Payments to Lead Lender Are Not Avoidable Preferences to Extent of Participation Interests

Pursuant to Section 547 of the Bankruptcy Code, payments made within 90 days of a filing are avoidable as preferences, subject to certain defenses. A defense that has been asserted and sometimes accepted is that the recipient was acting as a “conduit” for another party.

In Northern Capital, Inc. v. The Stockton National Bank et. al. (In re Brooke Corporation), 458 B.R. 579 (Bkrtcy.D.Kan.,2011) a recent case decided by the United States Bankruptcy Court for the District of Kansas, the Court addressed a conduit defense in the context of a participated loan.

In Brooke, the debtor borrowed $4.5 million from Stockton National Bank. On the same day the loan closed, Stockton sold participations in the loan to other financial institutions. The participations sold by Stockton totaled about 95% of the interests in the loan. Pursuant to the Participation Agreement, upon receipt of payments from Brooke, Stockton was obligated to distribute to each participant its pro rata share.

After the Brooke loan was closed, Brooke filed a bankruptcy petition. Thereafter, the trustee appointed in the Brooke case sued Stockton to recover allegedly preferential transfers totaling about $488,000.

Stockton asserted a number of defenses, including that (a) it had sold the participations to the participants, (b) it had distributed 95% of the alleged preferential payment to the participants, and (c) as to that 95%, it was a mere conduit and not an initial transferee from whom a preference could be recovered.

Initially, the Brooke Court noted that, in Bonded Fin. Serv. Inv. v. European Amer. Bank, 838 F. 2d 890, 893 (7th Cir. 1988), it was held that “the minimum requirement of status as a ‘transferee’ is dominion over the money or other asset, the right to put the money to one’s own purposes.” The Brooke Court then went on to state, “[T]he Bonded definition of initial transferee has been held to mean that if the entity receiving the funds is not permitted – by law, contract, or otherwise – from using the funds as it desires, it is a mere conduit and not an “initial transferee.” The Brooke Court then observed that there did not appear to be any case-law addressing the conduit defense in the context of participated loans.

The Brooke Court held that Stockton was a mere conduit from whom only the portion of the allegedly preferential payments which it retained (about 5%) could be recovered. As to the remainder, the Brooke Court held that the participants were the initial transferees.

The Brooke decision is driven by the fact that Stockton was contractually obligated to distribute 95% of the allegedly preferential payments to the participants and did, in fact, make those distributions. As a result, in the view of the Brooke Court, Stockton was a mere conduit from whom the funds distributed by Stockton to the participants could not be recovered notwithstanding that (a) the note evidencing the loan identified only Stockton as the creditor, (b) when received, the payments were commingled by Stockton with its other funds, and (c) Stockton filed a proof of claim for the entire amount of the loan.

While Brooke would appear to be good news for lead lenders in participated loans, two cautionary notes are appropriate.

First, arguably, the Brooke holding conflicts with the holding of the Seventh Circuit in Paloian v. LaSalle Bank, N.A., 619 F. 3d 688 (7th Cir. 2010). In Paloian, the trustee of a securitized asset trust received payments which it was contractually obligated to, and did, distribute to the trust beneficiaries. When sued for return of those payments in a subsequent bankruptcy filed by the obligor, the trustee asserted the mere conduit defense. However, that defense was rejected. The Brooke Court distinguished Paloian on the basis that the Paloian trustee had legal title to all of the trust’s assets (including the loan in question) while, pursuant to the Brooke participation agreement, the participants (not Stockton) had legal and equitable title to the portions of the loans equal to the participation interests. Whether that distinction is appropriate is an open question.

Second, the Brooke Court mentions that the debtor, Brooke, brought the participants to Stockton and therefore could not be said to have intended that only Stockton would benefit from the allegedly preferential payments. It is not clear the extent to which that fact influenced the Brooke decision. However, in most participations the borrower does not bring the participants to the lead lender. Therefore, it may be possible to distinguish the Brooke decision in cases where the lead lender cannot show that the borrower intended that the participants would benefit from a payment.

For More Information

For more information on how these issues may affect your rights, contact Robert Lapowsky at 215.751.2866.

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