At the end of February, the U.S. Supreme Court issued its unanimous decision in Merit Management Group, LP v. FTI Consulting, Inc., holding that 11 U.S.C § 546(e), which creates a safe harbor against the avoidance of certain transfers made “by or to (or for the benefit of)” financial institutions, does not apply merely because the challenged transfer is completed through a financial institution. This holding effectively overrules prior decisions of the Second, Third, Sixth, Eighth and Tenth Circuits that had adopted a more expansive view of the safe harbor protection.

In reaching its conclusion, the Court focused heavily on the text of the statute, instructing courts to focus their analysis on the “end-to-end transfer” the trustee seeks to avoid rather than any individual transaction the transfer comprises. By way of example, the Court found that Section 546(e) would not prevent a trustee from avoiding a transfer between two non-financial institutions (“A→D”), even where that transfer was effectuated through financial institutions as intermediaries (“A→B→C→D”).

The decision is the Supreme Court’s first to address the safe harbors under the U.S. Bankruptcy Code. As a result, although the specific holding of Merit may not be directly applicable to the rights of financial counterparties under qualified financial contracts, the case may affect how lower courts interpret the safe harbors more generally.

Background

In 2003, two racetracks, Valley View Downs, LP and Bedford Downs, both sought to operate racinos (combination horse track casinos). However, the operation of racinos required a harness-racing license, and, at the time, Pennsylvania had only one such license available. Rather than compete with Bedford Downs for the license, Valley View acquired all of Bedford Downs’ shares for $55 million in a cash-for-stock agreement.

To finance the acquisition, Valley View borrowed funds from a lending bank and several other lenders. At closing, the lending bank transferred the acquisition price to another bank, which acted as the escrow agent. Then, the escrow bank transferred cash payments to the shareholders of Bedford Downs, including $16.5 million to Merit Management Group.

Although Valley View was awarded the harness-racing license, it failed to acquire the gambling license it needed to operate the racino, resulting in a bankruptcy filing. FTI Consulting, Inc., trustee of the debtor’s litigation trust, subsequently sought to avoid the $16.5 million transfer to Merit as a constructively fraudulent transfer under Section 548(a)(1)(B) of the Bankruptcy Code.

Merit moved to dismiss the trustee’s action, arguing that the Bankruptcy Code’s safe harbors immunized the transfer from claims of constructive fraudulent conveyance. Specifically, Merit pointed to Section 546(e), which bars a bankruptcy trustee from avoiding under Section 548(a)(1)(B) (among other provisions) a settlement payment or transfer in connection with a securities contract if the settlement payment or transfer is “made by or to (or for the benefit of) a . . . financial institution” or another kind of entity listed in Section 546(e). (See also 11 U.S.C. § 546(e) (including “commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency” as covered entities.)

The trustee did not dispute that the transfer of $16.5 million was a settlement payment or a transfer in connection with a securities contract. However, it challenged that the transfer was “by or to” a “financial institution” or other entity listed in Section 546(e) because neither Valley View nor Merit was such an entity. Merit responded that neither Valley View nor Merit needed to be such an entity in order for the transfer to fall within the protections of Section 546(e) because the lending banks and escrow bank were “financial institutions” within the meaning of the Bankruptcy Code, and the $16.5 million was transferred by the lending bank and both by and to the escrow bank. The district court agreed with Merit and dismissed the trustee’s claims.

On appeal, the Seventh Circuit reversed and held that Section 546(e) does not protect transfers “that are simply conducted through financial institutions (or other entities named in Section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit.”

In addition to focusing on the “ambiguous” text of Section 546(e), the Seventh Circuit focused its purpose, stating that “the safe harbor’s purpose is to protect the market from systemic risk and allow parties in the securities industry to enter into transactions with greater confidence—to prevent one large bankruptcy from rippling through the securities industry.” By contrast, the case before it presented no systemic risk concerns.

As the Seventh Circuit acknowledged, its holding was a departure from the views of a number of its sister circuits. The Second, Third, Sixth, Eighth and Tenth Circuits have held that Section 546(e) applied even where the financial institution acts merely as a conduit. (See In re Quebecor World (USA) Inc., 719 F.3d 94 (2d Cir. 2013); Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009); In re QSI Holdings, Inc., 571 F.3d 545 (6th Cir. 2009); In re Resorts Int’l, Inc., 181 F.3d 505 (3d Cir. 1999); In re Kaiser Steel Corp., 952 F.2d 1230 (10th Cir. 1991).

The Supreme Court’s Decision

In a unanimous decision authored by Justice Sotomayor, the Court affirmed the Seventh Circuit’s decision, concluding Section 546(e) does not apply to the trustee’s attempt to avoid the transfer between Valley View and Merit. In coming to this conclusion, the Court did not address the question often framed in safe harbor litigation: whether Section 546(e) should apply where a financial institution is a “mere conduit” or intermediary to a transfer. Nor did the Court find the language of Section 546(e) ambiguous, as the Seventh Circuit did, nor did it engage in a policy-driven analysis, as employed by other courts.

