Judge Declines to Apply ‘Earmarking’ Defense to a GM Lien Avoidance

Bankruptcy Judge Martin Glenn declined to expand the so-called earmarking doctrine to save a group of banks from the consequences of a $1.5 billion mistake in refinancing General Motors Corp. before the auto lender’s bankruptcy in 2009.

The lenders now have three strikes against them. Previously, the Delaware Supreme Court and the Second Circuit both ruled that the lenders had released a lien securing a $1.5 billion loan, although that’s not what they intended.

How Did It Happen?

Before bankruptcy, GM had a $300 million synthetic lease financing and a $1.5 billion term loan, with the same bank serving as agent for both. GM paid off the $300 million loan in October 2008, before the chapter 11 filing in Manhattan in June 2009.

In the process of paying off the $300 million loan, the lawyers for the bank agent and GM mistakenly filed documents that, on their face, also terminated the security interest for the $1.5 billion financing that was supposed to continue.

Alerted to the mistake soon after commencement of the chapter 11 case, the GM creditors’ committee contended that the banks were unsecured creditors for the $1.5 billion loan. However, the bankruptcy judge ruled in the banks’ favor, saying that the loan’s secured status survived the error because it was not what either GM or the banks intended.

On direct appeal, the Second Circuit certified a question, asking the Delaware Supreme Court to resolve an undecided issue of state law under the Uniform Commercial Code.

In October 2014, the Delaware Supreme Court ruled in favor of the creditors, saying that “unambiguous provisions” in the Uniform Commercial Code “dictate” that the loan became unsecured because it was “enough that the secured party authorize[d] the filing” that released the lien.

After the Delaware court answered the certified question regarding state law, the Second Circuit still had to decide whether the law firm was authorized as agent to terminate the security interest.

On the agency issue, the Second Circuit explained how the task was first given to an associate who delegated some of the work to a paralegal. Documents were prepared that terminated not only the $300 million lien but also the $1.5 billion lien that was supposed to remain on the books.

In an unsigned 15-page opinion in January 2015, the Second Circuit reversed the bankruptcy court, ruling on the agency issues by concluding that the release of lien was authorized, although mistaken. In re Motors Liquidation Co., 777 F.3d 100 (2d Cir. 2015). The circuit court then sent the case back for the bankruptcy court to determine whether the lenders were secured under another theory.

The Facts Underlying the Earmarking Theory on Remand

Borrowing from a judge-made defense to preference claims, the banks argued that the earmarking doctrine gave them a complete defense to the lien-avoidance suit by the creditors’ trust.

The defense was based on the $33 billion of debtor in possession financing provided for GM’s reorganization by the U.S. and Canadian governments. The possible invalidity of the $1.5 billion lien already having surfaced, the lenders opposed approval of DIP financing unless the contested loan was repaid in full from the DIP loan proceeds.

Although the final DIP loan agreement provided that some of the proceeds would be used to repay the $1.5 billion loan, the approval order also allowed the creditors’ committee to challenge the validity of the lien.

The Genesis of the Earmarking Theory

In his January 29 opinion, Judge Glenn of Manhattan explained how the earmarking theory arose as a defense to preference claims. He said that earmarking is a “judge-made equitable doctrine” that “does not appear in the Bankruptcy Code.” He quoted the Collier treatise for the proposition that earmarking “is a judicially created exception that should be narrowly construed.”

Again citing Collier, Judge Glenn said that the earmarking defense arises “when a third person makes a loan to a debtor specifically to enable that debtor to satisfy the claim of a designated creditor, the proceeds never become part of the debtor’s assets, and therefore no preference is created.”

Judge Glenn said that no court had applied the earmarking defenses in the context of lien avoidance, but he did not rule on that basis. Instead, he analyzed whether the elements of the defense had been established.

Judge Glenn explained that earmarking “will only protect a transfer from avoidance to the extent it did not diminish the debtor’s estate.” In the case at hand, the estate was diminished because an unsecured debt was replaced with a secured debt in the form of the DIP loan.

The banks contended that part of the DIP loan was earmarked to pay off the contested $1.5 billion loan. Judge Glenn said it would be “nonsensical” to say the DIP loan gave rise to an earmarking defense when other provisions in the loan documents preserved the creditors’ ability to attack the validity of the lien.

Invoking the defenses, Judge Glenn said, “would be a perversion of the equitable earmarking doctrine.” He therefore refused “to apply a judge-made equitable doctrine to undermine equality of distribution, one of the most fundamental tenets of bankruptcy law.”

More emphatically, Judge Glenn said the “mistake should not be rewarded now by applying a judge-made equitable doctrine that has never been applied in circumstances such as those presented here.”

Judge Glenn therefore granted partial summary judgment against the banks by dismissing the earmarking defense.