statute, which suggests that those other decisions, which interpreted other portions of the statute, may be unaffected. It is likely that there will be a new round of safe harbor litigation in which the applicability of Merit to other safe harbor issues will be explored.
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 many 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. In some cases the safe harbor provides a complete defense, and in others it makes a plaintiff’s case more difficult. For example, 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 as protected 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). 
The Merit Decision
Merit involved efforts by the bankruptcy trustee to avoid as a fraudulent conveyance 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 transfers were either “settlement payments” or “payments made in connection with securities contracts,” two of the relevant types of protected 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.
The Supreme Court, in a unanimous decision, affirmed the ruling of the Seventh Circuit. It held that the applicability of the safe harbor is determined by the protected status of the parties to the 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 safe harbor purposes. As neither of those entities was a protected entity under the safe harbor, the safe harbor was held inapplicable.
Potential Effects of Merit Decision
In general, the safe harbor protected entities are limited to banks, brokers, clearinghouses and large funds. The Merit decision will significantly reduce the number of clawback defendants that can make use of the safe harbor, and make it more difficult for defendants to dismiss cases at the pleadings stage.
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 former Tribune Co. shareholders that are defendants in fraudulent conveyance actions, based in part on the existing Second Circuit precedent regarding the conduit issue [see prior alert] that was overruled in Merit. The Supreme Court has held in abeyance the certiorari petition filed by the Tribune plaintiffs, presumably awaiting the disposition of Merit. Now that Merit has been decided, the Tribune case might be remanded for separate determinations for each defendant regarding whether each 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.
Going forward, clawback plaintiffs will likely look to structure their complaints with an eye to whether prospective defendants are safe harbor protected entities. Parties to transactions involving securities will look to structure their transactions to maximize the likelihood that the safe harbor will provide protection against prospective clawback attack.
Kleinberg Kaplan represents certain defendants in the Tribune adversary proceedings.
 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. Also beyond the scope of this Alert is a discussion of other securities safe harbors in the Bankruptcy Code that deal with issues other than clawbacks.