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Lenders 360

A Loophole Big Enough to be a Wormhole

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Like most bank defendants, Key Bank was looking for the quickest way out of a $5 million fraudulent transfer lawsuit brought by a chapter 7 Trustee.  Rather than wait to win in the standard path of arguing facts, the bank relied on the broad and powerful “safe harbor” provision of the bankruptcy code which protects certain transfers from recovery.  In doing so, the bank utilized a technical, but effective, argument to avoid the need for trial and simply exit the case where it entered.

Intersteller

Credit: Paramount Pictures

I. The Underlying Loan

The basic transactional history of the case will sound fairly familiar to many readers; however, that is why it will be equally important in light of the outcome.  A loan in the amount of $11.2 million was made to an insider of the bankrupt debtor prior to bankruptcy.  While the bankrupt debtor had no obligation to repay the loan, the debtor did, in fact, pay back approximately $5 million to the lender.

Shortly after the note was signed and the loan was funded it was assigned to a REMIC as a CMBS governed by a Pooling and Servicing Agreement (“PSA”).  Key Bank’s servicing arm was the master servicer for another major bank as trustee (the “Trustee”) for the Loan.

 II. The Lawsuit

As I have said before, everyone gets sued in a large bankruptcy case – and this was no different.  The debtor in the lawsuit was an affiliate/insider of the original borrower under the loan.  Both entities were controlled by the same person.  For whatever reason, at some point the debtor began making payment for the borrower to Key totaling $5 million dollars.  At no point in time was the debtor obligated on the loan.

As alluded to above, the non-obligated affiliate filed bankruptcy and ultimately had a chapter 7 trustee appointed to administer the assets.

I will not go over (again) the elements of a fraudulent transfer, but in a non-bankruptcy context the chapter 7 trustee’s arrangement would usually be a win for the chapter 7 trustee / plaintiff.

When Key Bank was sued for recovery of the $5 million Key Bank filed a motion to dismiss. Key Bank asserted the safe harbor provisions of 11 U.S.C. 546(e) which essentially say that a purported fraudulent transfer payment cannot be recovered if it was made to a “financial institution” in connection with a “securities contract”.  Both of these terms are defined in the bankruptcy code very broadly

As discussed in the opinion, these terms are defined so broadly in the bankruptcy code that it makes it hard to place any liability of Key Bank or the Trustee.

III. The Holding

The bankruptcy court made a few notable rulings in this case.  The Court discussed Stern v. Marshal and the relation back doctrine.  Most importantly for this past, the Court made two findings concerning the safe harbor provisions of the bankruptcy code.

First, the Court held that the payments were made to a financial institution because there were first paid to Key Bank (ie, not the trust).  The Court so determined even though Key Bank agreed that it was a “mere conduit” of the funds.

Second, the Court held that payments were made in connection with a “securities contract” because the underlining notes referenced securitization and they were, in fact, securitized.

The result – the majority of the claims asserted against the defendants were dismissed.

 IV. The Take Away

In this case, the bankruptcy code provides a safe harbor which protects large lenders from recovery of (non-fraudulent) fraudulent transfer lawsuits.  The language of the safe harbor statute is so broad that it may provide a defense to almost any payments made on a CMBS loan.  While arguably not a loophole, it certainly provides the mechanism for lenders to short-cut a lawsuit to dismissal on the front end.

Krol v. Key Bank N.A., et al. (In re MCK Millennium Centre Parking, LLC), adversary no. 14-00392, pending in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division