In a case of first impression, the U.S. Bankruptcy Court for the Northern District of Illinois recently held that loan payments related to a two-tiered securitization structure are protected from avoidance by 11 U.S.C. § 546(e). Specifically, in Krol v. Key Bank National Association (In re MCK Millennium Centre Parking LLC),[1] the court held that the debtor’s payments on a nondebtor affiliate’s loan, which had been transferred into a trust as part of a commercial mortgage-backed securitization, were made “in connection with a securities contract” under § 546(e) and, therefore, were not avoidable as preferential or constructively fraudulent transfers.
The Facts
Key Bank made an $11.2 million loan to MCK Millennium Centre Retail, LLC. Key Bank subsequently transferred the loan into a commercial mortgage-backed securitization (CMBS) pursuant to a pooling and servicing agreement (PSA). A CMBS trust held the loan as part of a pool of mortgage loans and issued certificates representing interests in the trust to investors. Under the PSA, the trust designated Key Bank as master servicer to receive and administer loan payments on behalf of the trust and its investors.
As master servicer, Key Bank received a series of payments on MCK Retail’s loan from its affiliate, MCK Millennium Centre Parking, LLC (the debtor). The debtor was neither an obligor nor a guarantor on MCK Retail’s loan, but nonetheless made more than $5 million in payments on the loan to Key Bank, which eventually transferred the funds to the CMBS trust pursuant to the PSA.
The debtor later filed for bankruptcy. The chapter 7 trustee for the debtor brought an adversary proceeding to recover the loan payments from Key Bank and the CMBS trust, alleging that the payments were avoidable as preferential and constructively fraudulent transfers. The defendants moved to dismiss the trustee’s claims, arguing that § 546(e) of the Bankruptcy Code protected the payments from avoidance.
The Statute
Section 546(e) of the Bankruptcy Code provides a “safe harbor” that protects certain securities-related payments from being avoided as constructively fraudulent or preferential transfers. The statute provides, in pertinent part, that “[t]he trustee may not avoid a transfer ... that is a transfer made by or to (or for the benefit of) a ... financial institution ... in connection with a securities contract, as defined in section 741(7).”[2] Congress enacted § 546(e) to “minimiz[e] the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.”[3]
The Decision
The court analyzed two elements of the § 546(e) defense: whether the loan payments by the Debtor were made (1) by or to a financial institution and (2) in connection with a securities contract. The court ultimately determined that the debtor’s payments satisfied each of these elements, and therefore were shielded from avoidance by § 546(e).
As to the first element, the parties did not dispute that Key Bank constituted a financial institution under § 546(e). Instead, the trustee argued that Key Bank was a “mere conduit” and that the CMBS trust — which was not a financial institution under § 546(e) — should be treated as the transferee of the debtor’s payments. Noting a split of authority regarding the role that a financial institution must play in the underlying transaction, the court sided with the majority view that the plain language of the statute applies to any payments made “by or to” a financial institution, regardless of whether the institution serves as only a conduit or intermediary.[4] The court rejected the minority view that the financial institution must acquire a beneficial interest in the payments in order for § 546(e) to apply.[5] Thus, the court found that the debtor’s payments were made by and to a financial institution, Key Bank.[6]
As to the second element, the parties disputed whether the debtor’s payments were made in connection with a securities contract. The trustee argued that the payments were made on account of a mortgage loan, which is not a securities contract. The defendants, however, argued that the loan should be integrated with the subsequent PSA, which constituted a securities contract as broadly defined in the Bankruptcy Code.[7] The court agreed, stating that it “may properly consider two separate transactions as a single transaction when doing so would align with economic realities.”[8] The court further found that the loan payments were made “in connection with” — which may be liberally construed to mean “related to” — a securities contract, given that the PSA governed how the payments were to be maintained, held and distributed to investors.[9]
Accordingly, because the loan payments were protected by § 546(e), the court dismissed the trustee’s preference claim and recommended that the district court dismiss the trustee’s fraudulent transfer claims.
The Implications
The Krol decision is significant in several respects. First, it represents the latest decision weighing in on the existing circuit split about whether § 546(e) applies to a financial institution acting only as a conduit or intermediary in the underlying transaction. Second, it appears to be the first reported decision addressing whether loan payments related to a CMBS transaction are protected from avoidance by § 546(e). Third, given that this two-tiered securitization structure is commonly employed in CMBS transactions, the Krol decision, if accepted by the district court, may have a very broad application.[10]
[1] Adv. No. 14-00392, 2015 WL 1951036 (Bankr. N.D. Ill. Apr. 30, 2015).
[2] 11 U.S.C. § 546(e).
[3] Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329, 334 (2d Cir. 2011) (quoting H.R. Rep. No. 97-420, at 2 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583).
[4] 2015 WL 1951036, at *8 (citing QSI Holdings Inc. v. Alford (In re QSI Holdings Inc.), 571 F.3d 545, 550-51 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F.3d 981, 987 (8th Cir. 2009); Lowenschuss v. Resorts Int’l Inc. (In re Resorts Int’l Inc.), 181 F.3d 505, 516 (3d Cir. 1999)).
[5] Id. (rejecting Mumford v. Valuation Research Corp. (In re Mumford Inc.), 98 F.3d 604, 610 (11th Cir. 1996)). In any event, the court noted that Key Bank “was allowed to invest the funds, which may mean that it received transfers for its own benefit,” even under the minority view. Id. at 8 n.3.
[6] Id. at 8 (explaining that $5 million was transferred “to” Key Bank and then subsequently transferred “by” Key Bank to the CMBS trust).
[7] 11 U.S.C. § 741(7)(A) (defining a securities contract as “a contract for the purchase, sale, or loan of ... a mortgage loan, any interest in a mortgage loan, a group or index of ... mortgage loans or interests therein,” as well as any similar agreement).
[8] 2015 WL 1951036, at *10, n.5.
[9] Id. at *11.
[10] The trustee, in fact, is challenging the decision in the district court, arguing that this “broad unprecedented holding would allow every commercial lender ... to shield itself from bankruptcy avoidance actions simply by later bundling the loan with other commercial loans into a CMBS trust.” Plaintiff’s Objection to Proposed Findings of Fact and Conclusions of Law (Docket No. 86) at 11.