Corinne Ball
Corinne Ball ()

A recent decision by the U.S. Court of Appeals for the Seventh Circuit, currently under consideration for review by the U.S. Supreme Court, rekindles a circuit split regarding the interpretation of §546(e), which is one of the “safe harbor” provisions enacted to minimize displacement in the commodities and securities markets in the event of a major bankruptcy affecting those markets. Section 546(e) protects a payment to or for the benefit of a financial institution on a securities contract and prevents a trustee from avoiding such pre-petition transactions. The existing split focuses on the role of the financial institution, with the Seventh Circuit now joining the Eleventh Circuit in ruling that a transaction in which the financial institution is a “mere conduit” is not protected by the safe harbor, while the Second, Third, Sixth, Eighth and Tenth Circuits have ruled that the participation by a financial institution is sufficient to bring the transaction within the safe harbor. The Seventh Circuit decision highlights that even when a transaction is structured to be within the safe harbor, it may not qualify for protection, particularly when the transaction occurs in the context of a financially troubled company. Courts, at least in the Seventh and Eleventh Circuits, may look beyond the plain language of a statute and focus instead on the economic substance, rather than the form, of a transaction.

In FTI Consulting v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016), the Seventh Circuit held that §546(e) of the Bankruptcy Code, which protects transactions “made by or to (or for the benefit of)” a variety of financial entities (including brokers as well as financial institutions), did not prevent a bankruptcy trustee from avoiding a transfer which was merely channeled through a financial institution. Courts in five other circuits, including the Second Circuit, have ruled otherwise, holding that the plain language of §546(e) protects transfers made through financial institutions. The Seventh Circuit, however, joining the minority view held by the Eleventh Circuit, focused on the economics of the underlying transaction, and found that financial institutions must be more than mere conduits for a transaction for the §546 safe harbor to apply.


In 2003, Valley View Downs, LP, a racetrack operator in Pennsylvania, agreed to merge with another racetrack, Bedford Downs, in order to improve its chances of obtaining a harness-racing license—one of the licenses required to operate a combination horse track and casino (a so-called “racino”). The two companies had agreed that Valley View would acquire all shares of Bedford for $55 million. The share exchange took place through Citizens Bank of Pennsylvania, acting as the escrow agent. While Valley View was successful in obtaining the harness-racing license, it was unable to obtain a gambling license, prompting it to seek bankruptcy protection.

FTI Consulting was appointed trustee of a litigation trust that included the Valley View estate. Typically, a litigation trustee is appointed to pursue various claims against third parties on behalf of the trust and its beneficiaries. Thus, FTI filed an action to set aside a portion of the $55 million transaction by seeking recovery of $16.5 million transferred to Merit Management Group, a former 30 percent shareholder in Bedford. FTI alleged that the funds in question were property of the bankruptcy estate. In response, Merit argued that the funds fell within the §546(e) safe harbor because Citizens Bank effected the transfer from Valley View to Bedford. The district court agreed with Merit’s argument, and dismissed FTI’s action.

Seventh Circuit’s Decision

The Seventh Circuit reversed. After analyzing the language of §546(e), and other sections of Chapter 5 of the Bankruptcy Code governing trustee’s avoidance powers, the court held that transfers merely funneled through a financial institutions were outside the §546(e) safe harbor. In reaching this conclusion, the court first analyzed the language of §546(e), and found it ambiguous. “By or to” could be read to encompass either just the ultimate transferor and transferees—Valley View and Bedford—or to include Citizens Bank as well—a transfer from Valley View to Citizens Bank and then a subsequent transfer from Citizens Bank to Bedford. Likewise, the “for the benefit of” language also could be understood as meaning either “on behalf of” or “merely involving” a financial institution.

