Being paid with insurance proceeds can be a preference when the payment came from the debtor and the debtor could decide when and whom to pay, for reasons explained by Houston District Judge Lee H. Rosenthal, affirming Bankruptcy Judge Jeffrey P. Norman.

The chapter 7 debtor owned the working interest in an offshore well that “blew out.” To repair the damage, the debtor chartered a vessel.

The debtor had insurance for some of the loss. A week after the insurer paid the debtor about $4.8 million, the debtor paid almost $270,000 to the vessel owner within the 90-day preference period. The payments were for invoices that were paid 107 days, 87 days and 43 days after the invoices were issued by the vessel owner.

In chapter 7, the vessel owner claimed another $300,000 that the debtor never paid. In other words, the vessel owner was paid about 47% of its billings, but other creditors were paid nothing. Some creditors working on the blowout were paid in full.

The trustee sued the vessel owner for $270,000 in preferences. Rejecting the earmarking defense and others after trial, Bankruptcy Judge Norman gave the trustee judgment against the vessel owner for the $270,000, plus prejudgment interest at 5.34%. Sommers v. Offshore Marine Contractors (In re Magellan E&P Holdings Inc.), 654 B.R. 98 (Bankr. S.D. Tex. Aug. 18, 2023). To read ABI’s report, click here.

No ‘Earmarking’

The vessel owner fared no better on appeal before District Judge Rosenthal, where the outcome turned primarily on whether the vessel owner had been paid with property of the estate.

Section 547(b) permits a trustee to “avoid any transfer of an interest of the debtor in property . . . to or for the benefit of a creditor . . . on account of an antecedent debt owed by the debtor  . . . made while the debtor was insolvent . . . within 90 days before the date of the filing of the petition . . . that enables such creditor to receive more than such creditor would receive if . . . the case were a case under chapter 7 of this title [and] the transfer had not been made . . . .” [Emphasis added.]

Judge Rosenthal said that “an interest of the debtor in property” is not defined in the Bankruptcy Code but “is considered synonymous with the term ‘property of the estate’ under § 541.” Quoting the Fifth Circuit, she went on to say that “Courts often look at which party maintained control over funds in an account as a ‘predominant factor in determining [the] account’s ownership.’”

The vessel owner principally relied on the so-called earmarking defense. Judge Rosenthal said, “Earmarking occurs when a party transfers funds to a bankrupt debtor’s creditor, substituting the party as the debtor’s new creditor . . . . Earmarked funds are essentially a loan by a new creditor to the debtor to pay off a specific debt.”

“Physical control is not necessarily actual control,” Judge Rosenthal said, but “when there is no express agreement among the new creditor, former creditor, and debtor, physical control may be a factor strongly weighing against an earmarking defense.”

In the case on appeal, Judge Rosenthal noted that the payment to the debtor by the insurer was not a loan. Furthermore, the insurer had not designated the vessel owner as the recipient. Rather, she said that the insurer “required only that the payment be used to pay the well-control service providers, in no particular order.” In short, the debtor “made the choice to pay [the vessel owner].”

Although “the earmarking defense can apply to funds in the debtor’s physical control,” Judge Rosenthal read the record to mean that the debtor “controlled the funds in question here, precluding the earmarking defense.”

No ‘Ordinary Course’

The vessel owner fared no better with the “ordinary course defense,” where the tests are subjective or objective. The subjective test looks to the history of payments between the debtor and the preference defendant. The objective test examines credit arrangements between other “similarly situated” debtors and “creditors in the industry.”

Judge Rosenthal said that the payments to the vessel owner failed both tests. On the subjective test, the parties’ contract called for payments within 30 days, and all payments were made more than 30 days out. With regard to the objective test, the vessel owner offered no testimony or evidence about transactions between similarly situated debtors and creditors in the industry.

Fairness

Judge Rosenthal said that Judge Norman “correctly found that the facts give rise to a significant fairness issue,” because some creditors received nothing while others were paid in full.

Given that the vessel owner recovered almost half of what it was owed, Judge Rosenthal upheld the judgment in favor of the trustee because “payments are voidable under § 547(b) as preferential payments that allow the debtor to favor one creditor.”