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A Preview of the October 2017 United States Supreme Court Term with Respect to Bankruptcy Law


The Business Advisor

Summer 2017

The Supreme Court recently concluded its 2016-2017 term, which featured two bankruptcy cases. In Czyzewki v. Jevic Holding Corporation1, the Supreme Court reversed the United States Court of Appeals for the Third Circuit and held that a bankruptcy court, without the consent of the affected parties, cannot approve structured dismissals that deviate from the basic priority rules. (See “The Supreme Court Rejects Use of Non-Consensual Structured Dismissals that Violate the Code’s Priority Rules in Jevic”). In Midland Funding v. Johnson,2 in a decision that surprised many, the Supreme Court resolved a split that existed in the circuit courts and held that a debt collector who files a proof of claim that is time barred by the applicable statute of limitations has not engaged in false, deceptive, misleading, unconscionable, or unfair conduct under the Federal Debt Collection Practices Act. To date, the Supreme Court has added two cases to its docket for the upcoming October 2017 term.

U.S. Bank NA v. The Village at Lakeridge LLC

The first case added to the Supreme Court’s docket is U.S. Bank NA v. The Village at Lakeridge LLC, a case decided by the United States Court of Appeals for the Ninth Circuit. This chapter 11 case is somewhat unusual in that it involved only two creditors. The first creditor was a bank with a $10 million secured claim, and the second creditor was the debtor’s general partner, who held a $2.8 unsecured claim. Due to the fact that the debtor needed an non-insider creditor to vote in favor of the plan, the general partner sold its claim at a discount to someone who had a close business and personal relationship with the general partner. The Ninth Circuit held that third-party assignee of an insider claim could vote to confirm the plan, even though the claim could not be voted in the hands of the original claimant. Further, the Ninth Circuit applied a clearly erroneous standard of review for determining non-statutory insider status, without regard to the “arm’s length” test applied by the Third, Seventh, and Tenth Circuit Courts of Appeal. Although U.S. Bank NA requested that the Supreme Court address all of the issues decided by the Ninth Circuit Court of Appeals, the Supreme Court limited review to the appropriate standard of review for determining non-statutory insider status—namely, whether that standard is the de novo standard of review applied by the Third, Seventh, and Tenth Circuit Courts of Appeal, pursuant to which the appellate court acts as if it were considering the question for the first time, affording no deference to the decisions below, or the clearly erroneous standard of review set forth by the Ninth Circuit, where a trial court makes a finding of fact and such finding is not disturbed unless the appellate court is left with a definite and firm conviction that a mistake has been committed by trial court. For reasons unknown, the Supreme Court declined to decide the more interesting question concerning whether a purchaser of claim automatically assumes the seller’s insider status.

FTI Consulting Inc. v. Merit Management Group LP

The second case added to the Supreme Court’s docket is FTI Consulting Inc. v. Merit Management Group LP, a case decided by the Seventh Circuit. In this case, the Supreme Court granted certiorari to resolve a split in the circuit courts of appeal concerning the scope of section 546(e) of the Bankruptcy Code and whether such section applies when a financial institution acts only as a “mere conduit” with no beneficial interest in the stock being sold in a leveraged buyout transaction. It is not uncommon in bankruptcy proceedings for debtors or trustees to increase, through the use of lawsuits intended to claw back funds transferred by the debtor to third parties, the amount of funds available to pay creditors. Section 546(e) of the Bankruptcy Code generally limits the debtor or trustee’s ability to claw back payments that are considered “settlement payments” made in connection with a securities contract. In interpreting the breadth of section 546(e), the circuit courts of appeal are divided on whether the safe harbor is available only for settlement payments that are for the benefit of the entities specifically set forth in the statute or also available for any settlement payments that pass through these types of entities to others. To date, the Second, Third, Sixth, Eighth, and Tenth Circuits have held that the safe harbor protects settlement payments that merely pass through financial institutions to the ultimate beneficiaries. In this case, FTI Consulting Inc. v. Merit Management Group LP, the Seventh Circuit joined with the Eleventh Circuit in holding to the contrary. In reaching this conclusion, the Seventh Circuit held that the language of section 546(e) was ambiguous because the phrase “By or to” could mean any transfer where an owner of a bank account used the bank’s services to transfer funds, and “For the benefit of” could mean a transaction made on behalf of an entity, or one involving an entity receiving a financial or beneficial interest. Relying on a previous ruling, the Seventh Circuit held that there was no risk to the securities market in connection with a claw back suit where none of the parties to the litigation were parties in the securities industry. Finally, the Seventh Circuit held that financial intermediaries that received no benefit from a transfer are not included as transferees under the language of section 546(e). The stakes will be very high in this case, since a ruling affirming the Seventh Circuit will likely lead to increased litigation in bankruptcy courts surrounding securities transactions and may impact the broader securities market.

PEM Entities LLC v. Levin – Grant of Certiorari Reversed as “improvidently granted”

After having granted certiorari in this matter on June 27, 2017, the Supreme Court did an “about face” and dismissed the certiorari petition as “improvidently granted” on August 10, 2017. We review the decisions below nonetheless. In this petition for certiorari, the Supreme Court was asked to resolve a circuit split by deciding whether bankruptcy courts should employ state or federal law in connection with efforts to recharacterize debt as equity in connection with bankruptcy proceedings. Although all of the circuits that have addressed the issue agree that a bankruptcy court has the power to recharacterize debt as equity, the Third, Fourth, Sixth, Tenth, and Eleventh Circuits employ federal law, while the Fifth and Ninth Circuits follow state law.

In this case, a real estate project was encumbered by a substantial bank loan. When the loan was in default, certain of the debtor’s insiders formed PEM Entities LLC and purchased the bank loan at a discount. Ultimately, the debtor filed for chapter 11 protection, and creditors filed a lawsuit seeking to recharacterize the purchased debt as equity or to equitably subordinate the loan (which would likely result in no recovery on the purchased bank debt). Although the relevant state law would have resulted in the loan being recognized as a valid and enforceable debt, the Fourth Circuit affirmed the bankruptcy court’s decision to rely on federal law to recharacterize the debt as equity based on the substantial discount on the sale of the loan, the buyer’s failure to take enforcement actions with respect to the loan prior to the bankruptcy, the debtor’s poor financial condition, and the buyer’s insider status. This decision now stands that the Supreme Court has dismissed its earlier action granting the certiorari petition.

1 580 U.S. __ (2017).
2 581 U.S. __ (2017).