Instead, the Court reframed the question and adopted the arguments of the trustee in holding that the only relevant transfer for purposes of the safe harbor is the transfer that the trustee seeks to avoid, which in this case was the “end-to-end” transfer (i.e. A→D) and that courts should not “look to any component parts of the overarching transfer” (i.e. A→B→C→D).

The Court’s analysis opened with a review of the text of Section 546(e), which begins with “[n]otwithstanding section 544, 545, 547, 548(a)(1)(B), and 548(b) of this title.”  According to the Court, this language makes it clear that the safe harbor is nothing more than an exception to a trustee’s avoidance powers under the Bankruptcy Code. The Court found that “by referring back to a specific type of transfer that falls within the avoiding power, Congress signaled that the exception applies to the overarching transfer that the trustee seeks to avoid,” and not any individual transaction that transfer comprises. (This reading was further supported by the final clause of Section 546(e), which creates an exception to the exception for actually fraudulent transfers under Section 548(a)(1)(A).)

Continuing its textual analysis, the Court next seized on Section 546(e)’s language that the trustee may not avoid “a transfer that is” a settlement payment or made in connection with a securities contract (emphasis in original). In the Court’s view, this “dispels [any] doubt” that the statute’s focus is the overall transfer rather than its constituent parts, because the statute focuses only on transfers that are settlement payments or made in connections with securities contracts, not transfers that “involve” or “comprise” them. Thus, the Court held, “the transfer that the trustee seeks to avoid [is] the relevant transfer for consideration of the § 546(e) safe harbor criteria.”

Responding to concerns expressed at oral argument that this approach could allow a trustee to sidestep Section 546(e) by creatively defining the “relevant transfer,” the Court cautioned that a trustee “is not free to define the transfer that it seeks to avoid in any way it chooses,” but instead must satisfy the criteria set out in the Bankruptcy Code. This would leave a defendant free to argue that a trustee failed to properly identify an avoidable transfer, “including any available arguments concerning the role of component parts of the transfer.”

In arriving at its interpretation of Section 546(e), the Court rejected a number of counterarguments. First, the Court rejected Merit’s suggestion that the 2006 addition of “(or for the benefit of)” language in Section 546(e) demonstrated Congress’s desire to legislatively overrule In re Munford, Inc., in which the Eleventh Circuit held that Section 546(e) was inapplicable where financial institutions served as mere intermediaries. After observing that Merit cited no authority for this contention, the Court pointed to the avoidance provisions in the Bankruptcy Code that include the language “(or for the benefit of),” reasoning that Congress may have added that phrase in 2006 to bring Section 546(e) in line with other provisions of the Bankruptcy Code. 

The Court also addressed Merit’s argument that the statute’s inclusion of securities clearing agencies, the definition of which includes “an intermediary in payments or deliveries made in connection with securities transactions,” demonstrates that Congress intended Section 546(e) to be interpreted without regard to an entity’s beneficial interest in the transfer. Merit argued that that to hold otherwise would render portions of the statute “ineffectual or superfluous.” Rejecting this contention, the Court determined that if a trustee sought to avoid a transfer “made by or to (or for the benefit of)” a securities clearing agency that would otherwise be covered by Section 546(e), the safe harbor would bar such an action regardless of whether the securities clearing agency was acting as an intermediary. Contrary to Merit’s assertion that this interpretation would render portions of the statute superfluous, the Court found that its “reading gives full effect to the text of § 546(e).”

Finally, the Court briefly turned to the underlying purpose of Section 546(e). Merit argued that Congress intended the statute to be a broad, prophylactic measure to protect the securities and commodities markets and that it would be antithetical to that purpose for its application to depend on “the identity of the investor and the manner in which it held its investment,” rather than “the nature of the transaction generally.” The Court showed little interest in analyzing the purpose of the safe harbor, stating that even if this were the type of case in which the Court would consider statutory purpose, the statute flatly contradicted Merit’s position, because it specifically targeted transfers “by or to (or for the benefit of)” financial institutions. The Court suggested that if Congress had intended Section 546(e) to apply to transfers made “through” a financial institution, rather than simply by or to or for the benefit of, it would have included language to that effect. Thus, Merit’s argument amounted to disagreement with Section 546(e) itself.

Having concluded that the proper focus is on the transfer the trustee seeks to avoid, and that the transfer at issue in the instant case was the purchase of Bedford Downs’ stock by Valley View from Merit, the Court concluded that “[b]ecause the parties do not contend that either Valley View or Merit is a “financial institution” or other covered entity, the transfer falls outside of the § 546(e) safe harbor.

