Argument preview: Justices to parse Bankruptcy Code’s fine print in high-stakes dispute over recovering assets for creditors of bankrupts

When the justices hear oral argument next Monday in Merit Management Group v FTI Consulting, they will finally be turning their attention to one of this century’s most prominent disputes about how to read the Bankruptcy Code.

The case involves limits on the so-called “avoidance” powers of the bankruptcy trustee designed to protect intermediaries in the securities industry. Traditionally, bankruptcy courts (and the trustees acting in those courts) have had the power to recover (or “avoid”) dubious payments that bankrupts make shortly before they file for bankruptcy. In some cases, the trustees avoid “preferences,” payments that improperly prefer one creditor over another. In others, they avoid “fraudulent” transfers, transfers that defraud existing creditors by moving assets out of the estate unfairly.

The power to avoid transfers is subject to many qualifications and several exceptions, which Chapter 5 of the Bankruptcy Code describes in detail that you might regard as either lavish or painful, depending on your perspective. This case involves a problematic exception set forth in Section 546(e), which protects from avoidance any “settlement payment” that is made in connection with a “securities contract,” so long as the payment is “by or to (or for the benefit of)” any of six listed types of financial intermediaries.

Courts for many years have struggled over applying that provision when funds pass through a financial intermediary in the course of a payment transaction. For example, assume that one company needs to make a payment that is to be distributed to the shareholders of a large public company. Because of the institutions through which interests in public companies are held, the payment could not go directly from the paying company to the shareholders. Rather, the payment would pass first through the hands of a large financial institution in New York, which would have access to the registry necessary to allocate the payment among those shareholders. If we looked at the overall payment (from the paying company to the shareholders), we would say that the payment was neither “by” nor “to” the financial intermediary: It was made by the paying company and paid to the shareholders. On the other hand, if we looked at the last leg of the transaction, we would say that the payment ultimately was made to the shareholders by a listed intermediary.

This case presents exactly that problem. The trustee attempted to avoid a payment by the bankrupt company, Valley View Downs, which had hoped to establish a “racino” – a racecourse with slot machines – to the petitioner, Merit Management, in exchange for Merit Management’s shares in Bedford Downs, another aspiring racino operator. Merit Management argues that Section 546(e) protects the payment because it came into Merit’s hands from a financial intermediary. A prestigious panel of the U.S. Court of Appeals for the 7th Circuit (Chief Justice Diane Wood writing for the majority, joined by Judges Richard Posner and Ilana Rovner) disagreed, rejecting the contrary analysis of the U.S. Court of Appeals for the 2nd Circuit (the federal appellate court in New York City). FTI Consulting contends that the 7th Circuit got it right, arguing that the relevant “transfer” is the overall transaction in which Valley View agreed to make a payment to Merit Management and the other shareholders of Bedford Downs.

This is an issue with ramifications far beyond the particular dispute at hand. In particular, it is crucial in the frequent bankruptcies seeking to unwind unsuccessful leveraged buyouts. To give one notable example, this issue was one of the focal disputes in the recent bankruptcy of the Tribune publishing company. A petition raising that problem is pending before the Supreme Court; the parties to that case have filed amicus briefs on both sides of Merit Management.

The parties spend a good deal of effort debating the importance (or propriety) of preserving transactions in the securities markets from subsequent attack. My sense, though, is that the justices will approach this case as a straightforward vehicle for statutory interpretation, with the dispute turning almost entirely on whether the relevant “transfer” is the overarching payment (from Valley View to Merit) or instead the final leg of the payment (from the intermediary to Merit). My guess is that the argument will give us a pretty good sense of what the justices think about that.