By order of the Bankruptcy Appellate Panel, the precedential effect of this decision is limited to the

case and parties pursuant to 6th Cir. BAP LBR 8013-1(b). See also 6th Cir. BAP LBR 8010-1(c).

File Name: 08b0014n.06

BANKRUPTCY APPELLATE PANEL OF THE SIXTH CIRCUIT

 

In re: RONALD CHRISTOPHER KING

and SHERIL LINN KING,

Debtors.

 

MICHAEL L. BAKER, Trustee in Bankruptcy,

Plaintiff - Appellee,

v. No. 07-8045

MORTGAGE ELECTRONIC

REGISTRATION SYSTEMS, INC.,

ENCORE CREDIT CORP., and

OPTION ONE MORTGAGE CORP.,

Defendants - Appellants.

 

Appeal from the United States Bankruptcy Court

for the Eastern District of Kentucky, at Covington.

Case No. 05-24988; Adv. Pro No. 06-2093

Argued: May 13, 2008

Decided and Filed: August 20, 2008

Before: FULTON, PARSONS, and SHEA-STONUM, Bankruptcy Appellate Panel Judges.

____________________

COUNSEL

ARGUED: Norman J. Frankowski II, FLAGEL & PAPAKIRK, Cincinnati, Ohio, for Appellants.

Debra S. Pleatman, ZIEGLER & SCHNEIDER, Covington, Kentucky, for Appellee. ON BRIEF:

Norman J. Frankowski II, FLAGEL & PAPAKIRK, Cincinnati, Ohio, for Appellants. Debra S.

Pleatman, Michael Burris Baker, ZIEGLER & SCHNEIDER, Covington, Kentucky, for Appellee.
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____________________

OPINION

____________________

MARCIA PHILLIPS PARSONS, Chief Bankruptcy Appellate Panel Judge. In this appeal

we address an issue recently decided by the Sixth Circuit Court of Appeals in Chase Manhattan

Mortgage Corp v. Shapiro (In re Lee), 530 F.3d 458 (6th Cir. 2008): that a late-perfecting secured

creditor in the context of a refinanced mortgage is not protected from preference liability by either

the earmarking doctrine or the no-diminution-of-the-estate argument. Finding no determinative

factual distinction between Lee and the instant case, we AFFIRM the bankruptcy court’s order

granting judgment for the bankruptcy trustee in this preference action. In reaching this conclusion,

we reject the Appellants’ argument that the preferential transfer was excepted from avoidance by the

contemporaneous exchange defense of 11 U.S.C. § 547(c)(1). Although this issue was not raised

or addressed in Lee, our ruling is controlled by the Sixth Circuit’s earlier decision in Ray v. Security

Mutual Finance Corp. (In re Arnett), 731 F.2d 358, 360 (6th Cir. 1984). 

I. ISSUES ON APPEAL

1. In a refinancing where one secured creditor is substituted for another such that there is

arguably no diminution of the estate, does the earmarking doctrine bar the avoidance of a mortgage

perfected outside of the 10-day grace period in 11 U.S.C. § 547(e)?

2. Notwithstanding the failure to perfect within 10 days, is avoidance excepted by the

contemporaneous exchange defense of 11 U.S.C. § 547(c)(1)? 

II. JURISDICTION AND STANDARD OF REVIEW

The Bankruptcy Appellate Panel for the Sixth Circuit (the “Panel”) has jurisdiction to decide

this appeal. The United States District Court for the Eastern District of Kentucky has authorized

appeals to the Panel, and neither party elected to have this appeal heard by the district court. 28

U.S.C. § 158(b)(6), (c)(1). A bankruptcy court’sfinal order may be appealed as of right. 28 U.S.C.

§ 158(a)(1). An order is final if it “ends the litigation on the merits and leaves nothing for the court

to do but execute the judgment.” Midland Asphalt Corp. v. United States, 489 U.S. 794, 798, 109
 Encore assigned the servicing rights to Option One Mortgage Corp.

1

 Because the Debtors’ bankruptcy case was filed before October 17, 2005, all references to the Bankruptcy

2

Code, 11 U.S.C. § 101-1330, herein “§ ___,” are to the pre-BAPCPA version. See Bankruptcy Abuse and Consumer

Protection Act of 2005, Pub. Law No. 109-8, § 1501(b)(1), 119 Stat. 23, 216 (stating that, unless otherwise provided,

the BAPCPA amendments do not apply to cases pending before the effective date of BAPCPA).

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S. Ct. 1494, 1497 (1989) (citations omitted). The bankruptcy court’s order granting the trustee’s

motion for summary judgment is a final order. 