Implications

The Court’s decision is likely to have a significant impact on the application of the safe harbors to avoidance actions and related litigation.

• The Court’s heavy focus on “the transfer that the trustee seeks to avoid” as the relevant transfer will cause debtors or trustees to strategically frame avoidance actions in order to limit the scope of the safe harbor. As the Court acknowledges, however, they will continue to be constrained by the scope of avoidance powers granted in the Bankruptcy Code. We therefore expect more aggressive litigation tactics, especially by out-of-the-money creditor constituencies.
• The availability of the Section 546(e) safe harbor in leveraged buyouts and other stock acquisitions will be more limited. In many instances the courts will not have to focus on the distinction between public and private sales because they will not need to reach the question of whether a transfer is a settlement payment or in connection with a securities contract. The decision will likely have substantially less relevance to more traditional applications of the safe harbor (i.e. cases involving transfers made to financial institutions and other covered entities as principals).
• By interpreting the federal safe harbors more narrowly, the Court’s decision will make state law-based workarounds less relevant. Recently, there have been a number of cases in which bankruptcy estates, particularly in the LBO context, have abandoned fraudulent conveyance‑based avoidance claims to allow a creditor trust to bring state law-based fraudulent conveyance claims outside of the federal safe harbor. Now that Merit has limited the scope of the safe harbor in the LBO or acquisition contexts, there is less incentive to take this state law approach.
• The Court chose not to rely on the policy‑based arguments relating to the existence or non-existence of “systemic risk” to markets. Instead, the Court focused on the text of Section 546(e).

It remains to be seen what effect the Court’s decision will have on other safe harbor disputes, including, for example, what constitutes a qualified financial contract covered by the statute. These issues were not before the Court in Merit, but will obviously continue to be important.

It is an article of faith among transactional practitioners that an entity seeking to acquire another entity without being saddled with its liabilities does so by acquiring assets. As a general proposition, that method works. “Most jurisdictions, including Massachusetts, follow the traditional corporate law principle that the liabilities of a selling predecessor corporation are not imposed upon the successor corporation which purchases its assets. . . .” Milliken & Co. v. Duro Textiles, LLC, 451 Mass. 547, 556, 887 N.E.2d 244, 254 (2008) (quoting Guzman v. MRM/Elgin, 409 Mass. 563, 566, 567 N.E.2d 929, 931 (1991)). There are however, four important exceptions to the general rule. An asset transfer may carry with it successor liability where, “(1) the successor expressly or impliedly assumes the liability of the predecessor, (2) the transaction is a de facto merger or consolidation, (3) the successor is a mere continuation of the predecessor, or (4) the transaction is a fraudulent effort to avoid liabilities of the predecessor.” Id.

The possibility that exposure to successor liability will flow from an express assumption of liability is no doubt self-evident to attorneys guiding clients through an asset acquisition. Moreover, most practitioners are aware of the concerns that emerge under the Massachusetts fraudulent transfer statute. See G.L. c. 109A § 5. In addition, “mere continuations” will not be hard to recognize. A mere continuation “envisions a reorganization transforming a single company from one corporate entity into another.” Milliken & Co., 451 Mass. at 556 (quoting McCarthy v. Litton Indus., Inc., 410 Mass. 15, 21–22, 570 N.E.2d 1008, 1012 (1991)).  “The indices of a ‘continuation’ are, at a minimum: continuity of directors, officers, and stockholders; and the continued existence of only one corporation after the sale of its assets.” McCarthy, 410 Mass. at 23. It will not surprise most attorneys that shuffling the deck chairs will not be enough to shake free of liabilities of an enterprise continued under a nominally new entity.

The de facto merger, however, has fuzzier boundaries. Much like the alter ego analysis, found in My Bread Baking Co. v. Cumberland Farms, 353 Mass. 614, 233 N.E.2d 748 (1968), the de facto merger doctrine calls on courts to consult multiple specified factors to determine if there has been a de facto merger; however, “[n]o single factor is necessary or sufficient to establish a de facto merger.” Cargill, Inc. v. Beaver Coal & Oil Co., 424 Mass. 356, 360, 676 N.E.2d 815, 818 (1997). That is to say, the absence of any one factor will not preclude a finding of de facto merger, and, in some cases, the presence of some amount of each factor would not compel a finding of de facto merger.

