Section 546(e) Redux—The Proper Framework for the Construction of the Terms Financial Institution and Financial Participant Contained in the Bankruptcy Code After the U.S. Supreme Court’s Holding in Merit

Authors

Peter V. Marchetti, Thurgood Marshall School of Law

Abstract

This Article discusses and analyzes the proper framework for the construction of the terms “financial institution” and “financial participant” as defined in Sections 101(22)(A) and 101(22A) of the Bankruptcy Code (the Code), as they work in tandem with Section 546(e) of the Code. In 2018, the U.S. Supreme Court issued its long awaited decision in Merit, which held that the language regarding transfers “made by or to (or for the benefit of) . . . a financial institution” contained in Section 546(e) does not insulate the ultimate transferee of a constructive fraudulent action (a CFTA) simply because the company being acquired (the Target) through the leveraged buyout (an LBO) uses a bank as an intermediary between itself and its redeeming shareholders (Redeeming Shareholders). Merit stated that in such a transaction, for purposes of fraudulent transfer law and Section 546(e), the Target, not the intermediary bank, is the “transferor.” Likewise, Merit stated that the Redeeming Shareholder, as the ultimate recipient of the transfer, is the “transferee.” Merit concluded that Section 546(e) does not insulate a Redeeming Shareholder from a CFTA simply because a bank or similar entity acted as an intermediary between the Target and the Redeeming Shareholder.

Merit, however, did not address, an important issue in this context regarding the proper construction of certain language contained in Section 101(22)(A), which states that a “customer” of a financial institution will itself qualify as a “financial institution” when a financial institution, such as a bank, acts as an “agent or custodian for a customer (whether or not a ‘customer,’ as defined in section 741) in connection with a securities contract” (the Customer Language or the Customer as Financial Institution Defense). Following Merit, therefore, a large cloud of uncertainty remains as to whether a Target itself qualifies as a financial institution under the Customer Language, simply because a bank or similar entity acted as an intermediary between the Target and its Redeeming Shareholders. If the Customer Language is construed in this overly broad fashion, then essentially all Redeeming Shareholders would be insulated from CFTAs, which would make it virtually impossible for Bankruptcy Trustees to recover billions to trillions of dollars for unsecured creditors in the context of companies that file for bankruptcy within a short time period after completing an LBO or a share repurchase (or share buyback) transaction.

Courts and academics disagree on the proper construction of the Customer Language. The main misguided argument, supported by erroneous rulings of the U.S. District Court for the Southern District of New York and the Second Circuit, which drastically misconstrued the Customer Language, is that pursuant to this language a company being acquired through an LBO itself qualifies as a “financial institution,” because a bank or similar entity that functioned as an intermediary between that company and its Redeeming Shareholders acted as the company’s “agent” in the LBO, thus insulating the Redeeming Shareholders from a CFTA. The proper reading of Sections 101(22)(A) and 546(e), combined with knowledge of the securities lending industry, agency law, and the underlying policies of the Code’s “Safe Harbors,” however, belie this argument.

This Article makes the following novel argument never before raised in the academic literature regarding the interplay between Sections 101(22)(A) and 546(e): Congress inserted the Customer Language into Section 101(22)(A) to protect agent banks (Agent Banks) that act as agents for lenders in securities lending transactions (Agent SLTs). In Agent SLTs, an Agent Bank, usually a custody bank, generally holds substantial amounts of collateral for its lender-customer. Thus, in an Agent SLT, an Agent Bank generally acts as an agent and a custodian for its principal/customer—the lender of the securities. Likewise, in these transactions, the Agent Bank generally provides a guaranty to the relevant lender-customer, pursuant to which the Agent Bank agrees to indemnify the lender if the value of collateral posted by the borrower is insufficient to purchase equivalent securities to those initially loaned by the lender in the securities lending transaction (SLT) if the borrower defaults. This guaranty could be revived, making the Agent Bank liable, if after the Agent SLT is concluded: (i) the borrower files for bankruptcy; (ii) the borrower’s bankruptcy trustee later files an avoidance action such as a CFTA, and (iii) the lender becomes obligated to pay the borrower’s Trustee after either: (a) settling that avoidance action pursuant to a court-approved settlement; or (b) losing the avoidance action.

