Customers Merit a Safer Harbor: Courts of Appeals Reaffirm the Application and Scope of the Section 546(e) Safe Harbor

Backdrop: The 546(e) Safe Harbor and Disputes over Its Scope

The Bankruptcy Code empowers a trustee or a Chapter 11 debtor-in-possession to bring claims to avoid certain pre-bankruptcy transfers of property. Those avoidance powers are limited by certain statutory limits, or “safe harbors,” set forth in section 546 of the code. There are safe harbors in section 546(f) for prepetition transfers made “by or to (or for the benefit of) a repo participant or financial participant, in connection with a repurchase agreement,” and analogous safe harbors in sections 546(g) (transfers in connection with a “swap agreement”) and 546(j) (transfers in connection with a “master netting agreement”), but in particular, the safe harbor in section 546(e) bars the avoidance of prepetition transfers that are (1) either a “settlement payment” or made “in connection with a securities contract . . . commodity contract . . . or forward contract”; (2) “by or to (or for the benefit of)” a qualifying entity; that is, a “commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency,” which critical terms are each defined in sections 101, 741, or 761 of the code. The majority of circuits have held that section 546(e) also preempts attempts to use state law causes of action such as unjust enrichment to recover alleged fraudulent transfers. See, e.g., Petir v. BMO Harris Bank N.A., 98 F.4th 1090 (7th Cir. 2024). Importantly, section 546(e)’s safe harbor does not apply to prepetition transfers that are intentional fraudulent transfers under federal bankruptcy law; that is, that are avoidable under 11 U.S.C. § 548(a)(1)(A).  

The scope of section 546(e)’s safe harbor has been the subject of extensive debate and litigation. On the one hand, it is generally agreed that the purpose of section 546(e) (and the analogous safe harbors of sections 546(f),(g), and (j)) is to prevent disruption in the commodities and securities markets. H.R. Rep. No. 97-420, at 1 (1982). Litigation seeking to avoid long-settled transactions in public securities has demonstrated that disruption would occur if such transactions were unwound.  

On the other hand, the plain language of section 546(e)’s first requirement—that a transfer be a “settlement payment” or be made “in connection with a securities contract . . . commodity contract . . . or forward contract”—has generally been interpreted to be of “extraordinary breadth” (In re Bernard L. Madoff Inv. Sec. LLC, 773 F.3d 411, 417 (2d Cir. 2014)) and, by its plain statutory terms, applies to any payment that settles a transaction in securities and a host of contracts for or related to a securities transaction. Likewise, in a literal sense, any transfer in connection with a “securities contract” or settling a securities transaction of any material size will be made “by or to” a financial institution at some point in the transfer—i.e., by sending funds from an account at the buyer’s bank to an account at the seller’s.  

Thus, under such a literal reading of the statute, an entirely private transaction in the securities of a closely held corporation would be safe-harbored as long as the consideration is not paid by physical cash or commodities—that is, so long as the payment was made “to” a financial institution for the benefit of the seller, even though the transaction bears no nexus to the financial or public securities markets at all.   

Some courts looked to section 546(e)’s legislative history to impose a requirement that the transfer to be safe-harbored have a nexus to the public securities markets. E.g., Geltzer v. Mooney (In re MacMenamin’s Grill Ltd.), 450 B.R. 414 (Bankr. S.D.N.Y. 2011) (Drain, J.) (declining to apply 546(e) safe harbor to private sale of shares in a bar and grill for a total of $1.15 million; “the movants in fact have not provided any evidence that the avoidance of the transactions at issue involved any entity in its capacity as a participant in any securities market, or that the avoidance of the transactions at issue poses any danger to the functioning of any securities market”). But courts prior to 2018 split on two primary approaches to limiting the scope of section 546(e)’s safe harbor using the second prong—a transfer by, to, or for the benefit of a qualifying institution. Under the more restrictive approach, only transfers in which the qualifying entity had a “beneficial interest,” that is, did not serve as a “mere conduit,” were safe-harbored. See, e.g., In re Munford, 98 F.3d 604, 610 (11th Cir. 1996) (per curiam) (refusing to apply section 546(e) safe harbor to a transfer in which a financial institution acted as a “mere conduit”); In re MacMenamin’s Grill Ltd., 450 B.R. at 425–26. Under the broader approach adopted by the majority of circuits, the safe harbor applied to any transfer by or to a qualifying institution, even if that qualifying institution served only as a “mere conduit” holding an account for the benefit of a nonqualifying entity. See, e.g., In re Quebecor World (USA) Inc., 719 F.3d 94, 99 (2d Cir. 2013); In re Resorts Int’l, 181 F.3d 505, 516 (3d Cir. 1999); In re QSI Holdings, Inc., 571 F.3d 545, 555 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 987 (8th Cir. 2009); In re Kaiser Steel Corp., 952 F.2d 1230, 1240 (10th Cir 1991).

