Private Equity

Last week, in Merit Management Group, LP v. FTI Consulting, Inc.^[1] the Supreme Court settled a split in the circuit courts, unanimously holding that the safe harbor provision created by 11 U.S.C. § 546(e), 11 U.S.C. §§ 101-1532 (the “Bankruptcy Code”), will not shield the recipient of a constructively fraudulent transfer from liability solely due to the fact that the transfer in question was routed through a financial institution.  Section 546(e) is a safe harbor from the avoidance provisions of the Code, which generally otherwise permit a debtor or its assignees to “avoid” (i.e., unwind or claw back) certain transfers that a bankrupt entity makes before a bankruptcy filing.

In Merit Management, the petitioner, Merit Management Group, LP (“Merit Management”), sold its 30% stake in Valley View Downs, LP (“Valley View”) to Bedford Downs Management Corp. (“Bedford Downs”). The parties in the transaction used financial institutions as intermediaries to facilitate the sale of Valley View.  In particular, a third party bank served as escrow agent to hold certain of the total sale proceeds transferred from Bedford Downs before their ultimate distribution to Merit Management.  In total, approximately $16.5 million of sale proceeds were ultimately disbursed from escrow to Merit Management.

Thereafter, Bedford Downs was unable to receive a gaming license that was key to its business plan and filed for Chapter 11 bankruptcy.  Pursuant to Bedford Down’s chapter 11 plan, FTI Consulting, Inc. (“FTI”) was appointed to serve as the trustee for a litigation trust.  As trustee, FTI sought to unwind the transfer of Valley View’s stock to Bedford Downs as a constructively fraudulent transfer (on the theory that Bedford Downs “significantly overpaid”), thereby permitting FTI to claw back the $16.5 million in sale proceeds released from escrow to Merit Management.  At the trial level, Merit Management argued successfully the entire transfer was sheltered under section 546(e) of the Bankruptcy Code given, among other things, the intervening transfer of sale proceeds into escrow before their ultimate receipt by Merit Management.

The Seventh Circuit reversed, holding that the § 546(e) safe harbor did not apply where the financial institutions in question served as “mere conduits.”  In this regard, the Seventh Circuit’s opinion split with no less than 5 different appellate courts (including the Second and Third Circuits), which had reached the opposite conclusion.

The Supreme Court then sided squarely with the Seventh Circuit and flatly rejected the concept that a financial intermediary would automatically cause a constructively fraudulent transfer to fall within section 546(e)’s safe harbor—noting that “the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power, where that limit is defined by reference to an otherwise avoidable transfer . . . .”  Rather, the Supreme Court determined that the only transfer for purposes of the section 546(e) safe harbor is the transfer that is sought to be avoided, which was the ultimate distribution of $16.5 million in sale proceeds to Merit Management.  Put another way, the ultimate beneficiary of a particular transaction will not be protected from a subsequent clawback action by section 546(e) if a financial institution participates only as an “mere intermediary” or a conduit.

Until last week, a broad reading of the section 546(e)’s safe harbor provisions provided sellers of companies, including in connection with leveraged buyout transactions, with a clear method to protect sale proceeds against a later clawback under fraudulent transfer theory.  Sellers could simply intermediate the receipt of sale proceeds with a financial institution in that transaction, such as by using a paying or escrow agent.  Under Merit Management, however, sellers can no longer rely on this approach for protection from a later attack in this regard.  It is now more important than ever for sellers, especially in a leveraged buyout transaction, to consider conducting reverse due diligence on the purchaser and its capital structure to ensure that the purchasing entity will be solvent on a pro forma basis, after giving effect to the transaction.  And, while it is standard for a purchaser in such a transaction to give a representation as to solvency, such a representation may not be enough to adequately protect the seller.  Thus, asset sellers may which to consider alternative methods for protection, such as solvency certifications by a knowledgeable officer of buyer or requiring the buyer to deliver a third party solvency opinion in connection with the transaction.