Where successor liability is found to exist by virtue of a de facto merger, the successor entity stands in the shoes of the predecessor and is fully responsible for its liabilities, which can include liability for multiple damages under G. L. c. 93A. Milliken & Co., 451 Mass. at 565. Counsel advising a client in advance of an asset acquisition must confront the alchemy of these multiple factors to assess (or, maybe guess) whether the cumulative quantum of the factors is small enough to shake free from the acquired entity’s obligations, or substantial enough to expose the client to the liabilities from which it sought shelter. (Several other states have adopted some version of the de facto merger doctrine, with varying degrees of rigor applied in assessing the multiple factors. John H. Matheson, Successor Liability; 96 MINN. L. REV. 371.387-91 (2011). Delaware, for example, has a restrictive version of the doctrine that applies only where all assets of the predecessor are acquired, the purchase compensation is stock, and there is an agreement to acquire liabilities. Magnolia’s at Bethany, LLC v. Artesian Consulting Engineers Inc. No. CIV.A. S11C-04013ESB, 2011 WL 4826106, at *3 (Del. Super. Ct. Sept. 19, 2011)). Several courts have noted that the analysis for successor liability is largely uniform among the states but, nonetheless, a thicket. U.S. v. General Battery, 423 F.3d 294, 301 (3d Cir. 2005). “Beneath a veneer of uniformity, the ‘entire issue of successor liability . . . is dreadfully tangled, reflecting the difficulty of striking the right balance between the competing interests at stake.’” Id. (citing EEOC v. Vucitech, 842 F.2d 936, 944 (7th Cir. 1988)).

The factors considered in the analysis are whether:

(1) there is a continuation of the enterprise of the seller corporation so that there is continuity of management, personnel, physical location, assets, and general business operations; . . . (2) there is a continuity of shareholders which results from the purchasing corporation paying for the acquired assets with shares of its own stock, . . . (3) the seller corporation ceases its ordinary business operations, liquidates, and dissolves as soon as legally and practically possible, and . . . (4) the purchasing corporation assumes those obligations of the seller ordinarily necessary for the uninterrupted continuation of normal business operations of the seller corporation.

Cargill, Inc., 424 Mass. at 359–60. Whether the transaction is used to defeat creditors’ claims is also a factor. Milliken & Co., 451 Mass. at 556. The de facto merger doctrine is equitable in nature and, therefore, subject to equitable defenses. Id.

There has been some elasticity layered into these factors. For example, although the doctrine originally assumed application to transactions where shares were exchanged for assets, the shareholder component can now be met where the shareholders of the former entity paid to acquire their shares in the acquiring entity and may be satisfied with a small percentage of ownership in the acquiring entity. Cargill, Inc., 424 Mass. at 361 (12.5 percent of shares acquired satisfied the shareholder component); General Battery, 423 F.3d at 306—307 (4.5 percent held to be enough, as “[t]he continuity of shareholders element is designed to identify situations where the shareholders of a seller corporation retain some ownership interest in their assets after cleansing those assets of liability.”). In one decision, the court ruled that the shares received by the owners of the predecessor entity did not have to be shares of the acquiring entity, but could instead be shares of the acquirer’s parent entity, at least where the purchaser was a wholly owned subsidiary of the parent. In re Acushnet River, 712 F. Supp. 1010, 1017 (D. Mass. 1989). Formal dissolution of the predecessor is not required to establish the discontinuation of the prior business. Cargill, Inc., 424 Mass. at 361. The predecessor in Milliken continued in business for a period after the sale of its operating assets to manage and lease out substantial real estate assets. Milliken & Co., 451 Mass. at 559-60. (The operational assets had transferred and the “selling” entity continued only as a landlord. The formal dissolution, originally a component of the de facto merger doctrine was not formally met, but the selling entity did not continue in its prior business.) Factors that indicate a continuation of the predecessor’s business include whether the successor entity continued the general business of the predecessor, used some of the same personnel to continue the business, and acquired assets from the predecessor (including customer lists) to continue the business. Id. at 360-61. See also Lanee Great Plastic Co., LTD v. Handmade Bow Co., No. SUCV200705245, 2010 WL 6650330, at *5 (Mass. Super. Ct. Dec. 26, 2010). Satisfaction of the fourth prong, assuming obligations necessary for business continuation, does not require taking on all obligations of the predecessor, but only those necessary to continue business uninterrupted. In Cargill, the court found it enough that the party acquiring assets assumed certain obligations such as paying creditors that agreed to continue to do business with the “successor,” assuming executory contracts, assuming service contracts, and assuming delivery obligations to customers with credit balances. Cargill, Inc., 424 Mass. at 361. As the court noted, “[e]ach case must be decided on its specific facts and circumstances. Id. at 362.

