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Bankruptcy Court Denies Section 546(e) Safe Harbor Protection in Fraudulent Transfer Action

The Bankruptcy Code enables a trustee to set aside certain transfers made by debtors before bankruptcy.  See 11 U.S.C. §§ 544, 547, 548.  These avoidance powers are subject to certain limitations, including a safe harbor in section 546(e) exempting certain transfers.  Among other things, section 546(e) bars avoidance of a “settlement payment . . . made by or to (or for the benefit of) . . . a financial institution [or] a transfer made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract.”  The Bankruptcy Code in turn defines a “financial institution” to include not only financial institutions as conventionally understood, such as “a Federal reserve bank, or an entity that is a commercial or savings bank, industrial savings bank, savings and loan association, trust company, federally-insured credit union, or receiver, liquidating agent, or conservator for such entity,” but also a customer of such institutions when such institutions are “acting as agent or custodian for [such] customer . . . in connection with a securities contract.”  11 U.S.C. § 101(22)(A).  Because a transfer to a “financial institution” in connection with a securities contract is shielded by section 546(e) from avoidance, the question of which “customers” of financial institutions qualify as financial institutions under this definition has become highly litigated.  On October 22, the United States Bankruptcy Court for the Eastern District of Michigan issued a new decision on this question, ruling that the recipients of an alleged fraudulent transfer did not qualify as “financial institutions” under the Bankruptcy Code because the bank that transmitted the payments was not acting as an “agent or custodian” for the recipients.

The adversary proceeding arose from a series of transactions involving Greektown Casino, LLC (“Greektown Casino”), which owned and operated a casino in Detroit.  Dimitrios Papas, Viola Papas, Ted Gatzaros, and Maria Gatzaros (“Defendants”) indirectly owned 50% of the membership interests in Greektown Casino.  In 2000, they arranged to sell their membership interests in exchange for installment payments.  In 2005, another series of agreements provided for payment of the balance due to Defendants.  As part of this transaction (the “2005 Transaction”), Greektown Holdings, LLC (“Holdings”) was incorporated and acquired all the interests in Greektown Casino.  Holdings then issued $182 million in senior notes, which were sold to Merrill Lynch.  Merrill Lynch then sold the notes to various institutional investors.  Holdings used the proceeds of the notes to make wire payments to Defendants, also using Merrill Lynch for the wire payments.  In 2008, Greektown Casino, Holdings, and other related entities filed for bankruptcy.

The Liquidating Trustee brought an action against Defendants seeking to avoid the transfers from Holdings to Defendants that were part of the 2005 Transaction.  In 2015, Defendants brought a motion for summary judgment under section 546(e), arguing that the transfers were protected by the safe harbor.  The court held that the transfers were a “settlement payment” because they were part of the securities transaction involving Holding’s notes issuance, and also that they were “in connection with a securities contract” because Holdings was legally bound to use the proceeds of the notes issuance to pay Defendants.  Further, under then-binding Sixth Circuit precedent, a transfer was shielded under section 546(e) if a financial institution acted as an intermediary in making the transfer, and here Merrill Lynch actually executed the wire payments.  The court thus granted the motion for summary judgment.

The Liquidating Trustee appealed to the district court, which affirmed.  It then appealed to the Sixth Circuit.  During the pendency of the appeal, the Supreme Court decided Merit Management Group, LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), which held that, for purposes of section 546(e), the relevant transfer is the transfer the trustee seeks to avoid, and therefore intermediate transfers to or from financial institutions do not render the whole transfer protected by the safe harbor.  Based on Merit Management, the Sixth Circuit vacated the bankruptcy court’s ruling and remanded.  The bankruptcy judge who had issued the initial decision had retired and the newly assigned judge received renewed briefing on the summary judgment motion in light of Merit Management

The court held that, under Merit Management, Defendants needed to show that either Defendants or Holdings was a financial institution.  (Defendants argued that Merrill Lynch’s status was also relevant because the transfer was for Merrill Lynch’s “benefit,” based on the fees it received for the transaction, but the court concluded that the “for the benefit of” language in section 546(e) only applies when the value of the property transferred corresponds to the benefit conferred.)  Defendants argued that Holdings was a financial institution because it was a customer of Merrill Lynch and Merrill Lynch acted as “agent or custodian” in connection with the transactions.  The court rejected these arguments.

As to Defendants’ argument that Merrill Lynch acted as an agent, the court engaged in a close reading of the contracts and concluded that Merrill Lynch met none of the elements of agency with respect to Holdings.  Merrill Lynch was not a business representative of Holdings that could effectuate contractual obligations on Holdings’ behalf, but in fact was adverse to Holdings as the purchaser of Holdings’ notes.  The Note Purchase Agreement also expressly disclaimed an agency relationship.  In connection with its discussion of agency, the court rejected the Second Circuit’s ruling in In re Tribune Co., 946 F.3d 66 (2d Cir. 2019), which held that a financial institution acted as agent for a customer when it disbursed funds on behalf of that customer as part of a securities transaction.  The court held that Tribune failed to distinguish between mere intermediaries who effectuate a transaction and agents authorized to act on behalf of their customers in such transactions.

As to Defendants’ argument that Merrill Lynch acted as a custodian, the court held that the definition of “custodian” was controlled by section 101(11) of the Bankruptcy Code.  Defendants argued that Merrill Lynch was a “custodian” under the terms of section 101(11)(C), a “trustee, receiver, or agent under applicable law, or under a contract, that is appointed or authorized to take charge of property of the debtor for the purpose of enforcing a lien against such property, or for the purpose of general administration of such property for the benefit of the debtor’s creditors.”  The court held that Merrill Lynch was not a “trustee, receiver, or agent,” and was neither enforcing a lien nor acting for the benefit of the debtor’s creditors.  Merrill Lynch was thus not a “custodian” with respect to Holdings.

For these reasons, the court denied the motion for summary judgment.