The District Court In Tribune Circumscribes Merit And Maintains Section 546(E) Safe Harbor Protection For Shareholders In The Wake Of A Failed LBO

Last year, the Supreme Court issued its decision in Merit,1 unanimously ruling that a buyout transaction between private parties did not qualify for “safe harbor” protection under Bankruptcy Code section 546(e), on the basis that a “financial institution” acted as an intermediary in the overarching transaction. Section 546(e) protects from avoidance certain transfers by, to, or for the benefit of a financial institution.2 The Merit ruling is generally portrayed as a narrowing of safe harbor protections by withdrawing non-avoidance protections from transfers to beneficial owners of privately issued securities in a buyout transaction (while affirming protections afforded to securities industry participants, including financial institutions).

However, the question left unaddressed by the Supreme Court in Merit was the scope of the term “financial institution.”3

A District Court in the influential Southern District of New York recently answered the question and potentially restored the broad scope of avoidance protections available to parties to certain financial contracts, including securities contracts related to leveraged buyout transactions involving privately issued securities.

In an April 23, 2019 decision4 related to the failed LBO and subsequent bankruptcy of the Tribune Company (“Tribune”)5, Judge Denise Cote found that Tribune, the purchaser of stock (publicly traded securities) from its shareholders, (a) employed a bank (financial institution) to effect the two-step LBO and (b) was a customer of the bank. Consequently, Tribune itself was determined to be a “financial institution” under the broad statutory language of the Bankruptcy Code and the transfers to shareholders were protected from avoidance under Section 546(e).6

In the debate about the appropriate scope of safe harbor protections, the Tribune Decision may re-direct the discussion to the identity of the parties to a transaction and the tangential involvement of banks and other financial institutions, and away from examining the substance of the transaction and whether it has an impact on the securities markets that Congress intended to protect from disruption by creating the safe harbors in the first instance.

The Merit Decision

In Merit, Valley View Downs, a private company (race track), acquired a competitor, Bedford, also a private company, by acquiring Bedford's stock from its shareholders, including Merit Management Group, in exchange for cash transfers. The payment was routed through a foreign investment bank and a U.S. commercial bank. It was undisputed that the non-public transaction was a stock purchase (securities contract) and the payment was either a settlement payment or transfer in connection with a securities contract.

Valley View failed and filed for bankruptcy protection. The bankruptcy trustee subsequently sought to avoid and recover the payment to Merit Management. Neither Valley View nor Merit Management contended that either was a financial institution, but instead focused their arguments on whether the payment could not be avoided because financial institutions acted as intermediaries or conduits in the transaction.

The involvement of a financial institution in the transaction would have been sufficient to invoke Section 546(e) protections in a majority of the Circuit Courts that had previously addressed the issue.7 But, in the decision that was appealed to the Supreme Court, the Seventh Circuit declined to read the safe harbor protections “expansively,” focused its analysis on the “economic substance of the transaction,” and reversed the dismissal of the trustee's avoidance action.

Justice Sotomayor wrote for the Supreme Court and affirmed the Seventh Circuit. She...