Purchase of a predecessor’s assets is a necessary predicate to finding a de facto merger, but how much of its assets must be acquired can be an open question. Recent decisions have held that the asset acquisition must be extensive in order for the de facto merger doctrine to apply. “Our decisions addressing successor liability have recognized consistently that successor liability depends on a transfer of all, or substantially all, assets from predecessor to successor.” Premier Capital, LLC v. KMZ, Inc., 464 Mass 467, 475, 984 N.E.2d 286, 292 (2013). The Supreme Judicial Court (SJC) cited to the Milliken, Guzman, and Cargill cases referenced above, to support the contention that its decisions have included the “all or substantially all” qualification. Those cases do not actually articulate that principal, although it might be inferred from Cargill. (Guzman concerned a doctrine, accepted in some states, pursuant to which successor liability can arise from continuing to manufacture a line of product previously manufactured by a different manufacturer. The SJC in Guzman rejected the doctrine.) In Milliken, however, the predecessor retained its real estate assets, which represented nearly 25 percent of the pre-transaction value of the predecessor. Milliken & Co., 451 Mass. at 556. This factor did not preclude the court from finding a de facto merger. Id. Perhaps after Premier Capital, acquiring three-quarters of the predecessor’s assets will not be enough to satisfy the “all or substantially all” requirement, or perhaps Milliken defines what “substantially all” means.

(One court concluded that two entities in combination may succeed to the business of a predecessor so as to establish a de facto merger. Lanee Great Plastic Co., LTD v. Handmade Bow Co. No. SUCV200705245, 2010 WL 6650330, at *5 (Mass. Super. Dec. 26, 2010).

Passage of time may camouflage the risk of successor liability rather than shield an acquirer from its grasp. The General Battery case makes that point. See General Battery, 423 F.3d at 294. There, General Battery merged with Exide Corporation in 2000, making Exide undisputedly a successor to General Battery’s liabilities. Id. at 295. Shortly after that merger, the United States Environmental Protection Agency brought claims against Exide for liability of the long-defunct Price Battery Corp., a corporation from which General Battery had acquired assets in 1966. Id. Applying the four-prong test described above, the Third Circuit concluded that General Battery was Price’s successor and heir to its environmental liability. Id. at 309. When Exide merged with General, it became responsible for that liability. Id. The court in General Battery purported to be deciding based on federal common law, even though it used the four-pronged analysis adopted by most states. Id. at 305. Although the acceptance of the 4.5 percent share ownership as satisfaction of the second prong might be a leniency driven by the remedial statute to which the court was giving effect, there is no reason to think that the passage of time would serve as better protection in the state court. If the entity that incurred a liability were a predecessor to the entity on which a third party seeks to impose liability, there is no reason the passage of time would change that. Knowing the acquisition history of an acquisition target is an important goal of the pre-acquisition due diligence.

Assessing the likelihood that a transaction will be deemed a de facto merger can be particularly difficult where the principal assets of the predecessor are intangible, such as a service entity or a business for which the principal assets are intellectual property.

Take, for example, a financial consulting firm whose principal assets are goodwill and client relationships. Owners and principals of a struggling firm may seek to be employed by a more successful competitor. Those “acquired” owners engage in negotiations to be hired by the “acquirer,” promising to bring with them “all or substantially all” of their client base. Top management and some employees (important to the newly hired executives’ ability to service clients) from the acquired firm are hired by the “acquirer,” which agrees to pay the employees’ salaries going forward and honor accrued vacation. Those managers are offered the opportunity to buy into the “acquirer” and are given executive titles—and maybe board seats.

They close down their former business and serve their previous client base from their new offices in the acquirer’s suite. If one adds to the mix the fact that the “predecessor” entity was faced with liabilities, such as client suits, that they endeavor to leave behind, the transaction hits many of the benchmarks for a de facto merger set out in the governing authority.   In a fact pattern such as the above, a service provider, believing it was only engaging in hiring new executives, might find itself branded a “successor” and learn that it must answer for the liabilities that contributed to the demise of its new employees’ entity.

The de facto merger doctrine presents circumstances where the flexibility of equity creates a double-edged sword.  On the one hand, it gives the courts the ability to address the clever culprit who devises novel transactions to preserve its business while shaking free of liabilities for which, in fairness, it should answer. On the other, it leaves counsel advising on the structure of an asset acquisition with a measure of uncertainty as to which liabilities may piggyback onto the assets transferred. Unexpected successor liabilities can arise from an asset acquisition. Given the ad hoc nature of the de facto merger analysis, and its fact-driven character, it will at times be difficult to predict when a transaction may stand the risk of being held to be a de facto merger.

In its February 9, 2018 decision The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System  (Court Decision), the United States Court of Appeals for the District of Columbia Circuit (DC Circuit) overruled the decision of a United States District Court and decided that collateral managers for open market collateralized loan obligation transactions (open-market CLOs ) are not subject to the risk retention requirements of Section 941 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and the risk retention regulation (Regulation) promulgated by the Securities and Exchange Commission (SEC), the Board of Governors of the Federal Reserve System (Board) and other regulators (collectively with the SEC and the Board, the Agencies) thereunder. Only the SEC and the Board (Defendants) were defendants in the litigation. The decision will not result in a change in the law until after the period for appeal within the DC Circuit has passed or any such appeal process has concluded. 

