The U.S. Bankruptcy Court for the Northern District of Illinois recently held in Krol v. Key Bank National Association (In re MCK Millennium Centre Parking, LLC) that the safe harbor of section 546(e) of the Bankruptcy Code applies to a debtor’s payments made in respect of mortgages pooled and held by a REMIC trust.  The case appears to be the first to interpret the phrase “in connection with a securities contract” to include payments of this type. 
In 2008, MCK Millennium Centre Retail, LLC, a subsidiary and insider of debtor MCK Millennium Centre Parking, LLC, obtained a loan from Key Bank National Association.  Key Bank sold the promissory note to a trust qualified as a real estate mortgage conduit (“REMIC”).  The promissory note was pooled with other mortgages, and certificates representing beneficial ownership interests in the trust were issued to investors.  The certificates entitled the holders to payments from principal and interest on the pool of mortgages, in the manner provided for in the pooling and servicing agreement (“PSA”) among Key Bank, Wells Fargo, as trustee, and other financial institutions.
Key Bank acted as the master servicer under the PSA.  In that capacity, Key Bank handled day-to-day loan administration functions, including receiving payments on account of the loans when they were not in default.
The payments Key Bank received included a series of payments by MCK in respect of Retail’s loan during the four years leading up to MCK’s bankruptcy filing.  In total, MCK paid over $5 million to Key Bank in repayment of Retail’s loan.  Key Bank held these payments temporarily before transferring them to the REMIC trust and applying them to Retail’s loan.
MCK commenced a chapter 11 case, which later was converted to a chapter 7 case.  MCK’s chapter 7 trustee commenced an adversary proceeding against Key Bank to recover the payments that MCK made on Retail’s loan, alleging that such payments were preferential transfers and actually and constructively fraudulent transfers.  The trustee asserted that the payments were made for no consideration because the transfers were repayments on a loan on which Retail, not MCK, was the obligor.
Section 546(e)
Key Bank sought to dismiss all counts of the trustee’s complaint, asserting as a defense that the transfers were protected by section 546(e) of the Bankruptcy Code.
Section 546(e) of the Bankruptcy Code provides a “safe harbor” that exempts a transfer from avoidance under sections 544, 545, 547, 548(a)(1)(B), and 548(b) of the Bankruptcy Code if, among other things, the transfer is “made by or to (or for the benefit of) a . . . financial institution . . . in connection with a securities contract, as defined in section 741(7).”
Under section 741(7)(A) of the Bankruptcy Code, a “securities contract” is broadly defined to include a “contract for the purchase, sale, or loan of a security, . . . a mortgage loan, any interest in a mortgage loan, a group or index of securities … or mortgage loans or interests therein (including an interest therein or based on the value thereof).”  Further, section 741(7)(A)(vii) states that “any other agreement or transaction that is similar to an agreement or transaction referred to in this subparagraph” may be a “securities contract.”
Key Bank had to prove (1) that the transfers were made by or to a financial institution and (2) that the transfers were made “in connection with” a class of defined “securities contracts.”
Holdings and Analysis
It was not contested that Key Bank was a financial institution, within the meaning of the Bankruptcy Code.  However, the trustee asserted that Key Bank did not qualify for protection under section 546(e) because, as master servicer for the loan, Key Bank was a conduit for the transfers and did not use or benefit from the debtor’s payments.  The bankruptcy court noted that the Courts of Appeal are split on whether a financial institution that serves only as an intermediary or conduit qualifies for safe harbor protection, or whether the financial institution must acquire a beneficial interest in the transferred property.  The majority of circuits have found that the plain language of section 546(e) does not require that the financial institution obtain a beneficial interest in the transferred property.  The Eleventh Circuit, however, has held that the transferee must acquire a beneficial interest in the transferred property for the safe harbor to apply.
The bankruptcy court followed the majority view and determined that the plain meaning of the phrase “by or to” in section 546(e) means that payments made either by or to a financial institution, including those that serve only as a conduit or intermediary, qualify for safe harbor protection.  The court declined to read into the statute the additional requirement that the financial institution receive some financial benefit or acquire the funds for its own use.  Applying the text as written, the court found that the transfers were made to Key Bank, a financial institution, and then subsequently transferred by Key Bank to the REMIC trust; thus, those transfers were made by and to a financial institution.  Nonetheless, the court also noted that Key Bank was allowed to invest the funds, which could mean that it received transfers for its own benefit.
The more central dispute was whether MCK’s payments to Key Bank on account of Retail’s loan were “in connection with a securities contract.”  Key Bank argued that the integration of the loan with the PSA qualified as a “securities contract,” as defined by the Bankruptcy Code.  The trustee argued that, while some courts have broadly interpreted the phrase “in connection with a securities contract,” no court has applied the exception to payments in respect of a securitized loan, and MCK’s payments on the Retail loan were not in connection with a securities contract.
The court found that the PSA governing the REMIC trust was a securities contract within the meaning of section 741(7)(A) of the Bankruptcy Code.  The PSA set forth the general structure of the CMBS transaction:  the depositor would sell pass-through certificates evidencing the entire beneficial ownership interest in the trust fund to be created under the PSA, with the mortgage loans that were transferred into the trust and bundled together constituting the primary assets of the trust.
The court noted that it “may properly consider two separate transactions as a single transaction when doing so would align with economic realities.”  In this case, the economic realities were such that it made sense to view the transfer of loans to the trust and the subsequent issuance of the certificates as an integrated transaction.
Further, once the promissory note evidencing Retail’s loan was transferred to the trust, it was subject to the PSA, which in turn defined the manner in which payments from the mortgages flowed to certificate holders.  The court read the phrase “in connection with” broadly to mean “related to” and found that, although the debtor’s payments on the loan were not necessarily made for the purchase or sale of securities, they were made in relation to the PSA and therefore fell within the section 546(e) safe harbor.
The court dismissed, with prejudice, the trustee’s allegations of constructively fraudulent transfer as protected by section 546(e) of the Bankruptcy Code.  Because the safe harbor does not cover actual fraud, though, the court addressed those counts of the complaint separately and found that the trustee had alleged no factual allegations tying the debtor’s actions to the elements required to prove an actual fraudulent transfer.  Accordingly, the claims of actual fraud were dismissed without prejudice.