Earmarking Seems to Be a Dead Letter in the Tenth Circuit

The Tenth Circuit Bankruptcy Appellate Panel wrote an intriguing opinion finding that a triangular transaction was a preference. Without saying so, the opinion hints that the so-called earmarking defense to a preference may not hold water in the Tenth Circuit.

Although fair minds might not agree about the outcome, the BAP’s hands were tied by a Tenth Circuit opinion. Notably, the BAP was politely critical of the appeals court precedent it was required to follow.

The Loan from Mom

The facts were undisputed. A son (who was to become the debtor) owed $21,700 to a law firm. The son gave his mother a note for $21,700. Three days later, the mother wrote a check to the firm on her personal bank account for $21,700.

The son filed a chapter 13 petition two weeks later. After the case was converted to chapter 7, the trustee sued the law firm for a preference and filed a motion for summary judgment.

The mother submitted an affidavit in opposition to the trustee’s motion for summary judgment. She said in the affidavit that her son had no interest in the account she used to pay the law firm.

Evidently intending to lay the foundation for an earmarking defense, the mother went on to say in the affidavit that the loan was conditioned on paying the law firm and no one else. She said that her son never had any possession, dominion or control over the proceeds, nor could he direct how the proceeds would be applied.

The law firm cross moved for summary judgment.

The bankruptcy court denied the law firm’s summary judgment motion and granted judgment in favor of the trustee, finding that the transaction was a preference under Section 547. The bankruptcy court did not consider the mother’s affidavit, ruling that it was inadmissible parol evidence.

The law firm appealed and won a battle, but it lost the war.

Not Parol Evidence

Writing a nonprecedential opinion for the BAP on June 4, Bankruptcy Judge Dale L. Somers ruled that the mother’s affidavit should not have been excluded. Nonetheless, he held that the error was harmless because Tenth Circuit authority required finding the transaction to be preferential.

Parol evidence is a substantive rule, not a rule of evidence. Judge Somers therefore followed Colorado law, where the parol evidence rule does not bar oral representations that are not inconsistent with a final, written document.

When parol evidence is submitted alongside a negotiable instrument, Judge Somers quoted Williston on Contracts for the proposition that courts have been more prone to admit parol evidence when dealing with negotiable instruments if there is no holder in due course.

Judge Somers said the mother’s affidavit was not inconsistent with the note, which had no integration clause. Since the note was silent about issues laid out in the affidavit, he said that the affidavit should have been admissible on summary judgment because it “was offered to provide additional, consistent terms which were not included in the Note.”

Binding Circuit Precedent on Preferences

On the merits, the BAP had little room to maneuver in light of Parks v. FIA Card Services N.A. (In re Marshall), 550 F.3d 1251 (10th Cir. 2008), a case that was “factually similar,” Judge Somers said.

In Marshall, the debtor had paid off one credit card balance with a loan from another credit card issued by a different bank. The bank making the loan directly paid off the balance on the other credit card.

Given the expansive definition of “property” in Section 541, the Tenth Circuit employed two tests to determine whether the loan proceeds were property of the debtor, making the payment a preference. The appeals court in Marshall concluded that both tests were satisfied.

The first test, dominion or control, was satisfied because the Tenth Circuit said that the transaction was “essentially the same” as if the debtor had drawn down the line of credit on the new card and used the proceeds to pay off the old card balance. Id. at 1256.

The second test, diminution of the estate, was satisfied, the Tenth Circuit said, because the loan proceeds “were an asset of the estate for at least an instant before they were preferentially transferred” to pay off the old card. Id. at 1258.

Although the BAP decided it must consider the mother’s affidavit, the appellate panel concluded that the facts in the affidavit did not change the outcome in view of Marshall.

Judge Somers said the debtor exercised “his ability to control the loan proceeds” by executing the note. He said the debtor could have refused to accept the loan.

“There is no material distinction between Marshall . . . and this case,” Judge Somers said. “What matters is that borrowed funds were used to pay the Debtor’s creditor,” he said.

The law firm argued there was no diminution of the estate, to which Judge Somers said that Marshall adopted “a rule of law based upon the purpose served by recovery of preferential transfers.” He went on to say that the “dominion/control test and the diminution of the estate test are strained, but they are required by Marshall.”

Marshall, Judge Somers said, is “based upon a legal fiction, not reality.”

Following Marshall, the BAP upheld the bankruptcy court’s ruling that the transaction was a preference.

Observations

The BAP opinion casts doubt on whether the Tenth Circuit would recognize the so-called earmarking defense.

Generally, the earmarking defense arises when someone makes a loan to a debtor specifically to enable the debtor to satisfy the claim of a designated creditor. When the defense is upheld, the court will say that the proceeds never became the debtor’s property, meaning there could be no preference by definition.

However, earmarking is a judge-made defense. It can only apply when there is no diminution of the estate. The Collier treatise teaches that earmarking “is a judicially created exception that should be narrowly construed.”

Earmarking would seem to fit the case before the BAP. However, the bankruptcy court had ruled that earmarking is limited to cases involving codebtors. Furthermore, Marshall seemingly precludes the earmarking defense, given the fiction that the loan proceeds fleetingly became the debtor’s property.

The Solution

To no avail, the law firm apparently performed legal research and drafted the mother’s affidavit to lay out all the elements of an earmarking defense. The preference could have been avoided, however, by employing a different structure.

Richard P. Carmody from Adams & Reese LLP of Birmingham, Ala., told ABI, “I would have had momma buy the debt.” ’Nuff said.