Such liability to Agent Banks could upend the securities lending market (the SLM). Indeed, absent the Customer Language, an Agent Bank generally could face significant liability in an Agent SLT because one or more of the Agent Bank’s “customers,” such as insurance companies and pension funds, may not qualify for the protection offered by the Safe Harbor contained in Section 546(e) if the borrower later files for bankruptcy. By deeming such entities “financial institutions” in a situation where an Agent Bank acts as “an agent or custodian” for its lender-customer, Congress protected Agent Banks from liability under a revived guaranty. The SLM, like the derivatives market, is an international market that involves trillions of dollars of transactions. Agent SLTs involve agent lenders that, in many situations, are “financial institutions” that act as intermediaries between their “lending” customers and the borrowers of securities. Thus, Congress did not intend the “agent or custodian” language contained in Section 546(e) to apply to garden-variety Redeeming Shareholders in LBOs, and similar transactions such as share buybacks. This interpretation of Section 101(22)(A) is consistent with the plain language of the Customer Language and with Congress’s intent in enacting, and, over the years, amending, the Safe Harbors.

This Article discusses several recent cases that have interpreted Section 101(22)(A). This Article will discuss the recent Second Circuit decision in Tribune II and argue that it was improperly decided. Likewise, this Article will discuss recent post-Tribune cases. One of those cases, Nine West, erroneously expanded Tribune II. In Greektown, however, the Bankruptcy Court for the Eastern District of Michigan disagreed with Tribune and reached an opposite conclusion—that a company being purchased through an LBO does not qualify as a financial institution under the Customer Language, simply because a bank or similar entity acted as an intermediary between the Redeeming Shareholders and the company purchased through the LBO. This Article argues that Greektown was properly decided. The Article will also discuss recent academic literature that argues that Sections 546(e) and 101(22)(A) should be construed to insulate Redeeming Shareholders of stock in publicly traded companies, but not be construed to insulate Redeeming Shareholders in nonpublicly traded companies. This Article argues that no such distinction exists under current law.

This Article makes a novel argument regarding the proper framework for the interpretation and application of Section 101(22)(A) and argues that it applies to lenders of securities in Agent SLTs that may not otherwise qualify as a customer of a broker dealer as defined in Section 741. Examples of such entities are: insurance companies, endowments, and pension funds. An understanding of the SLM combined with the text, structure, legislative history, and policy objectives of the Code readily and strongly support this conclusion.

The Article further argues that, even if courts do adopt this approach to Sections 101(22)(A) and 546(e), Congress should amend the Code so that it partially insulates shareholders in publicly traded securities, so long as those shareholders: (i) are not “insiders” of the debtor; and (ii) act in good faith.

Finally, this Article discusses and analyzes whether a debtor itself may qualify as a “financial participant” under Section 101(22A), thus insulating Redeeming Shareholders from constructive fraudulent transfer or preference liability (the Financial Participant Defense). Redeeming Shareholders have recently raised the Financial Participant Defense as an alternative to the Customer as Financial Institution Defense. Only two decisions have considered this defense, and each one of them reached opposite conclusions. This Article argues that the proper construction of the Code leads to the conclusion that a debtor itself may not qualify as a “financial participant.”

Keywords

Bankruptcy Law, Bankruptcy, Congress, Legislative Branch, Securities Law, Banking and Finance Law, Financial Law, Legal Profession, Taxation--Federal, Taxation

Disciplines

Banking and Finance Law | Bankruptcy Law | Law | Legal Profession | Securities Law | Taxation-Federal

Recommended Citation

Peter V. Marchetti, Section 546(e) Redux—The Proper Framework for the Construction of the Terms Financial Institution and Financial Participant Contained in the Bankruptcy Code After the U.S. Supreme Court’s Holding in Merit, 43 Cardozo L. Rev. 1107 (2022).
Available at: https://larc.cardozo.yu.edu/clr/vol43/iss3/6