Applicability of the Earmarking Defense to a Preference Action

Journal Issue

May 2006

Column Name

Last in Line

Citation

ABI Journal, Vol. XXV, No. 4, p. 20, May 2006

Bankruptcy Code

547

Topic Tags

Preferences

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The elements of a voidable preference are enumerated in §547(b) of the Bankruptcy
Code and well known to practitioners. The trustee must prove that the transfer
in question (1) was to or for the benefit of a creditor, (2) was for or on account
of an antecedent debt owed by the debtor before such transfer was made, (3)
was made while the debtor was insolvent, (4) was made on or within 90 days before
the bankruptcy filing date, or within one year for insiders, if the creditor
was an "insider" at the time of the transfer, and (5) enabled the
creditor to receive a greater percentage of its claim than the creditor would
have received had the transfer not taken place and the debtor's assets liquidated
in a chapter 7 case. 11 U.S.C. §547(b); Union Bank v. Wolas, 502
U.S. 151 (1991).
In addition to the specifically enumerated elements above, the trustee must
also prove that there was a transfer of "an interest of the debtor in property...."
11 U.S.C. §547(b). Although not specifically identified along with the
other elements of a voidable preference, there is ample authority supporting
this additional requirement.1 Indeed, the requirement is clearly housed in the
prefatory language of §547(b).
Elements of Earmarking Doctrine
 A creature of judicial invention, the earmarking doctrine provides an equitable
defense for a creditor in a preference action. Essentially, the earmarking doctrine
provides that the debtor's use of borrowed funds to satisfy a pre-existing debt
is not deemed a transfer of property of the debtor, and therefore, it is not
avoidable as a preference.2 Under the earmarking doctrine, if a third party
provides funds for the specific purpose of paying a creditor of the debtor,
the funds may not be recoverable as a preferential transfer because the funds
never become part of the debtor's estate.3

Courts uniformly agree that three requirements must be met in order to apply
the earmarking doctrine as a defense to a preference action: (1) there must
be an agreement between the new lender and the debtor that the new funds will
be used to pay a specified antecedent debt; (2) performance of that agreement
must be made according to its terms; and (3) the transaction viewed as a whole
(including the transfer in of the new funds and the transfer out to the old
creditor) must not result in any diminution of the bankruptcy estate.4
While the earmarking doctrine is routinely accepted as a valid defense to a
preference action, courts are divided on the applicability of earmarking as
a defense to a voidable preference action in a "refinance" situation
where the new lender is tardy in perfecting its security interest in accordance
with §547(e). The atypical scenario involves a debtor that borrows funds
from a new lender to satisfy an antecedent secured debt whereby the lender pays
the funds directly to the debtor's pre-existing secured creditor. The debtor
then grants a lien in favor of the new lender in the same property now serving
as collateral for the new loan. However, the new lender fails to timely perfect
its security interest in the refinanced property as prescribed in §547(e).5
Courts generally agree that the earmarking defense insulates from preference
recovery, the receipt of funds by the pre-existing creditor from the new lender.
Yet courts are divided as to whether the earmarking defense applies to insulate
the new lender from preference exposure for the untimely perfection of its lien.
This disagreement stems largely from competing views regarding the classification
of a refinancing transaction.
One view holds that the refinancing transaction consists of two separate and
distinct transfers. The first transfer consists of the initial disbursement
of funds to the pre-existing creditor from the new lender; this transfer does
not result in a transfer of an interest in the debtor in property and is not
preferential. The second transfer occurs when the debtor grants a security interest
in the refinanced property to the new lender, which, if not timely perfected,
results in a preferential transfer.
The opposing theory reasons that a refinancing transaction must be viewed as
one large cohesive transaction. Thus, when applying the earmarking doctrine,
no transfer of an interest of the debtor in property occurs, and the net result
is one where a secured creditor is merely replaced by another, such that no
diminution of the estate occurs.
Case Law on the Earmarking Defense 
 The courts that have held that the earmarking doctrine may be employed as
a defense by a refinancing creditor that is untimely in perfecting its security
interest generally base their reasoning on the absence of a transfer of an interest
of the debtor in property and the "net result" of the refinancing
transaction viewed as a whole. These courts are willing to apply the earmarking
doctrine as a defense even where there is a substantial delay in the perfection
of the new refinanced security interest within the time required in §547(e).
As noted in Kaler v. Community First National Bank (In re Heitkamp),
137 F.3d 1087 (8th Cir. 1998), the trustee brought an adversary proceeding to
avoid the chapter 7 debtors' second mortgage interest in their home. The debtors
borrowed additional funds from a new lender to satisfy subcontractors' liens
upon the property. The funds were paid directly to the subcontractors by the
new lender, and in return, the debtors granted the new lender a second mortgage.
However, due to an oversight, the second mortgage held by the new lender was
not perfected until several months later. The court applied the earmarking doctrine
protecting the new lender's security interest despite the considerable delay
in perfecting its security interest. The Eighth Circuit noted: "Because
the transfer of the mortgage interest to the bank merely replaced the subcontractors'
security interest, there was no transfer of the [debtors'] property interest
avoidable under §547(b)." Id. at 1089. Heitkamp and
its progeny contend that if the new creditor's funds are earmarked to pay off
an existing obligation, the funds never became part of the debtor's estate.
Accordingly, in a refinance situation, no avoidable preference occurs even with
the untimely perfection of the refinancing creditor's security interest, since
there was no transfer of an interest of the debtor in property.6

