How far do the Bankruptcy Code’s “safe harbor” provisions extend in the commercial mortgage-backed securitization (CMBS) market? Do these safe harbor provisions protect financial institutions that act merely as conduits for CMBS payments? These questions were addressed recently by the Northern District of Illinois District Court, and the court’s decision provides ammunition for CMBS investors in clawback claims brought by a bankruptcy trustee.

In Krol v. Key Bank, N.A., the chapter 7 trustee filed preference and fraudulent transfer claims against Key Bank and LaSalle Bank. At issue were payments made by the debtor on a loan (the “Loan”) extended by a trust (the “Trust”) to an entity related to the debtor. Prior to the bankruptcy, the note evidencing the Loan had been transferred to the Trust as part of a securitization process. Key Bank was the master servicer for the Loan, and held the payments temporarily before transferring them to the Trust. LaSalle Bank was the trustee under the Trust

The defendants moved to dismiss the bankruptcy trustee’s claims arguing, among other things, that the payments were shielded by the safe harbor provisions of section 546(e) of the Bankruptcy Code. Section 546(e) provides a safe harbor from preference and constructively fraudulent transfer claims where the transfers (1) were made by and to a financial institution, and (2) were made in connection with a securities contract. The purpose of these safe harbor provisions is to minimize the displacement caused in the commodities and securities markets by a bankruptcy filing affecting those industries. The safe harbor does not extend to intentionally fraudulent transfers (those transfers made with an actual intent to hinder, delay or defraud creditors).

The first question before the court was whether Key Bank was a “financial institution” for purposes of Section 546(e) since Key Bank acted as a mere conduit for payments on the Loan. The bankruptcy trustee argued that Key Bank’s status as a mere conduit required the court to determine whether the Trust, the ultimate recipient of the money, was a financial institution. The court rejected these arguments and refused to read into the statute an additional requirement that the financial institution receive some financial benefit or acquire the funds for its own use. This reasoning is consistent with the approach taken by most of the federal circuits that have addressed the issue.

The second question was whether payments made to Key Bank on the Loan were made in connection with a “securities contract.” The bankruptcy trustee argued that the payments were made in connection with the Loan which was not a securities contract. However, looking to the economic realities of the transaction, the court found that the Loan had been securitized as a CMBS. In a CMBS, securities are collateralized pursuant to a pooling and servicing agreement (PSA) by a pool of mortgages on commercial real estate in which all principal and interest from the mortgages flow to certificate holders in a defined sequence or manner. Here, the Loan had been transferred to the Trust and that the Trust had issued certificates representing investors’ interests in multiple bundled loans. Writing that “in connection with” as used in Section 546(e) should be construed broadly, the court held that the payments to Key Bank, which Key Bank then transferred to the Trust, were made “in connection with” the PSA. The court rejected the bankruptcy trustee’s “novel proposition” that any two-tiered transaction precludes a finding that a securities contract is involved.

Based on this analysis, the court dismissed the bankruptcy trustee’s preference claims and recommended dismissal of the constructive fraudulent transfer claims.

The Krol decision is an important decision for participants in the CMBS market. First, the decision is further support that Section 546(e)’s safe harbor provisions apply where financial institutions act simply as a mere conduit for funds. Under the majority approach, as adopted by the Krol court, a financial institution does not need to acquire any ownership interest in the funds in order to qualify for the safe harbor protections. Second, the Krol decision recognizes the economic reality of CMBS transactions, and brings within the protection of Section 546(e) loan payments where the loan has been collateralized. Third, the decision provides more security for CMBS investors since it increases the scope of the safe harbor protections of Section 546(e).