The Court Decision

The Court Decision was rendered by a panel (Panel) of three judges of the DC Circuit: Circuit Judge Brett Kavanaugh; Senior Circuit Judge Douglas Ginsburg; and Senior Circuit Judge Stephen Williams, who wrote the opinion. The opinion analyzed Section 941, which requires the Agencies to issue regulations:

to require any securitizer to retain an economic interest in a portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells, or conveys to a third party.

Section 941 further defines a “securitizer” as:

(A) an issuer of an asset-backed security; or

(B) a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer… 

The Panel was considering an appeal, filed by The Loan Syndications and Trading Association (LSTA), of a District Court decision issued on December 22, 2016, rejecting a challenge to the Regulation and upholding the Agencies’ conclusion in the Regulation that the collateral manager of an open-market CLO is the party required to comply with risk retention requirements of Section 941 as detailed in the Regulation.

The Panel concluded that to be a “securitizer” under clause B , an entity would have to have had a possessory or ownership interest in the assets that it then transferred, directly or indirectly, to the issuer. The Panel rejected the argument that a person could come within the definition merely by causing the transfer to the issuer without itself ever having had any ownership interest in the transferred assets. Accordingly, because the collateral manager of an open-market CLO only directs and consummates asset acquisitions on behalf of the issuer through open market purchases, it would not be a securitizer and therefore would not be subject to the risk retention requirements. Although the decision did not address whether the issuer of an open-market CLO may still be a securitizer pursuant to clause A, the discussion in the opinion indicated that, in the view of the Panel, the Regulation effectively eliminated the issuer from the definition.

Note that the Court Decision would not apply to a transaction where the assets come from a financial institution or asset manager involved in the organization and initiation of a securitization with its own assets (balance-sheet CLO). The Court Decision did not specifically address, and it therefore remains unclear, whether risk retention requirements would apply to transactions in which a portion of the assets acquired in the open market are first acquired by the collateral manager in order to meet certain requirements for European Union risk retention; to so-called “call and roll” transactions in which assets in one open-market CLO are transferred into a new comparable securitization transaction; or to a securitization of assets acquired in the open market but held by a party other than the issuer under a warehousing arrangement prior to securitization.

Effective Date; Appeal Period

The Court Decision will not become effective until after a period has passed without appeal within the DC Circuit, or an appeal process has been successfully completed. In the event the Defendants decline to appeal the Court Decision within 45 days after the date the decision was issued (the 45^th day in question being March 26, 2018), the decision will become effective on or shortly after April 2, 2018, when the DC Circuit issues its mandate finalizing the decision and the Regulation (insofar as it imposes risk retention requirements on collateral managers of open-market CLOs) will be vacated when the District Court enters a judgment consistent with that mandate.

Alternatively, the Defendants may petition the Panel to rehear its decision or petition all of the active judges of the DC Circuit for a rehearing en banc or both. In that case, the Court Decision would not become final until late April 2018, at the earliest, or several months after that, at the latest. The DC Circuit may summarily deny the Defendants’ petition for rehearing without further briefing a few weeks after the Defendants file their petition, but if the DC Circuit grants the Defendants’ petition or requests additional briefing, the Court Decision may not be finalized for several months after that.

In addition to or instead of filing a petition for rehearing in the DC Circuit, the Defendants could petition the US Supreme Court for a writ of certiorari. In that case, the Defendants must file their certiorari petition within 90 days of the Court Decision or denial of a petition for rehearing by the DC Circuit, whichever is later. The Defendants’ certiorari petition would thereafter take 44 days to brief and several additional weeks to decide. However, because a certiorari petition does not, by itself, stay the DC Circuit’s issuance of the mandate finalizing the Court Decision, unless the Defendants petition the DC Circuit for rehearing or successfully move to stay the mandate pending a response to their certiorari petition to the Supreme Court, the Court Decision could nevertheless become effective as early as April 2, 2018.

The foregoing are only a few of the possible appeal scenarios. The Defendants’ and the courts’ choices in the next few weeks will be critical for attempting to determine the timing of an effective date for the Court Decision. Until the appeal process is completed, there can be no assurance that the Court Ruling will stand.

The Regulation, to the extent applicable to collateral managers of open-market CLOs, remains effective until vacated by the District Court as directed by the Panel. The District Court will not have jurisdiction to vacate the applicability of the Regulation to collateral managers of open-market CLOs until the DC Circuit issues its mandate after the Defendants have exhausted their appellate rights (or the Defendants are unsuccessful in staying the mandate pending a petition for writ of certiorari).

A final decision in the DC Circuit will bind the Agencies, and accordingly there would be no opportunity for a contrary decision in the Court of Appeals of another Circuit absent further rulemaking action by the agencies.

