Opinion analysis: Justices reject limits on bankruptcy recovery of fraudulently transferred assets

Today’s decision in Merit Management Group v. FTI Consulting brought few surprises to observers familiar with the argument.  As I explained in my post about the argument, the justices in November showed broad skepticism about the idea that a Bankruptcy Code provision protecting “securities payments” should provide a broad shield against exercise of the bankruptcy court’s power to recover fraudulent conveyances. So the prompt and unanimous opinion of Justice Sonia Sotomayor (only the second decision from the November argument session) was just what you should have expected.

As I explained in more detail in my preview, the case involves the “avoidance” powers of the bankruptcy court, which generally permit the court to recover (“avoid”) dubious payments that bankrupts make before their bankruptcy filings. The provisions have numerous detailed exceptions including one that bars recovery of any “settlement payment” made under a “securities contract” if it is “by or to” a financial institution. The issue in this case is whether that provision protects the transaction if the financial institution is involved only as a conduit. The U.S. Court of Appeals for the 2nd Circuit and almost all of the other courts of appeals have held for many years that the statute protects those conduit payments: In the terms of the statute, that reading insulates the transactions from scrutiny because the final leg of those transactions (typically) is a payment made “by” a protected intermediary. The Supreme Court here embraced the U.S. Court of Appeals for the 7th Circuit’s rejection of that view: Bankruptcy courts can avoid fraudulent transfers even if those transfers are effected by transfers of funds or assets through the intermediaries that operate our securities and payments networks.

The opinion deploys a contextual mode of textual interpretation, rather explicitly choosing between two different readings of the statute based on the Supreme Court’s sense about which reading would fit more comfortably within the broader structure of the relevant part of the Bankruptcy Code – looking both to “the language itself [and] the specific context in which that language is used.” Thus, the court starts by noting that the debate in the lower courts and, for the most part, the briefs of the parties involves the question whether it is fair to characterize a transfer as one made “by” a financial institution when the institution is a “mere” conduit without an active role in directing the transaction.

The Supreme Court’s opinion offers no direct explication of the language protecting transfers “by” intermediaries, explaining that starting from “those inquiries put[s] the proverbial cart before the horse.” Properly directed, a court cannot “determine whether a transfer was made by or to or for the benefit of a covered entity” unless it can “first identify the relevant transfer to test in that inquiry.” In its concerted analysis of context, the court starts with the introductory clause of the securities exception in Section 546(e), which defines a group of securities payments that are protected from avoidance “notwithstanding” the trustee’s various avoidance powers. For the court, the “notwithstanding” clause “already begins to answer the question,” because “[i]t indicates that §546(e) operates as an exception to the avoiding powers afforded to the trustee under the substantive avoidance provisions.” Thus, the court reasons, “the text makes clear that the starting point … is the substantive avoiding power … and, consequently, the transfer that the trustee seeks to avoid as an exercise of those powers.”

The opinion continues with several similarly contextual points, presented more summarily. For example, the last clause of Section 546(e) provides an exception to the securities exception, defined by reference to a specific avoidance power, “signal[ing] that the exception applies to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.” Again, the section heading (“Limitations on avoiding powers”), although admittedly of minor relevance, “demonstrates the close connection between the transfer that the trustee seeks to avoid and the transfer that is exempted from that avoiding power pursuant to the safe harbor.” Similarly, the opinion notes the evident parallelism between the exceptions statement that “the trustee may not avoid” specified transfers and the verbal design of the avoidance powers, all of which provide that the “trustee may avoid” designated transfers.

Continuing in the same vein, that section closes with Sotomayor’s most notable rhetorical flourish:

The transfer that “the trustee may not avoid” is specified to be “a transfer that is” either a “settlement payment” or made “in connection with a securities contract.” Not a transfer that involves. Not a transfer that comprises. But a transfer that is a securities transaction covered under §546(e).

For its last affirmative point, the Supreme Court turns to the “statutory structure” – marked out as a separate subpart of the opinion, apparently to underscore the justices’ view that statutory “structure” is distinct from the statutory “context” I have been discussing in the last three paragraphs. The court offers a laudatory quotation from the 7th Circuit’s opinion to support the argument that the structure “reinforces” the court’s “reading” of the statute: “As the Seventh Circuit aptly put it, the Code ‘creates both a system for avoiding transfers and a safe harbor from avoidance—logically these are two sides of the same coin.’”

Applying that reasoning, the disposition of the case is straightforward: The trustee identified a purchase of stock as a fraudulent transfer (because the stock did not provide fair value for the transferred purchase price); the use of securities intermediaries to finalize the transfers of the stock and funds does not justify exempting the transaction from the ordinary application of the avoidance powers of the bankruptcy court.

With the affirmative explanation of its reasoning complete, the Supreme Court closes with a brief rebuttal of the principal arguments advanced to support the broad reading of the securities exception that has prevailed in the lower courts. First, the court addresses the possibility that the present language of the exception (recently expanded so that it reaches transfers made “for the benefit of” the listed intermediaries) was adopted to overrule a lower-court decision that had given a narrow reading to a previous version of the exception. On that point, the court offers two responses. For one thing, the argument founders on the utter absence of any legislative history suggesting an intention to overrule the decision in question. More generally, the court suggests that the addition of the language makes sense because it parallels language in the avoidance powers that reaches to transactions that are made “for the benefit of” a particular creditor.

Second, the court rejects the argument that its reading renders superfluous the inclusion of “securities intermediaries” as protected parties – because those entities always act as “intermediaries.” On that point, the court questions the factual premise of the argument, pointing to at least one well-known lower court case in which parties plausibly had contended that securities intermediaries acted with “a beneficial interest in a challenged transfer.” In those cases, the court explains, because the challenged transfer would be “made ‘by’ or ‘to’ a securities clearing agency, [the statute] will bar avoidance,” giving effect to the statute’s inclusion of those entities in the exemption.

Third and finally, the Supreme Court firmly resists the suggestion that “Congress’ purpose in enacting the safe harbor” reflected a “prophylactic” rather than a “surgical” interest in broad protection of the finality of transactions. Whatever the court might have thought about the policy arguments, the opinion suggests that the text Congress chose is simply too specific to give weight to such a general concern:

In fact, [the] perceived purpose is actually contradicted by the plain language of the safe harbor. Because, of course, here we do have a good reason to believe that Congress was concerned about transfers “by an industry hub” specifically: The safe harbor saves from avoidance certain securities transactions “made by or to (or for the benefit of)” covered entities. … Transfers “through” a covered entity, conversely, appear nowhere in the statute.

At bottom, then, for the Supreme Court, the policy argument “is nothing more than an attack on the text of the statute.”

It remains to be seen how important this decision will be on the ground. It is, to be sure, a broad and firm rejection of the consensus understanding of the courts of appeals, which has the apparent purpose of making it easier to challenge overpriced leveraged-buyout transactions that end up in the bankruptcy courts (a category that includes many of the largest cases of the last several years).

Having said that, it is at least possible that the exception still might be read to protect many if not most of these transactions. The most obvious possibility is that close ties between the parties to the avoided transfer and the financial institutions that they use as intermediaries might allow the exception to apply on the theory that the parties to the transfer are themselves protected institutions. The defendants in this case did not brief that question (having conceded it in the lower courts), but Justice Stephen Breyer went out of his way at oral argument to suggest it as an alternate justification for protecting these transfers. The court notes in a brief footnote that the question was waived in this case, but undoubtedly it will be raised quickly as a justification for limiting the effect of this decision. So in the end the one group most likely to benefit from the decision is the competing groups of litigators that will continue to challenge, and defend, these transactions.