The Tenth Circuit Bankruptcy Appellate Panel made an educated guess about the circuit’s recognition of the so-called earmarking doctrine as a defense to preferences and fraudulent transfers.
The BAP concluded that earmarking is a defense in the Tenth Circuit if (1) the debtor did not have dominion and control over the transferred property, and (2) the transfer did not diminish the estate.
A corporation confirmed a chapter 11 plan. Unsecured creditors were to be paid in full before insiders with unsecured claims.
After confirmation, the company was unable to survive without some $450,000 in new loans made by insiders. The company used some of the money for payments to general unsecured creditors. In contravention of the plan, the company used some of the new loans to pay off about $50,000 owing to insiders on their claims that were subordinated by the plan.
The company failed a second time. In chapter 7, the company’s trustee sued the insiders to recover the $50,000 as preferences and fraudulent transfers.
The insiders raised earmarking as a defense. They contended that they made the loans in part to pay themselves. They argued that the payments with proceeds from their loans were not transfers of estate property, thus obviating preferences and fraudulent transfers.
The bankruptcy court agreed and entered judgment in favor of the insiders. The trustee appealed to the BAP and won.
Tenth Circuit Law on Earmarking
The insiders admitted that all of the elements of preferences were present except transfers of estate property. Similarly, they conceded the elements of constructive fraudulent transfers, other than transfers of estate property. The argued that the loans were earmarked for payments to insiders and thus were not estate property.
In his May 27 opinion for the BAP, Bankruptcy Judge Joseph G. Rosania said that the appeal boiled down to a question of whether the insiders received transfers of estate property. The Tenth Circuit, he said, has given “no clear guidance” about the circuit’s recognition of the earmarking doctrine or the facts that must be shown before invoking earmarking.
Judge Rosania laid out the history of the earmarking. Originally, earmarking was a defense to a preference when a guarantor paid off a creditor directly, without running the payment through the debtor’s bank account. In those situations, the courts said that the payments were not transfers of the debtor’s property, and there was no diminution of the estate.
The doctrine was expanded in some courts to cover situations where someone other than a guarantor made a transfer to the debtor with instructions to pay a creditor. In those situations, some courts held that the debtor lacked control over the earmarked funds.
Judge Rosania cited the Eighth Circuit in 1988 for questioning whether earmarking was limited to transfers emanating from guarantors.
Without alluding to earmarking specifically, the Tenth Circuit had three cases that were “eerily similar” to earmarking, Judge Rosania said. In one of those cases, the minority opinion said that the circuit had “impliedly” adopted earmarking, according to Judge Rosania.
From the three cases, Judge Rosania concluded that the dominion and control test and the diminution of the estate tests were defenses. However, he read the Tenth Circuit as not having said whether both tests must be met or whether satisfaction of one test would raise the defense successfully.
Predating the trio of Tenth Circuit decisions, Judge Rosania cited a Tenth Circuit BAP which ruled that earmarking “never applies when an unsecured loan . . . is replaced by a secured loan. . . .” Manchester v. First Bank & Tr. Co. (In re Moses), 256 B.R. 641, 651 (10th Cir. BAP 2000)
Circuit Law Applied to the Facts
Following Moses, Judge Rosania said he would “apply the Tenth Circuit’s dominion/control test and the diminution-of-the-estate test to determine whether there was a transfer of an interest of the Debtor in property.”
First applying the dominion and control test, Judge Rosania cited the insiders for “unequivocally” testifying about an oral understanding that the loans had to be used to pay insiders. He concluded that the dominion and control test had been met because “the Debtor did not have control over the conditionally lent funds because the Debtor could not direct their distribution.”
The insiders lost on the diminution of the estate test, because “the Debtor’s estate was diminished through each Transfer by the replacement of subordinated debt . . . (which was not supposed to be paid until all [noninsider] claimants under the chapter 11 plan were paid in full) with new, unsubordinated debt to the insiders.”
Judge Rosania said that the case on appeal was “analogous” to Moses. Even if earmarking were a viable doctrine in the Tenth Circuit, Moses, he said, the defense “never applies when an unsecured loan is replaced by a secured loan.” Similarly, he said that “leaving the Debtor saddled with new, unsecured debt rather than with old, subordinated debt” diminished the estate.
Despite “definitive guidance from the Tenth Circuit,” Judge Rosania held that “notwithstanding the Debtor’s lack of control over the borrowed funds — each Transfer was a transfer of an interest of the Debtor in property due to the diminution of the Debtor’s estate caused by the subordinated-for-unsecured debt exchange.”
Having found transfers of estate property, Judge Rosania reversed and held that the insiders had received preferences and constructively fraudulent transfers.
The Tenth Circuit Bankruptcy Appellate Panel made an educated guess about the circuit’s recognition of the so-called earmarking doctrine as a defense to preferences and fraudulent transfers.
The BAP concluded that earmarking is a defense in the Tenth Circuit if (1) the debtor did not have dominion and control over the transferred property, and (2) the transfer did not diminish the estate.
A corporation confirmed a chapter 11 plan. Unsecured creditors were to be paid in full before insiders with unsecured claims.
After confirmation, the company was unable to survive without some $450,000 in new loans made by insiders. The company used some of the money for payments to general unsecured creditors. In contravention of the plan, the company used some of the new loans to pay off about $50,000 owing to insiders on their claims that were subordinated by the plan.
The company failed a second time. In chapter 7, the company’s trustee sued the insiders to recover the $50,000 as preferences and fraudulent transfers.