Impact on Open-Market CLOs

If and when the portion of the Regulation applicable to collateral managers of open-market CLOs is effectively nullified, absent new regulations, open-market CLOs generally would not appear to be subject to the requirements of risk retention. This would appear to be the case since (i) the statutory requirement, on its face, is dependent on an implementing regulation being in effect, (ii) the portion of the Regulation imposing such requirements on collateral managers of open-market CLOs will have been invalidated and (iii) under the remaining active components of the Regulation, no other party to a typical open-market CLO would constitute a “securitizer” as that term was interpreted by the Panel. In respect to outstanding open-market CLOs, a collateral manager currently holding such a risk retention interest would accordingly appear to no longer be required to retain that interest under the Regulation. Any collateral manager would, however, continue to be subject to the terms of any applicable transaction documents, which may continue to restrict the disposition, hedging and financing of such risk retention interest.

The Agencies would be free to promulgate new regulations consistent with the ruling, although it is not clear upon which other open-market CLO transaction party the Agencies might attempt to impose an alternative risk retention obligation, or what would be the statutory basis for doing so—possibly, the Agencies could promulgate interpretations that impose risk retention obligations on the issuer pursuant to clause A of Section 941 quoted above, and impose certain requirements on equity holders thereof or others to give substantive effect to such obligations. The procedural posture and timing of any new regulation is also not clear at this time, and it is not known if the Agencies might seek to issue interpretative guidance in the interim (or what form or substance any such guidance might take).

Possible Impact of Court Decision on Other Types of Securitizations

Although the Court Decision specifically addressed only the treatment of collateral managers of open-market CLOs, the analysis of the Court Decision may be equally applicable to a number of other asset classes. For example, the Panel’s argument may be applied to the following:

• Sponsors of resecuritizations in which the underlying securities are acquired by the issuer in open market transactions rather than from a person holding such securities prior to the securitization who is involved in the securitization transaction;
• Managers of commercial paper conduits that acquire assets in the open market or directly from their customers; and
• Sponsors of conduit securitizations that acquire the assets directly from third party originators rather than hold any such loans on balance sheet.

In each case, it would be essential that the issuer acquire the underlying assets directly from third parties, and that the organizer and initiator of the securitization transaction or program not be included in the chain of title. Removing the manager or sponsor of any of these securitizations as a securitizer would, of course, increase the risk that one or more parties transferring assets to the issuer would be characterized as securitizers. That risk would likely be substantially reduced to the extent that the assets so transferred themselves constituted asset-backed securities separately subject to risk retention (as is often the case with resecuritizations or commercial paper conduits).

The Court Decision relied on an interpretation of the language of Section 941, and rejected several policy arguments made by the Agencies, including the concern that the decision would create a loophole for many securitizations that were intended to come within the Regulation but could be structured in a way to come within the open-market CLO model. The Panel recognized the concern, but nevertheless concluded that “[p]olicy concerns cannot, to be sure, turn a textually unreasonable interpretation into a reasonable one.” The opinion further stated that any loophole so created “is one that the statute creates, and not one that the agencies may close with an unreasonable distortion of the text’s ordinary meaning.”

Notwithstanding the clear conclusions stated in the Court Decision, it should be recognized that the Court Decision, in what is arguably dicta, offered reasons why the decision was appropriate for open-market CLOs, which might be used by other courts to distinguish the case in making a comparable decision with respect to other asset classes that do not have a number of the features that are present in open-market CLOs. The Panel in particular noted the following with respect to open-market CLOs:

• The loans are generally large loans, limited in number (typically up to 100 to 250 loans), from companies that are public companies or for which credit information is otherwise available to investors, providing transparency not always available in other asset classes.
• The loans are often portions of larger syndicated loans involving multiple parties as originators.
• The loans are generally of a type actively traded in a secondary market.
• The collateral manager is generally compensated in whole or in part with incentive compensation, and therefore in effect has skin in the game through its compensation structure. As such, it operates much like a mutual fund (which, though not stated in the opinion, is viewed as not subject to risk retention).
• Open-market CLOs performed relatively well during the financial crisis.

Assuming the Court Decision is not appealed, or is upheld on appeal, there will be a desire to extend its applicability to other types of securitizations, to the extent they can be structured in a manner similar to open-market CLOs. In light of the foregoing, transaction participants would need to conduct a thorough analysis of all the facts and circumstances present in any given transaction, and a careful consideration of the regulatory uncertainties involved, before relying on an extension of the Court Decision’s rationale as a basis for not complying with the risk retention requirements in other types of securitizations.