In further applying earmarking as a defense, the Heitkamp view asserts
that a refinancing situation should be viewed as one cohesive transaction where
the refinancing creditor's lien has merely replaced the original creditor's
lien. Accordingly, no diminution of the estate occurs, and in effect, the debtor's
assets and net obligations remain the same. Although not decided under the earmarking
doctrine, the court in Burton v. Community Credit Co. (In re Biggers),
248 B.R. 873, 875 (Bankr. M.D. Tenn. 2000), focused on whether the estate was
diminished by virtue of an untimely perfection of a non-purchase money security
interest in a refinance situation. The court held that no preferential transfer
had occurred. The court recognized that a refinancing transaction involves several
different transactions (i.e., the execution of a new note and disbursement
of funds to the pre-existing creditor, and the perfection of the new creditor's
security interest). Yet the court noted that a refinancing transaction was better
viewed as one whole transaction. The court stated: "Looking only at the
'trees' and parsing each component of the refinancing, it is easy to conclude
that the transfer allowed the [refinancing creditor] to receive more than it
would have in a chapter 7 case." Id. at 877. As it further noted,
however, "in transactions that involve collateral substitution or renewal
of a lien or security interest, many courts have measured the transaction as
a whole to determine whether the estate was diminished." Id. at
877. Similarly, the court in Ward held that "preference attacks on transfers
to new creditors in earmarking situations must be analyzed in terms of this
net result rule to determine if there has been a transfer of property of the
debtor." In re Ward, 230 B.R. 115, 120 (8th Cir. 1998). Consequently,
courts aligning with the Heitkamp view assert that for a transfer to
constitute a preference, there must be some resulting diminution of the estate,
and when viewing a refinancing transaction as a whole, no such diminution occurs.

The counterargument posits that the earmarking doctrine does not apply to
insulate a refinancing creditor from preference recovery that belatedly perfects
its security interest during the preference period. This view asserts that a
refinancing transaction involves two separate and distinct transfers. The first
transfer involves the distribution of funds between the new and old creditor,
of which the earmarking doctrine applies to such transfer insulating the old
creditor from preference recovery. The second transfer involves the debtor granting
a security interest in favor of the new creditor, which, if not timely perfected
as prescribed by §547(e), is not protected by the earmarking doctrine.7
The Messamore view purports that this second transfer, which occurs
with the perfection of the refinancing creditor's security interest, is clearly
a transfer of the debtor's interest in property, as it depends on the debtor's
granting of a security interest to the refinancing creditor. As noted, "although
earmarking is appropriate in a refinancing situation as a defense for the old
creditor who receives borrowed funds as payment on an antecedent debt, it is
illogical to say there was no transfer of the debtor's interest in property
to the new creditor when the debtor has granted a security interest to that
creditor." In re Messamore, 250 B.R. 913, 918, 919 (Bankr. S.D.
Ill. 2000). As it further noted, "the [Heitkamp court's] analysis
failed to distinguish between the transfer of borrowed funds to the original
creditor and the subsequent transfer that occurred when the new creditor belatedly
perfected its security interest in the debtor's property. The earmarking doctrine,
while appropriate to prevent avoidance of the transfer of borrowed funds to
the original creditor, was wrongly invoked as a defense for the new creditor's
tardy perfection." Id. at 917, 918.
The Messamore camp reasons that it is this second transfer (i.e.,
the debtor's granting of a security interest to the refinancing creditor) that
results in a transfer of an interest of the debtor in property, ultimately diminishing
the estate. This view holds that until the refinancing creditor perfects its
security interest, it remains an unsecured creditor. Therefore, the transfer
of the debtor's property does not occur until the refinancing creditor perfects
its security interest. If such perfection does not occur within the safe-harbor
period prescribed by §547(e), but instead is completed belatedly during
the 90-day preference period, it is deemed preferential. See 11 U.S.C.
§547(e). The untimely perfection creates a diminution of the estate because
the delay results in a transfer made for or on account of an antecedent debt.
This, in turn, diminishes the estate by encumbering the equity in the refinanced
property resulting in a loss to the creditors.