Merit Management’s Middle Path

In 2018, the Supreme Court resolved this split, holding that a transfer is not safe-harbored if a qualifying institution acts as a “mere conduit”; instead, the ultimate transferor, transferee, or beneficiary must be a qualifying entity for the safe harbor to apply. Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 583 U.S. 366, 377–78 (2018). Without more, this holding would seem to adopt the more restrictive approach and narrow the scope of protected transfers. But instead, the Merit Management Court highlighted a third path: It observed that section 101(22)(A) of the Bankruptcy Code defines a qualifying “financial institution” to encompass not only traditional banks, trust companies, and the like but also a customer of such a financial institution when the financial institution “is acting as agent or custodian for [the] customer . . . in connection with a securities contract.” Id. at 373 n.2. In other words, in these circumstances, the financial institution’s customer itself qualifies as a “financial institution.”

While the Merit Management Court did not apply the “customer” prong of the Bankruptcy Code’s definition of a “financial institution” to the facts of that case, the courts of appeals and lower courts have relied on the middle path Merit Management charted to conclude that transfers to the customer of a financial institution are transfers to a “financial institution” when the institution is acting as an agent or custodian for a customer.

One of the earliest, and most prominent, examples of this approach was the Second Circuit’s 2019 decision in In re Tribune Co. Fraudulent Conveyance Litigation, 946 F.3d 66 (2d Cir. 2019), which revisited its prior conclusion that transfers made in connection with the Tribune Company’s leveraged buyout were protected by section 546(e) in light of Merit Management.

In its 2016 decision in the Tribune case, the Second Circuit had affirmed the dismissal of claims to avoid transfers of payments made from Tribune to participants in its 2007 leveraged buyout (LBO) on the ground that such transfers were safe-harbored by section 546(e). Following Merit Management, the Second Circuit recalled its mandate and, in 2019, reaffirmed its conclusion that the transfers were safe-harbored by section 546(e).

Tribune Company, the Second Circuit concluded, was itself a “financial institution” because it was the “customer” of a qualifying institution, Computershare, that Tribune retained as its agent to make payments to LBO recipients. In so concluding, the Second Circuit rejected attempts to give a narrow reading to “agent” or “customer,” and instead adopted the common-language meaning of “customer” and the common-law approach to agency. In re Trib. Co. Fraudulent Conv. Litig., 946 F.3d at 77–78 & n.9. In determining that Computershare was Tribune’s agent, the Second Circuit adopted the common-law approach to agency. Id. at 79.

Tribune’s approach was subsequently applied in several bankruptcy and district court decisions in the Second Circuit. E.g., Holliday v. Credit Suisse Sec. (USA) LLC, No. 20-civ-5404 (GBD), 2021 WL 4150523 (S.D.N.Y. Sept. 13, 2021); In re SunEdison, Inc., 620 B.R. 505 (Bankr. S.D.N.Y. 2020); In re Boston Generating LLC, 617 B.R. 442 (Bankr. S.D.N.Y. 2020). In a notable decision, a bankruptcy court concluded that a bank does not act as an “agent” or “custodian” for a bank customer when the bank simply holds an ordinary deposit account. In re Tops Holding II Corp., 646 B.R. 617, 686–87 (Bankr. S.D.N.Y. 2022) (concluding that the safe harbor did not apply; bank holding account for customer was not acting as “agent” or “custodian” such that customer would qualify as a “financial institution” under section 101(22)(A)).

The Eighth Circuit, in 2022, joined the Second Circuit in endorsing the “customer” approach of Tribune in Kelley v. Safe Harbor Managed Account 101, 31 F.4th 1058 (8th Cir. 2022).

The Second Circuit’s Decision in Nine West

The Second Circuit’s November 2023 decision in Nine West both reaffirms the ongoing viability of the path charted in Merit Management and followed in Tribune, and further clarifies the limits of that approach.

In 2014, Sycamore Partners acquired Jones Group (the parent company of Nine West and other retailers) through an LBO. Wells Fargo, a “financial institution” as defined in the Bankruptcy Code, was hired to act as a paying agent to distribute LBO payments to public shareholders. Separately, Jones Group’s directors, officers, and employees (referred to as the “individual shareholders”) would be paid for their shares through Jones Group’s payroll processor, which the plaintiff argued is not a “financial institution” as defined in the code.

