he recent opinion of the Seventh Circuit Court of Appeals (the “Seventh Circuit” or the “Court”), Paloian v. Lasalle Bank, N.A., found that a securitization trustee could be held liable as the “initial transferee” of a fraudulent transfer. The Court found that the trustee, as “the legal owner of the trust’s assets”, was the “initial transferee” or “the entity for whose benefit the transfer was made” within the meaning of Section 550(a)(1) of the Bankruptcy Code and therefore could be required to return the payments to the debtor’s estate, if they were found to be fraudulent transfers. Although the Seventh Circuit fell short of finding the payments at issue to be fraudulent conveyances and remanded the decision to the Bankruptcy Court for further fact-finding on several issues, it did open the door to avoidance recoveries from securitization trustees and from the assets of the trusts.

In Paloian, the Seventh Circuit became the first Federal Court of Appeals to hold that a trustee, as “the legal owner of the trust’s assets” is an “initial transferee” under Section 550(a)(1) of the Bankruptcy Code and may be liable for payments that are later avoided in bankruptcy. The decision could expose securitization trustees, trust assets and investors to increased litigation risks that could adversely affect both the timing and amount of investor recoveries.

The Facts

In August 1997, Nomura Asset Capital Corporation (“Nomura”) provided Doctors Hospital of Hyde Park, Inc. (the “Hospital” or the “Debtor”) with a $50 million loan (the “Loan”) through HPCH LLC (“HPCH”), an affiliate of the Hospital that owned the Hospital’s building and land. In exchange HPCH received additional monies in rent from the Hospital. HPCH granted Nomura a security interest (the “Security Interest”) in the excess rent payments. Nomura securitized the Loan by selling it, along with the Security Interest, to a trust (the “Trust”) that purchased other assets and issued certificates for resale to commercial investors (the “Investors”). Lasalle National Bank acted as the trustee (the “Trustee”) of the Trust, on behalf of the Investors who were the beneficiaries of the Trust. On April 17, 2000, the Hospital filed for chapter 11 bankruptcy. On April 15, 2002, the Hospital filed a complaint against the Trustee seeking to recoup certain of the excess rent payments made by the Hospital to the Trust prior to its bankruptcy filing on the theory that the payments were fraudulent transfers.

The Rulings

The Bankruptcy Court for the Northern District of Illinois found that certain payments on the Loan made by the Hospital while insolvent, were fraudulent conveyances and required the Trustee to return these payments to the Hospital’s bankruptcy estate. The District Court for the Northern District of Illinois affirmed the Bankruptcy Court’s decision. On appeal to the Seventh Circuit, the Trustee argued that it could not be held liable in the fraudulent conveyance action because it was merely a conduit through which the payments flowed to the Investors, not an “initial transferee” under Section 550(a)(1) of the Bankruptcy Code1. In an opinion written by Judge Easterbrook, the Seventh Circuit rejected the Trustee’s argument and concluded that the Trustee, as “the legal owner of the trust’s assets”, was the “initial transferee” of the transfers and therefore could be liable in the fraudulent conveyance action.

In reaching its decision, the Court noted that the Bankruptcy Code does not define an “initial transferee”; however, other courts have adopted a functional approach intended to allow the bankruptcy estate to recover funds from the “real recipient of the preferential transfers” who has “full control” over the funds. Notwithstanding the Trustee’s duties to the Investors and contractual obligations to pay the funds according to a prescribed formula, the Court determined that, in this instance, the Trustee was the “initial transferee.” In support of its decision, the Seventh Circuit indicated that the Trustee would likely pay the judgment from the corpus of the trust and thus the Investors would be the ones who would incur the cost of the judgment. Further, the Seventh Circuit suggested that it makes more sense for a bankruptcy trustee or debtor, as the case may be, to file one lawsuit against a trustee, rather than sue thousands of investors who may have received the avoidable payments, thereby rationalizing its decision on an efficiency basis.

The Analysis

The Paloian decision might be of concern to investors in securitizations, as well as to trustees and other transaction parties. Prior to this decision, the generally accepted view was that once the funds were distributed to investors, a debtor would have to sue the investors directly to obtain a recovery on a fraudulent or preferential transfer. Under this approach, debtors were less likely to vigorously pursue avoidance claims because they would have to locate and sue hundreds or thousands of investors. Indeed, one rationale for the Seventh Circuit’s decision was that it would allow a debtor’s estate to recover from one party, the trust, rather than pursuing numerous suits against investors. Now, under Paloian, the debtor could bring one suit against the securitization trustee.

The implications of this decision are far reaching. For example, many securitization documents do not expressly contemplate allocation of avoidance liability which raises issues, such as:

• Whether the trustee is entitled to offset the liability against future distributions?
• Whether the trustee can clawback distributions from the investors who were the beneficiaries of the transfer?
• What claims may exist against investors who sold their interests after the receipt of the challenged distributions?
• What happens if the securitization has terminated?
• What happens if there are insufficient or no remaining trust assets?

The decision also complicates the trustee’s narrowly defined role and raises issues such as:

• Who is responsible for payment of the trustee’s legal fees and expenses?
• What funds can be reserved to protect the trustee in this situation?
• Whether trustees should holdback distributions to protect against avoidance suits?
• Whether the trustee could become obligated to seek recoveries from investors if the trust lacks sufficient assets?
• Whether trustees would be exposed to additional liability?

The impact of the Paloian decision remains unknown and to date no other Circuit Court of Appeals has adopted this view. Nonetheless, investors and trustees may want to carefully review their securitization trust documents to determine if additional provisions are needed to protect their respective interests.