As litigators are aware, the cost of discovery is a significant component of the cost of litigation, a fact the U.S. Supreme Court noted in 2007 in Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 559 (2007), when it stated that “the threat of discovery expense will push cost-conscious defendants to settle even anemic cases . . . .” Given the rapid expansion of the volume of electronic data in our society, it is no surprise that both the discovery of electronically stored information, or “e-discovery,” and disputes relating to e-discovery can further exacerbate the burdensome cost of litigation. When resolving e-discovery disputes, the parties must weigh the relevance, proportionality, cost, and accessibility of information. At least one court has commented that weighing these factors and working out the practical, technical method of producing the relevant electronic records “is a cooperative undertaking, not part of the adversarial give and take.” In re: Seroquel Prods. Liab. Litig., 244 F.R.D. 650, 660 (M.D. Fla. 2007). Given the number of complex factors that must be balanced and the substantial risk to the parties arising from an adverse e-discovery ruling, more parties are turning to mediation to resolve e-discovery disputes. Mediation can provide a forum for litigants to explore potential alternatives to cost-effectively exchange information relevant to the underlying litigated dispute. By mediating e-discovery issues, litigants can limit the time and cost associated with seeking judicial intervention, control the cost of electronic discovery, maintain confidentiality, and avoid potential adverse results, such as sanctions.

In the e-discovery arena, mediation can be used either to create a mediated e-discovery plan or to resolve underlying disputes regarding electronically stored information. A skilled mediator who is knowledgeable about e-discovery can facilitate the negotiation and resolution of complicated e-discovery issues without judicial intervention. Further, by eliminating acrimonious discovery battles, mediating e-discovery disputes can also improve the prospect of settlement of the underlying litigation.

Who Should Participate? The success of any mediation depends upon the participation of those persons whose input or consent is needed to reach an agreement. This is certainly true of mediations of e-discovery disputes. In addition to the decision makers for the respective parties and litigation counsel, e-discovery mediations should include IT personnel or other technical consultants who have knowledge of the parties’ electronically stored information systems. The participation of IT personnel and/or IT consultants who are familiar with the litigants’ electronic systems and capabilities is key to successful e-discovery mediation.

Preparation for e-Discovery Mediation. Electronic information can take many forms, including active data, inactive data, metadata, deleted data, ghost data, legacy data, archived data, and back-up data. In advance of e-discovery mediation, it is imperative that counsel becomes familiar with the type of information stored and how it is stored, preserved, retrieved, and produced, as well as the cost of producing it. In addition, counsel should become familiar with the inventory of storage devices used by the client, the location and ownership of those devices, the client’s retention policies, and any automatic deletion procedures that may need suspending. Counsel should also become familiar with the client’s data mapping and systems mapping.

Mediation Statement. The parties should prepare a confidential mediation statement and deliver it to the mediator well in advance of the mediation. The mediation statement should include the following:

• the identity of the persons who will attend the mediation, including all IT representatives and whether the IT representatives are employees of the litigant or hired consultants, and if the IT representative is a hired consultant, the scope and nature of the consultant’s engagement with the litigant;
• a candid discussion of potential issues identified by counsel, including potential spoliation issues, cost concerns, timing issues, and specific privilege concerns;
• a candid assessment of the technological capacity of both the litigant and counsel’s law firm together with any proposed solutions to obvious deficiencies in their respective capacities;
• a disclosure of whether any depositions of corporate representatives have been taken regarding electronically stored information, and if any such depositions have been taken that elicited testimony regarding electronically stored information that would help the mediator understand the electronic landscape, a notation of any relevant testimony and copies of relevant portions of the deposition transcripts; and
• if the specific purpose of the e-discovery mediation is to resolve disputes arising from discovery requests already propounded in the litigation, a summary of the specific disputes and copies of the discovery requests, responses and objections, motions to compel, relevant scheduling orders, and related documents.

Issues to be Addressed Through Mediation. Although the issues to be addressed through e-discovery mediation will vary with the procedural posture of the litigation and the specifics of the dispute at hand, the issues likely to be addressed through e-discovery mediation include:

• the scope of reasonably accessible electronic data to be preserved and reviewed;
• the search parameters to be used to locate electronic data;
• the method of review to be employed;
• the data format for preservation and production;
• the time and manner of production;
• the procedures for handling inadvertently produced privileged information;
• the potential need for protective orders;
• the methodologies to evaluate compliance with any e-discovery plan or mediated e-discovery agreement; and
• the mechanism and protocol to enforce any mediated e-discovery plan or mediated e-discovery agreement.

The outcome of e-discovery mediation, e.g., an agreed e-discovery plan or an agreement resolving objections to propounded discovery requests, should be reduced to writing and signed by all parties and counsel according to the appropriate rules governing mediation in the jurisdiction of the litigation.

E-discovery mediation can provide litigants with a confidential venue to efficiently manage the discovery of electronically stored information. Mediation can help parties control e-discovery costs, maintain confidentiality, and avoid potential adverse results, such as the imposition of sanctions. Although mediation will not eliminate all e-discovery disputes, it is a tool to reduce or eliminate e-discovery motion practice that should not be overlooked.