‘Earmarking’ Only Applies When a Debtor Receives a Loan from a Third Party

Success in bankruptcy is like success as a stand-up comedian: It’s all in the timing. In a case before Chief Bankruptcy Judge Richard E. Fehling of Reading, Pa., the debtor’s timing was off.

The debtor was behind on her mortgage. To cure arrears, she took about $45,000 from her 401(k) account as a hardship withdrawal. The debtor received the check for the $45,000 about 30 minutes before she filed a chapter 7 petition. 

The debtor gave the check to her attorney, who deposited the withdrawal in the firm’s trust account. One week after filing, the attorney paid the mortgage lender, as instructed.

The chapter 7 trustee filed an adversary proceeding against the mortgage lender to recover the transfer, contending that the $45,000 payment was an unauthorized post-petition transfer under Section 549(a).

In his May 7 opinion, Judge Fehling granted the trustee’s motion for summary judgment. In the process, he denied the lender’s cross motion for summary judgment based on the earmarking doctrine and the idea that the funds never became estate property. Indeed, the case came down to a question of whether earmarking applied.

Section 549(a) permits a trustee to avoid a transfer that occurred after the commencement of the case and was not authorized by the court or the Bankruptcy Code. Earmarking is a judge-made doctrine typically arising when a third party makes a loan to a debtor to pay the claim of a specified creditor.

Earmarking is a defense to a preference suit, based on the concept that the third party’s loan was not estate property. Since the payment was not made with estate property, there is no preference as a definitional matter. (Section 547(b) requires a “transfer of an interest of the debtor in property.”)

Judge Fehling did not rule on whether the earmaking defense is confined to preferences or can fend off a claim under Section 549. Instead, he decided that the elements of earmarking did not exist, in view of authority that earmarking must be narrowly construed.

Initially, the trustee had the burden of proof under Section 547 to show that the property belonged to the estate. Judge Fehling said the trustee met her initial burden by showing that the debtor withdrew the funds from the exempt 401(k) account before filing. “When the funds were withdrawn, they ceased being part of the 401(k) fund and became property of the Debtor” and therefore turned into estate property.

The burden then shifted to the lender to prove the elements of the earmarking doctrine.

The lender failed to prove the first element of the doctrine, Judge Fehling said, because the money did not come from a lender. “Because no new lender existed, the earmarking doctrine is inapplicable to the facts of the case.”

In the absence of a valid earmarking defense, Judge Fehling granted the trustee’s motion for summary judgment and declared that the payment was an unauthorized post-petition transfer under Section 549(a).

Judge Fehling has announced his retirement at the end of the month. Judge Magdeline D. Coleman of Philadelphia likely will be the new chief bankruptcy judge in the Eastern District of Pennsylvania.