Without the aid of a clear statutory direction, the Seventh Circuit considered other avoidance sections in Chapter 5 of the Bankruptcy Code. In analyzing the various avoidance provisions of Chapter 5, the court’s analysis was driven by the economic substance of the transaction over its form. As such, the court found that Citizens Bank’s role in the Valley View-Bedford transaction was only to convey funds in accordance with instructions provided by Valley View. Taking this view of the transaction, the funds were not transferred to Citizens Bank in any meaningful sense, and were thus not transferred on its behalf (or for its benefit). Citizens Bank merely acted at the direction of Valley View and had no beneficial interest in, or real control over, the funds. To hold otherwise would produce, at least in the eyes of the Seventh Circuit, absurd results. Expanding the safe harbor to protect all transactions simply because the funds flowed through a bank, would “render any transfer non-avoidable unless it were done in cold hard cash.”

The court found further support for its conclusion in the legislative purpose of the statute. Section 546(e) was enacted to reduce “systematic risk in the financial marketplace,” by ensuring that the bankruptcy of one financial participant would not trigger the failure of other institutions through the avoidance of transfers. The Seventh Circuit found no conflict between this purpose and its holding. As the only parties affected were Merit and Valley View, and not Citizens Bank, the narrowing of the safe harbor would not increase systemic risk to financial entities. Under the Seventh Circuit’s holding, §546(e) would still protect a financial institution that is the ultimate recipient of a transfer.

Circuit Split

In In re Munford, 98 F.3d 604 (11th Cir. 1996), the Eleventh Circuit also found that a leveraged buyout was not protected by §546(e) because the ultimate recipients of the transferred funds were not protected entities. Like the Seventh Circuit, the Munford court was concerned primarily with analyzing which parties held a beneficial interest in the funds transferred. The FTI decision, however, is at odds with the Second, Third, Sixth, Eighth and Tenth Circuits, all of which have found that §546(e) protects transfer made through financial institutions. Courts in those circuits have found the plain language of §546(e) to be dispositive and rejected the “conduit” argument embraced in the FTI decision. The majority view is that any transfer to a financial institution is protected, regardless of any subsequent transfers.


Merit has appealed the Seventh Circuit’s ruling, and the Supreme Court will shortly decide whether review of the decision is warranted. In the meantime, the existing circuit split results in various levels of risk for participants in financial transactions, depending on the likely venue for a later challenge. The Seventh Circuit approach should serve as a warning for those dealing with a financially troubled company, whether in a restructuring of its debt or an acquisition. The risk could persist for four to six years, potentially affecting the price that third parties are willing to pay for the acquisition of a financially troubled company or accept in the context of compensation for an exchange offer or early prepayment. The FTI holding may apply to both public and private securities. As such, it creates a venue consideration for company side counsel and sounds a warning to third parties dealing with a company having potential bankruptcy venue in either of the Seventh or Eleventh Circuits.

The extent of the §546(e) safe harbor is also the subject of lively debate among scholars and commentators. Section 546(e) has been criticized for protecting transfers of privately issued securities (such as leveraged buyouts) that leave a company with insufficient capital. These commentators focus on the impact of the safe harbor on the private securities market, which they believe does not serve the intent of §546(e), which was intended to protect the securities markets and prevent the rippling effect of undoing or avoiding transactions that had the potential to affect multiple financial institutions. In response to this concern, the 2011 report of the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 recommended that §546(e) be amended to limit the safe harbor protection to publicly issued securities, even when a financial institution only acts as a conduit. However, practitioners have realized the potential extent of protection provided by the broad reading of §546(e) adopted by the majority of the circuits, especially in the context of leveraged buyouts and restructuring a financially distressed business. Reliance on this protection in a context that does not involve or affect commodities or securities markets has caused the circuit split, indeed, the Eleventh and Seventh Circuits both looked to Congressional intent as part of their analysis. Nevertheless, a plain meaning interpretation extends the safe harbor protection to many situations. Practitioners must take that opportunity into account in any transaction with a distressed company or any highly leveraged transaction. It remains to be seen whether judicial resolution of this split will end the controversy or lead to reforming legislation. Given the ambitious legislative agenda potentially before Congress, it is unclear if bankruptcy reform will merit Congressional attention in the near term.