Trustees Beware! Securitization Trustees May Be Liable for Fraudulent Transfers

In a lively opinion authored by Judge Easterbrook, the Seventh Circuit has addressed an issue of first impression among the federal appellate courts:  whether a trustee for a securitized investment pool that receives repayments on behalf of the trust beneficiaries can be held liable as the “initial transferee” of a fraudulent transfer under section 550(a)(1) of the Bankruptcy Code, and is not a mere conduit of the funds, even though the trustee was obligated to distribute the funds pursuant to the applicable trust agreement.  Paloian v. LaSalle Bank, N.A., 619 F.3d 688 (7th Cir. 2010)Paloian also addresses what constitutes separateness for entities in a corporate family and serves as a reminder that creditors cannot obtain the benefits of a “bankruptcy-remote vehicle” unless the special purpose entity truly is separate from its affiliated entities.  Today’s blog entry focuses on the issue of whether LaSalle could be liable as an initial transferee.
The debtor in Paloian was Doctor’s Hospital of Hyde Park, a Subchapter S corporation controlled by James Desnick.  In the words of Judge Easterbrook, Desnick was “an ophthalmologist with a checkered past.”  Desnick also formed and was the principal owner of MMA Funding, L.L.C., a non-debtor that was intended to be a “bankruptcy-remote vehicle,” and HPCH LLC, a non-debtor that owned the Hospital’s building and land.  Prior to its bankruptcy, the Hospital purportedly transferred all its current and future accounts receivable to MMA.
The underlying dispute before the Seventh Circuit involved two prepetition loans:  (i) a revolving $25 million line of credit that lender Daiwa Healthco extended to MMA, which was secured by the Hospital’s receivables and the proceeds of which were used to pay the Hospital’s operating expenses, and (ii) a $50 million loan made by Nomura Asset Capital Corporation to HPCH, which was secured by incremental rent that the Hospital agreed to pay to HPCH through MMA. 
Nomura sold its loan to a third party that packaged several billion dollars of commercial loans in a securitization.  Accordingly, all the Nomura loan rights were transferred to a securitization trust, of which LaSalle National Bank acted as trustee.
After the Hospital’s bankruptcy filing, the trustee appointed in Hospital’s case sued to recover various payments made on account of the Nomura loan as fraudulent conveyances.  The Seventh Circuit’s opinion does not dwell on why the transfers were considered fraudulent transfers, as opposed to preferences.  Judge Easterbrook noted, though, that the bankruptcy court had recharacterized the Hospital’s lease payments to HPCH as debt service on the Nomura loan, but he also noted that LaSalle had not raised the defense to a fraudulent transfer under section 550(b)(1) of the Bankruptcy Code that the transfers were made in satisfaction of an antecedent debt. Instead, one focus of the opinion was on whether the trustee could recover from LaSalle, which only received payments in its capacity as trustee of the securitization trust.
LaSalle argued that section 550(a)(1) of the Bankruptcy Code only allows recovery of avoided transfers from an initial transferee, a subsequent transferee, or the entity for whose benefit such transfer was made.  Because LaSalle clearly was not a subsequent transferee, and the transfers were not made for LaSalle’s economic benefit, the issue was whether LaSalle could be considered the “initial transferee.”  As Judge Easterbrook pointed out, the Bankruptcy Code does not define “initial transferee,” although courts have found that any entity with control over the funds – the “real recipient of preferential transfers” – meets the definition. 
Likening itself to a bank holding money subject to its customer’s orders, LaSalle argued that it was a “mere conduit” for the funds in the trust and lacked the requisite control over the funds to be held liable as an initial transferee under section 550(a)(1) of the Bankruptcy Code.  The Seventh Circuit disagreed.  It held that LaSalle, as trustee, was the legal owner of the securitization trust’s assets.  Notwithstanding LaSalle’s contractual duties to the trust’s certificateholders (the beneficiaries of the transfers) to apply the funds, LaSalle was the owner of the assets, and, therefore, the proper subject of an avoidance action.  Recognizing the dearth of appellate case law on the subject of whether a trustee for a securitized investment pool is an “initial transferee” under section 550(a), the court relied on “lots of decisions hold[ing] that an entity that receives funds for use in paying down a loan, or passing money to investors in a pool, is an ‘initial transferee’ even though the recipient is obliged by contract to apply the funds according to a formula.”  The court also found it would be appropriate to recover the transfers from LaSalle because LaSalle would, in turn, recover any amounts it was required to pay from the trust.
The holding in Paloian is significant for the scope of liability as an initial transferee under section 550(a)(1) of the Bankruptcy Code.  Notwithstanding that a trustee for a securitization trust may be contractually obligated to transfer funds to investors, and does not hold a beneficial interest in such funds, courts following Paloian may reject a trustee’s status as a conduit, and instead allow an avoidance action to proceed against the trustee (who, if held liable, may or may not ultimately recover against the trust).  Interestingly, Paloian does not discuss whether the control that a trustee may be permitted to exercise over distribution of funds to certificate holders under the relevant trust agreement should play any role in determining whether the trustee is a mere conduit for funds, as opposed to an initial transferee.