Northern Capital, Inc. v. The Stockton National Bank, et al. (In re Brooke Corporation), 2011 WL 4543484 (Bankr. D. Kan. Sept. 28, 2011)
In this case of first impression, the court determined whether the status of the lead bank in a loan participation was that of an “initial transferee” or a mere conduit for the purposes of establishing preference liability. At stake was more than $460,000 in loan payments made by the debtor to the lead bank, which were then disbursed to the loan participants. The court analyzed the roles of the lead bank and participants set forth in the participation agreements, as well as case law, and found that the lead bank was a mere conduit. This decision paved the way for the trustee to recover the payments from the loan participants.
The Brooke Corporation solicited several banks to participate in a loan package, through which Brooke borrowed $4.5 million. Brooke executed a promissory note and security agreement in favor of Stockton National Bank. On that same day, Stockton entered into eight identical Participation Certificates and Agreements with the loan participants. The participants’ aggregate ownership of the note and security was 94.44 percent; Stockton’s ownership was 5.56 percent.
Each Participation Agreement identified Stockton as the “Originating Lender (Seller),” and each participant as a “Participating Lender (Purchaser).” Each Agreement provided that in “consideration of the sum of $ (Purchaser’s Investment) Seller hereby sells and certifies to Purchaser an undivided … percent interest (Share), without recourse to Seller, in the Principal and Interest hereby accruing from the Loan.” Each Agreement also provided that the Purchaser would be considered, for all purposes, the legal and equitable owner of its share in the loan, documents, and security. Each Agreement provided that the Seller retained the duties of loan administrator, and the Seller was required to collect from Brooke all payments, which would be “held for the benefit of Seller and Purchaser until the payments are actually paid to and received by Purchaser.” Stockton was also required to remit payments to each Purchaser no later than 10 days after receipt, subject to a penalty if the funds were not remitted within that time.
At issue are three payments, totaling $480,000, that Stockton received from Brooke in the 90 days prior to Brooke’s bankruptcy filing. Stockton distributed more than $460,000 of these payments to the participants, retaining $28,000 for its 5.56 percent share of the participation, and fees it earned as the loan administrator. Stockton maintained a correspondent relationship with another bank where payments were deposited until disbursed. The bankruptcy trustee initiated an adversary proceeding to recover the total of nearly $480,000 in payments Brooke made to Stockton, alleging the payments were preferential transfers. Stockton countered that it was a mere conduit with respect to the $460,000 paid to the other loan participants, and that the trustee could not recover that amount from Stockton. The other participants intervened, arguing that Stockton was the “initial transferee” of the $460,000, so that the trustee could recover that amount only from Stockton under section 550(a)(1) of the Bankruptcy Code.
Section 550(a)(1) provides that a trustee may recover preferential transfers from an “initial transferee,” but the term “initial transferee” is not defined in the Code. In analyzing the legal claims, the court considered Bonded Fin. Serv., Inc. v. European Amer. Bank, 838 F.2d 890 (7th Cir. 1988), which had previously been cited favorably by the Tenth Circuit. In Bonded, the court held that “[t]he 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.” This “conduit theory” recognizes that a party that merely acts as a financial agent or conduit, is not an “initial transferee.” If a transferee receives no benefit from the transferred funds, follows instructions as to the disposition of the transferred funds, or would be liable to the transferor for using the funds for the transferee’s own purposes, then the transferee is not an “initial transferee.”
Applying the conduit theory to the facts before it, the court found that the Agreements unambiguously established that Stockton sold interests in the loan to each participant without recourse to Stockton. Each Agreement identified Stockton as the Seller, and the participant as the Purchaser, and each Purchaser was “considered for all purposes the legal and equitable owner” of its share of the loan, documents, and property securing the loan. Stockton’s role was that of a loan servicing agent, payment collector and disbursement agent. Furthermore, the court found that Stockton’s actions always comported with its duties set forth in the Agreements. As such, the court concluded that Stockton (other than with respect to its 5.56 percent share) did not exercise legal dominion or control over the payments, and that that Stockton was a mere conduit.
The court flatly rejected the participants’ arguments that, because Stockton retained some discretion as to how to administer the loan payments, it had dominion and control over the funds. The court reasoned that administrative discretion is not equivalent to payment discretion, and was therefore not legal dominion. The court likewise rejected the argument that Stockton’s relationship as a creditor of the debtor made Stockton an initial transferee. Stockton was only a creditor with respect to its share of the loan participation; its relationship to the 94.44 percent was that of an administrative agent. Moreover, Stockton’s commingling of payments with unrelated funds in its correspondent bank account did not convert Stockton to an initial transferee. That account was used only for administrative convenience, and there was no language in the participation agreements requiring Stockton to segregate payments. There was no trustee relationship between Stockton and the participants, and so, legal title of the $460,000 in payments resided with the participants. Finally, the fact that Stockton filed a proof of claim for the entire amount of the balance due on the Note did not evidence dominion over the funds. The court found that Stockton was only fulfilling its contractual duty to administer the loan “as though it were the sole owner and holder thereof.”
The Bankruptcy Court held that Stockton was not an “initial transferee,” and that, to the extent the transfers were preferential, the trustee could recover from Stockton only the $28,000 it retained as its share of the loan participation. Stockton was a mere conduit with respect to the $460,000.
As stated by this court, the purpose of section 550(a)(1) is to recover preferential transfers from the “real recipients” of the transfers. An overly literal application of the Code section could easily lead to an inequitable recovery from a bona fide middleman that has no dominion or legal control over the funds or property. Because the Code does not define “initial transferee,” courts have created the conduit theory, to differentiate between transferees that actually take ownership and have dominion and control of transfers, and those that serve merely as conduits. This case makes it clear that documentation, as well as conduct, must clearly define the roles of the parties.