On September 28, 2011, the US Bankruptcy Court for the District of Kansas issued an opinion holding that a bank that sold participations in a loan (a "lead bank") was a "mere conduit," rather than an "initial transferee" under the Bankruptcy Code, of certain loan payments that it remitted to participants in accordance with the applicable loan participation agreements. The lead bank was therefore not subject to an avoidance action for those funds as preferential transfers under section 547 of the Bankruptcy Code.

In December 2007, Brooke Corporation (Brooke) executed a promissory note in favor of Stockton National Bank (Stockton). On the same date, Stockton entered into eight participation agreements which transferred a total of 94.44% of the loan evidenced by the note to eight participants. Stockton retained a 5.56% ownership interest in the loan. Each participation agreement stated that, for all purposes, the participant was the legal and equitable owner of its share of the loan.

Brooke subsequently filed a bankruptcy petition. Within 90 days before filing the petition, Brooke made a total of $487,973.29 in loan payments to Stockton. Stockton timely transferred to the participants their shares of these payments, totaling $460,014.71. The Brooke bankruptcy trustee brought an adversary proceeding against Stockton seeking to avoid and recover the full amount of the payments made to Stockton as preferential transfers under section 547 of the Bankruptcy Code. (Section 547 has a 90-day look-back period from the date of the filing of the debtor's bankruptcy petition for non-insiders.)

Section 550(a) of the Bankruptcy Code allows avoidable transfers of funds, such as preferential payments, to be recouped from "initial transferees" of those funds. The issue before the bankruptcy court was whether Stockton, as lead bank, was an initial transferee of the allegedly preferential payments, or a mere conduit with respect to the payments which it disbursed to the participants in accordance with the participation agreements.

Bankruptcy courts have generally adopted a test formulated by the US Court of Appeals for the Seventh Circuit that establishes the minimum requirements for a party to be considered an initial transferee under section 550. The recipient of the funds must have dominion and control over the funds and the right to use the funds for its own purposes.

The bankruptcy court granted summary judgment in favor of Stockton, holding that it was not subject to the trustee's avoidance action for return of the funds as preferential transfers under Bankruptcy Code section 547 because:

(The bankruptcy court found that Stockton was an initial transferee only as to funds it retained on account of its 5.56% retained portion of the loan.)

The decision indicates that if the terms of a participation agreement require the lead bank to distribute funds received from a borrower to the participants on account of undivided partial interests in the loan that the lead bank sold to the participants, the participants, rather than the lead bank, may face liability for preferential loan payments made by the borrower if it later becomes a debtor in bankruptcy.

It is noteworthy that the Brooke court also discusses another Seventh Circuit case, Paloian v LaSalle, which raised similar issues as those addressed by the bankruptcy court in Brooke. In Paloian v LaSalle, the Seventh Circuit found that LaSalle Bank was not a mere conduit but rather an initial transferee subject to avoidance action for funds transferred to it in payment of certain notes held in a securitization trust for the benefit of the investors in the securitization. The bankruptcy court in Brooke distinguished Paloian on the basis that in Paloian, LaSalle, as trustee for the investors in the securitization, was legal owner of the trust's assets, whereas there was no such ownership by Stockton of the funds at issue in Brooke. For more information on the Paloian case, see Practice Note, New Trends in Securitization: Paloian v. LaSalle.

To learn more about loan participations, see Practice Note, Assignments and Participations of Loans, and for more on preferential transfers, see Practice Note, Preferential Transfers: Overview and Strategies for Lenders and Other Creditors.