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U.S. Supreme Court limits safe harbor bankruptcy provision

By on February 27, 2018

SAN JUAN – The U.S. Supreme Court on Tuesday resolved a circuit-court split over the scope of the Bankruptcy Code’s safe harbor provision that exempts certain securities transactions from being clawed back.

The top court ruled unanimously that the clawbacks can take place in bankruptcy if the funds simply move through a financial institution without benefiting it.

The decision could have implications in the manner debtors engage in debt restructuring, including Puerto Rico, which is in a bankruptcy-like process under Title III of the Promesa law, as many of the bankruptcy provisions have been carried over to these cases.

A view of the U.S. Supreme Court building is seen in Washington, DC, U.S. (REUTERS/Jonathan Ernst/File Photo)

Safe Harbor precludes trustees or others representing the bankruptcy estate from bringing actions that allege preferences or constructive fraudulent transfers based on federal bankruptcy law. For Safe Harbor to be applicable, the transaction must be of a type specified in the statute and be “by or to or for the benefit of” one of several designated entities, such as brokers and financial institutions.

In July 2016, the Seventh Circuit held that the safe harbor provision did not protect transfers that are “simply conducted through financial institutions where the entity is neither the debtor nor the transferee but only the conduit.” The ruling was made in FTI Consulting v. Merit Management Group.

In this case, Valley View Downs acquired the shares of a competitor for about $55 million, in which Merit had a 30% ownership interest. Valley View’s business strategy failed, and it filed for bankruptcy protection. Subsequently, the trustee sought to recover $16.5 million paid to Merit for the purchase of the shares of the estate.

While neither Merit nor the debtor were qualifying financial entities subject to the safe harbor provision, the payment passed through two banks before being transferred by the debtor to Merit. The Seventh Circuit determined that the statutory language was vague and that Congress intended to protect only qualifying financial entities from avoidance, but not to protect entities that are not qualifying financial entities simply because a transfer passed through a financial intermediary, according to stateside reports.

The Seventh Circuit joined the Eleventh Circuit in so holding, while the majority of circuits–the Second, Third, Sixth, Eighth and Tenth have held that the safe harbor section does shield transfers that pass through a financial institution as merely a conduit.

The Supreme Court also held oral arguments on the U.S. v. Microsoft, which could have an impact on the communications industry. The controversy in the case is whether a U.S. email service provider must comply with a probable-cause-based warrant issued under the law even if the content is stored abroad.

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