Section 546(E) Redux—Does the Proper Construction of the Term Financial Institution Contained in Section 101(22)(A) of the Bankruptcy Code Undo the U.S. Supreme Court’s Holding in Merit?

This article discusses and analyzes the proper construction of the term “financial institution” as defined Section 101(22) of the Bankruptcy Code (the “Code”) as it works 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) only insulates avoidable transfers made by a “financial institution” to the ultimate recipient of the transfer. Thus Merit, held that Section 546(e) does not insulate a shareholder from a constructive fraudulent transfer action (“CFTA”) because a bank or similar entity acted as a conduit between shareholders who redeemed their shares (the “Redeeming Shareholders”) through an LBO and the company cashing out those shares. 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 of a customer . . . in connection with a securities contract” (the “Customer Language”). Thus following Merit, a large loophole of uncertainty remains as to whether a company being purchased through an LBO itself qualifies as financial institution under the Customer Language, simply because a bank or trust company acted as an intermediary between the Redeeming Shareholders and the company purchased through the LBO. If the Customer Language is construed in this fashion, then essentially all Redeeming Shareholders would be insulated from CFTA’s, which would make it virtually impossible for Bankruptcy Trustees to recover billions of dollars for unsecured creditors in the context of failed LBO’s. 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 trust company that functioned as a conduit between that company and its Redeeming Shareholders acted as the company’s “agent” in the LBO, thus insulating the Redeeming Shareholders from a CFTA. A textual 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 Sections101(22)(A) and 546(e): Congress inserted the Customer Language into Section 101(22)(A) to protect, inter alia, agent banks that act as agents for lenders in securities lending transactions (“SLTs”). In these transactions, the agent banks generally hold substantial amounts of collateral for their lender-customers. Likewise, in these transactions, agent banks generally provide a guaranty to the relevant lende-customer, pursuant to which the Agent 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 SLT if the borrow defaults. This guaranty could be revived, making the agent bank liable, if after the 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) 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. Thus, in such transactions, agent banks generally act as an agent and a custodian for their principal/customer—the lender of the securities. Such liability to agent banks could upend the SLM. Indeed, in these types of SLT’s, absent the Customer Language, an agent bank generally could face significant liability in an SLT because some 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 securities lending market, similar to the derivatives market, is an international market that involves trillions of dollars of transactions. Many SLT’s 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 LBO’s, and similar transactions such as share-buy backs. This textual 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, expanding, the Safe Harbors. This article discusses several recent cases that have interpreted Section 101(22)(A). This article will discuss the recent 2nd Circuit decision in Tribune II and argue that it was improperly decided. Likewise, this article will discuss the more recent post-Tribune case of Greektown, which was properly decided. The article will also discuss recent academic literature which 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 non-publicly 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 parties in SLT’s involving agent banks that may not otherwise qualify as a customer of a broker dealer as defined in Section 741 such as insurance companies, endowments, and pension funds. Indeed, a basic knowledge of the securities lending industry combined with a basic knowledge of the Code readily and strongly supports this conclusion. The article further argues that, even if courts do adopt this approach to Section 101(22)(A) and 546(e) Congress should amend the Code so that it partially insulates non-insider shareholders in publicly traded companies that redeem their shares through an LBO if they act in good faith.