The Messamore view also asserts that insulating this second transfer
from preference recovery undermines the requirement that a refinancing creditor
perfect its security interest within the time prescribed in §547(e). In
addition, it would improperly expand the safe-harbor time period provided in
§547(e), effectively allowing a refinancing secured creditor to belatedly
perfect its security interest and then rely on the earmarking doctrine as a
defense to a voidable preference action. As the court in Schmiel held,
"the 10-day safe harbor provision simply would have no meaning if a secured
creditor could perfect its interest at any time after the 10 days and then depend
upon the earmarking doctrine to somehow avoid the operation of the statute when
its [security interest] was later perfected." In re Schmiel, 319
B.R. 520, 529 (Bankr. E.D. Mich. 2005). Therefore, the Messamore view
reasons that once the safe-harbor time period to perfect in §547(e) elapses,
the refinancing creditor is not protected from preference exposure.
Conclusion
 As a result of this split, a refinancing creditor can take solace in knowing
that a belated perfected security interest is not fatal when subject to a preference
attack from a trustee. In addition, a trustee may encounter a daunting challenge
establishing that there has been a transfer of an interest of the debtor in
property and that there has been a diminution of the estate, before prevailing
on its preference action in a refinance situation.
<h3> Footnotes</h3>

1 See, e.g., McLemore v. Third National Bank in Nashville
(In re Montgomery), 983 F.2d 1389 (6th Cir. 1993); In re Safe-T-Brake
of South Florida Inc., 162 B.R. 359 (Bankr. S.D. Fla. 1993).
2 See, e.g., National Bank of Newport v. National Herkimer
County Bank, 225 U.S. 178, 32 S.Ct. 633, 56 L.Ed. 1042 (1912); Adams
v. Anderson (In re Superior Stamp & Coin Co. Inc.), 223 F.3d
1004 (9th Cir. 2000) (discussing the history of the earmarking doctrine).

3 See, e.g., Brown v. First National Bank of Little Rock
(In re Ark-La Materials Inc.), 748 F.2d 490 (8th Cir. 1984).
 4 McCuskey v. National Bank of Waterloo (In re Bohlen Enterprises
Ltd.), 859 F.2d 561 (8th Cir. 1988); In re McDowell, 258 B.R. 296
(Bankr. M.D. Ga. 2001).

5 Under the 2005 amendments to the Bankruptcy Code, the §547(e)(2) grace
period was extended from 10 days to 30 days. BAPCPA, Pub.L. 109-8, Title IV,
§403, 119 Stat. 23 (2005).
6 See, e.g., Krigel v. Sterling National Bank (In re
Ward), 230 B.R. 115 (8th Cir. 1999); Luker v. Lewis Auto Glass Inc.
(In re Francis), 252 B.R. 143 (Bankr. E.D. Ark. 2000); Collins v.
Greater Atlantic Mortgage Corp. (In re Lazarus), 334 B.R. 542 (Bankr.
D. Mass. 2005); Chase Manhattan Mortgage Corp. v. Shapiro (In re Lee),
2006 WL 563690 (Bankr. E.D. Mich. 2006).

7 See, e.g., Vieira v. Anna National Bank (In re Messamore),
250 B.R. 913 (Bankr. S.D. Ill. 2000); Sheehan v. Valley National Bank
(In re Shreves), 272 B.R. 614 (Bankr. N.D. W.Va. 2001); Scaffidi v.
Kenosha City Credit Union & State of Wisconsin (In re Moeri),
300 B.R. 326 (Bankr. E.D. Wis. 2003); Gold v. Interstate Financial Corp.
(In re Schmiel), 319 B.R. 520 (Bankr. E.D. Mich. 2005).

Journal Authors

Paul A. Rogers

Journal Date

Monday, May 1, 2006 - 12:00

Bankruptcy Rule

2006

none