Nine West filed for bankruptcy in 2018; thereafter, a litigation trustee pursued certain estate causes of action, including fraudulent transfer claims against the public shareholders and the individual shareholders. In 2020, Judge Rakoff of the U.S. District Court for the Southern District of New York dismissed the fraudulent transfer claims against both groups. Judge Rakoff concluded that all of the LBO payments were protected because Nine West was a customer of Wells Fargo and that Wells Fargo was an agent in connection with a “securities contract,” i.e., the merger agreement effecting the LBO (a “contract-by-contract” analysis). The litigation trustee appealed to the Second Circuit.

On November 27, 2023, the Second Circuit affirmed the district court’s ruling with respect to payments to the public shareholders but reversed with respect to the payments to the individual shareholders.

The Nine West panel disagreed with the breadth of the district court’s analysis. The majority concluded that section 546(e)’s statutory language and legislative purpose require courts to assess whether a financial institution is acting as an agent or custodian for a customer in connection with each transfer to be avoided (a “transfer-by-transfer” analysis). In support of this approach, the majority noted that the structure of the avoidance and safe harbor provisions focuses on transfers and that the purpose of the safe harbor—avoiding systemic risks to the financial markets—was better served by a transfer-by-transfer approach.

Applying its analysis to the facts of the case, the Second Circuit held that Wells Fargo acted as an agent for the transfers made to the public shareholders (for example, by distributing payments to these shareholders), and thus those transfers were protected; however, no “financial institution” acted as an agent for the transfers made to the individual shareholders (the payroll processor distributed these payments), and thus those transfers were not protected. Judge Sullivan dissented in part, writing that the district court’s broader “contract-by-contract” analysis was the correct approach under the plain text of the relevant statutes.

The Second Circuit ruled on two additional legal issues: (1) It joined other courts in holding that the section 546(e) safe harbor is an affirmative defense, and (2) it reaffirmed its analysis in the Tribune holding that section 546(e) preempts state law claims that seek the same remedy as fraudulent transfer claims, here, unjust enrichment claims seeking to recover the payments to public shareholders.

On February 5, 2024, the Second Circuit stayed the issuance of its mandate pending the filing and disposition of a petition for certiorari by certain individual shareholders; the Supreme Court denied cert in May 2024.

Key Takeaways

• The Second Circuit reaffirmed its holding in Tribune: The section 546(e) safe harbor applies to transfers made to an entity that is a “customer” of a financial institution, and courts in the Second Circuit will apply the common-law test for agency to determine whether the financial institution is acting as the customer’s agent.
• The Second Circuit confirmed that section 546(e) is an affirmative defense on which the defendant bears the burden of demonstrating that the challenged transfers qualify for the safe harbor. Accordingly, if section 546(e) is raised at the motion to dismiss stage, the facts demonstrating the defense must be ones that can be considered at that stage—generally facts alleged in the complaint or appearing in documents incorporated into the complaint (e.g., transaction documents).
• Nine West adopted a “transfer-by-transfer” approach to the application of the “customer” prong of the Bankruptcy Code’s definition of “financial institution.” This approach is consistent with Merit Management’s direction that section 546(e) must be evaluated by reference to the “transfer the trustee seeks to avoid,” and also preserves the post-Merit Management balance between the trustee’s avoidance powers and the need to safe-harbor transactions that might disrupt public securities and financial markets. Consequently, large transfers in connection with transactions in public securities are likely to remain protected because such transfers typically involve a financial institution acting as agent or custodian, as seen in Tribune, Nine West, and the Eighth Circuit’s decision in Kelley. But after Nine West, at least in the Second Circuit, transfers will not be safe-harbored where no financial institution acts as agent or custodian, even if those transfers are part of a securities or other safe-harbored transaction.
• The “customer” exception is likely to remain a focus of disputes over the scope of section 546(e)’s safe harbor as appellate courts have continued to reject attempts to narrow section 546(e)’s application by reference to its legislative history or by constraining the broad statutory definitions of “settlement payments” or “securities contracts.” Most recently, in March 2024, the Seventh Circuit reaffirmed that a broad scope of transfers meets section 546(e)’s first requirement, holding that a loan agreement used to finance a securities purchase and a related guarantee qualified as “securities contracts,” and rejecting an attempt to limit section 546(e) to transactions in public securities that implicate the national securities markets. Petr v. BMO Harris Bank N.A., 95 F.4th 1090, pincite (7th Cir. 2024).