Krol v. Key Bank National Association, et al. (In re MCK Millenium Centre Parking, LLC), Adv. No. 14-00392 (N.D. Ill. Apr. 24, 2015)

Case Snapshot In Krol v. Key Bank National Association, et al. (In re MCK Millenium Centre Parking, LLC), Adv. No.14-00392 (N.D. Ill. Apr. 24, 2015), the U.S. Bankruptcy Court, Northern District of Illinois (the “Court”) issued a decision of particular importance to lenders and securitization servicers facing complications from the bankruptcy of a borrower involved in a commercial mortgage-backed securitization (“CMBS”). The Court clarified the scope of safe harbor protections for loan payments which are “related to” a securities contract, dismissing a chapter 7 trustee’s avoidance claims seeking to claw back over $5 million in pre-petition loan payments made to repay loan obligations owed to a trust. The Court held that the safe harbor under section 546(e) of the Bankruptcy Code protected from avoidance the debtor’s payments to the bank on account of a non-debtor affiliate’s loan. Because the loan was evidenced by a promissory note which was then transferred to a real estate mortgage conduit trust and managed as a CMBS, the payments on the underlying loan “related to” a securities contract – a type of transaction covered by the Bankruptcy Code safe harbors. The Court dismissed the trustee’s preference claim and recommended dismissal of the trustee’s constructive fraudulent transfer claims.

Factual Background Prior to the debtor’s bankruptcy filing, the trust made a loan in the amount of $11.2 million to a subsidiary - and insider - of the debtor. The subsidiary executed a promissory note and, as part of the securitization process outlined in the pooling and servicing agreement, the promissory note evidencing the loan was transferred into the trust. Wells Fargo, as successor trustee of the trust, held legal title to the loan, and a number of other loans, for the benefit of the owners of the trust and managed as CMBS. During the four years prior to the debtor’s bankruptcy filing, the debtor made payments to Key Bank in repayment of the loan to the subsidiary, and Key Bank in turn transferred those funds to the trust. Following the debtor’s bankruptcy filing, the chapter 7 trustee sought to avoid the loan payments arguing that the debtor received no consideration for the loan payments. The defendants filed a motion to dismiss certain of the trustee’s claims arguing, among other things, that the safe harbor under section 546(e) of the Bankruptcy Code protected the loan payments from avoidance as they were made to a financial institution and were in connection with a securities contract. The chapter 7 trustee argued, among other things, that Key Bank was a mere conduit for the trust and the trust itself was not a financial institution, rendering the safe harbors inapplicable.

The Decision Section 546(e) of the Bankruptcy Code provides a “safe harbor” from the avoidance of certain prepetition payments (1) made by or to specified financial market participants and (2) in connection with a securities contract. Section 546(e) is intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy filing affecting those industries.

As to the first element, the parties did not dispute that the bank constituted a financial institution. The chapter 7 trustee, however, contended that the Court must look past Key Bank and to the trust itself – which was not a financial institution under the Bankruptcy Code – as the bank held the payments temporarily from the debtor before transferring them to the trust and was therefore merely a conduit which did not receive any transfers for its own benefit or use. The Court rejected the trustee’s argument that the payments to the bank should not be protected because the bank neither used nor benefited from the payments by the debtor. Noting a split among the circuits as to whether the safe harbors protect transfers to financial institutions that serve as a conduit or intermediary, the Court sided with the majority view and decisions from the United States Courts of Appeals for the 3rd, 6th, and 8th Circuits, finding that the plain language of section 546(e) of the Bankruptcy Code only requires that the transfer be “by or to” a financial institution and does not impose requirements regarding the use of the payment. Payments made “by” the debtor to the bank and then by the bank “to” the trust therefore fell within the first prong of Section 546(e).

As to the second element, the Court agreed with the defendants that the integration of the loan with the pooling and servicing agreement for a CMBS transaction rendered the loan payments made on account of a promissory note transferred to the trust “in connection with a securities contract” under the Bankruptcy Code. The expansive language “in connection with” must be construed liberally where loan payments were related to a securities agreement. The CMBS transaction involved the transfer of the loan into the trust and the subsequent issuance of certificates representing investors’ interests in the bundled loans. The Court found nothing in the statute or case law supported the chapter 7 trustee’s assertion that a two-tiered transaction precludes a finding that a securities contract is involved. Although the loan payments were not necessarily made for the purchase or sale of securities, the loan payments were made in connection with securities contract, namely the CMBS transaction. The payments were maintained in a distribution account maintained by the trust and distributed to certificate holders based upon a prearranged distribution program under the pooling and servicing agreement.

The Court dismissed the trustee’s preference claim and recommended dismissal of the trustee’s constructive fraudulent transfer claims.

Takeaways Noting a split of authority, the Court held that a financial institution which seeks safe harbor under section 546(e) of the Bankruptcy Code need not acquire a beneficial interest in the transferred funds in order to trigger the safe harbor. Even a conduit financial institution will benefit from the protections from avoidance actions where the transfers are in connection with a securities contract. The Court also found that a commercial mortgage securitization is a “securities contract” such that a payment made to the agent for the securitization trust and then eventually transferred to the trust by the agent, is protected by the safe harbor. By taking an expansive view of circumstances in which transfers are made “in connection with” a securities contract, the decision also may protect investors’ expectations in securitization vehicles in the event an individual mortgagor files for bankruptcy.

Client Alert 2015-123