As it turned out, the Tenth Circuit Bankruptcy Appellate Panel correctly guessed about the showing that must be made to establish the so-called earmarking defense to preferences and fraudulent transfers in the Tenth Circuit.
To be valid, the defense indeed requires the debtor to have no dominion and control over the transferred property and that there must be no diminution of the estate.
However, the Tenth Circuit reversed the BAP and upheld the defense because the bankruptcy court’s inferences from the facts were not clearly erroneous.
The Earmarked Loans
A corporation had confirmed a chapter 11 plan where unsecured creditors were to be paid in full before insiders’ unsecured claims.
The company couldn’t survive after confirmation without $450,000 in new loans made by the owner and chief executive. The company used most of the money to pay general unsecured creditors. In violation of the plan, however, the company used $50,000 to pay insiders on their claims that should not have been paid because they were subordinated by the plan.
The company failed a second time and ended up in chapter 7. The trustee sued the insiders to recover the $50,000 as preferences and fraudulent transfers.
Without contravention, the owner and chief executive testified that he would not have made the loans unless a portion was paid to insiders on their subordinated claims. The insiders raised earmarking as a defense, contending that the payments to them were not transfers of estate property, thus obviating preferences and fraudulent transfers.
Bankruptcy Judge David T. Thuma of Albuquerque agreed and entered judgment in favor of the insiders, dismissing the claims. The trustee appealed to the BAP and won a reversal.
Reading Tenth Circuit precedent on earmarking, the BAP concluded that the dominion/control test and the diminution-of-the-estate test were defenses. However, the BAP did not believe that the appeals court had decided whether both tests must be met, or just one, before invocation of earmarking.
Ultimately, the BAP decided that the Tenth Circuit would require both the “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.” Montoya v. Goldstein (In re Chuza Oil Co.), 639 B.R. 586, 599 (B.A.P. 10th Cir. May 27, 2022). However, the BAP decided that the insiders were not entitled to the earmarking defense because the debtor had control over the disposition of the loans and the payments to the insiders had diminished the bankrupt estate. To read ABI’s report on the BAP opinion, click here.
The insiders appealed and won a reversal in a December 12 opinion by Tenth Circuit Judge Timothy M. Tymkovich.
Dominion and Control
The trustee’s complaint alleged both preferences and fraudulent transfers. For transfers to be avoided, both Sections 547(b) and 548(a) require the transfer “of an interest of the debtor in property.” Judge Tymkovich described earmarking as “a judicially created mechanism to determine whether the debtor had an interest in transferred property.”
Like the BAP, Judge Tymkovich surveyed Tenth Circuit precedent and held that “earmarking applies if the transfers can satisfy both the dominion/control and the diminution tests.”
Next, Judge Tymkovich analyzed whether the debtor had dominion and control over the loans. He alluded to uncontradicted testimony by the owner that he would not have made the loans unless some had been directed to insiders.
Based on the testimony, Judge Tymkovich pointed to the bankruptcy court’s finding that the owner “placed a valid condition” on use of the loans. On “clear error” review, he set aside the BAP’s conclusion to the contrary and held that the debtor “did not control the funds under our dominion/control test.”
Diminution of the Estate
The bankruptcy court had found no diminution of the estate because the owner loaned significantly more than the payments to insiders. On the other hand, the BAP had relied on the same evidence to conclude there had been a diminution because subordinated creditors were paid before general creditors.
“On clear error review,” Judge Tymkovich said, “we cannot disagree with the bankruptcy court’s finding that the bankruptcy estate was not diminished by the combination of payments into and out of [the debtor].” Elaborating, he said that the bankruptcy court had adopted the view that the payments to the insiders “didn’t harm other unsecured creditors because the payments had been conditioned on the infusion of extra cash into [the debtor].”
Judge Tymkovich said that the bankruptcy court had taken a “reasonable” inference that the infusion of new money did not diminish the estate. “Given the reasonableness of that inference,” he said, “the bankruptcy court’s finding is not clearly erroneous.”
According to Judge Tymkovich, “every circuit to [have] address[ed] the issue has considered the infusion of new money into the bankruptcy estate when determining whether later payments had resulted in a diminution.”
“Under clear-error review,” Judge Tymkovich ruled that “the bankruptcy court did not err in finding that [the debtor] did not control the earmarked funds, nor did the transfers diminish the estate.” Also agreeing with the bankruptcy court that the transfers were contemporaneous exchanges for new value, he “affirm[ed] the bankruptcy court’s rejection of the trustee’s claims involving improper preference and constructive fraud.”
Observations
The Tenth Circuit’s dissertation on the elements of an earmarking defense is not surprising. The opinion is perhaps more noteworthy for saying that the trier of fact’s inferences from the evidence are reviewed for clear error just like the findings of fact themselves.
On that topic, Judge Tymkovich cited Anderson v. City of Bessemer City, 470 U.S. 564 (1985). “Where there are two permissible views of the evidence,” the Supreme Court said, “the factfinder’s choice between them cannot be clearly erroneous.” Id. at 574.
As it turned out, the Tenth Circuit Bankruptcy Appellate Panel correctly guessed about the showing that must be made to establish the so-called earmarking defense to preferences and fraudulent transfers in the Tenth Circuit.
To be valid, the defense indeed requires the debtor to have no dominion and control over the transferred property and that there must be no diminution of the estate.
However, the Tenth Circuit reversed the BAP and upheld the defense because the bankruptcy court’s inferences from the facts were not clearly erroneous.