 On summary judgment, determinations of whether payments are preferential transfers under

11 U.S.C. § 547(b) are conclusions of law reviewed de novo. Spradlin v. Jarvis (In re Tri-City Turf

Club, Inc.) 323 F.3d 439, 442 (6th Cir. 2003). “De novo means the appellate court determines the

law independently of the trial court’s determination.” Treinish v. Norwest Bank Minn., N.A. (In re

Periandri), 266 B.R. 651, 653 (B.A.P. 6th Cir. 2001). “No deference is given to the trial court’s

conclusions of law.” Booher Enters. v. Eastown Auto Co. (In re Eastown Auto Co.), 215 B.R. 960,

964 (B.A.P. 6th Cir. 1998).

III. FACTS

In August 2004, Ronald and Sheril King (“Debtors”) purchased a home in Independence,

Kentucky. In orderto finance the purchase, the Debtors borrowed from Homecomings Financial and

Wilshire Credit Corporation, granting mortgages in favor of both which were duly recorded on

September 30, 2004 (“Original Mortgages”). 

Less than a year later, the Debtors refinanced their Original Mortgages by obtaining a new

loan from Encore Credit Corp. (“Encore”) on July 22, 2005, in the amount of $138,600, a sum

sufficient to pay off the Original Mortgages and the closing costs on the new loan. That same day,

the Debtors executed a mortgage in favor of Mortgage Electronic Registration Systems, Inc.

(“MERS”), as nominee for Encore (“New Mortgage”). The funds to pay off the two Original 1

Mortgages were advanced on July 28, 2005, but MERS did not record the New Mortgage until

August 26, 2005.

Less than 90 days later on October 16, 2005, the Debtors filed a voluntary petition for relief 2

under chapter 7. On November 9, 2006, the chapter 7 trustee, Michael Baker (“Trustee”),

commenced this adversary proceeding, asserting that the New Mortgage was avoidable as a
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preferential transfer under § 547 because it had been recorded more than10 days after it was executed

by the Debtors and less than 90 days before the filing of the bankruptcy petition. Both parties moved

for summary judgment, agreeing that no facts were in dispute and that the only legal issues were

application of the earmarking doctrine and the contemporaneous exchange defense. Rejecting these

arguments, the bankruptcy court granted summary judgment for the Trustee, finding the New

Mortgage to be avoidable. The Appellants timely filed this appeal.

IV. DISCUSSION

A. 11 U.S.C. § 547(b)

Under § 547 of the Bankruptcy Code, a trustee may avoid certain transfers made to creditors

within 90 days prior to the commencement of the bankruptcy case. The elements of a preferential

transfer are set forth in § 547(b), which states:

Except as provided in subsections (c) and (i) of this section, the trustee may avoid

any transfer of an interest of the debtor in property—

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer

was made;

(3) made while the debtor was insolvent;

(4) made—

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the

petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if—

(A) the case were a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the

provisions of this title.

“All five elements are prerequisites to the finding of a voidable preference.” In re Arnett, 731 F.2d

at 360. 

1. The Lee Decision

As noted, this preference statute, as well as the earmarking doctrine, was recently considered

by the Sixth Circuit Court of Appeals in Lee, a case with very similar facts to the instant case. In
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Lee, the debtor purchased a residence in Michigan, with the purchase financed by a mortgage loan

and secured by a recorded mortgage on the realty. Chase Mortgage Company (“Chase”) eventually

became the holder of the loan note and the mortgage. Approximately six months before the debtor’s

bankruptcy filing, the debtor refinanced his residential mortgage loan with Chase. On October 6,

2003, Chase disbursed the new loan proceeds to pay off the earlier loan held by it, but the new

mortgage granted Chase was not recorded until December 17, 2003, 72 days later. The debtor filed

for bankruptcy relief under chapter 7 on March 4, 2004, 77 days after the recording of Chase’s new

mortgage. The chapter 7 trustee sought to avoid the new mortgage granted Chase as a preferential

transfer under § 547(b). The bankruptcy court granted summary judgment for the trustee, finding

that the trustee had met his burden on all elements under § 547(b) and that the earmarking doctrine

did not apply. Chase Manhattan Mortgage Corp v. Shapiro (In re Lee), 326 B.R. 704, 708 (Bankr.

E.D. Mich. 2005), rev’d 339 B.R. 165 (E.D. Mich. 2006). Although the district court reversed, the

court of appeals reinstated the bankruptcy court’s judgment in favor of the trustee. In re Lee, 530

F.3d 458.

As in the instant case, the preference defendant in Lee, Chase, did not dispute that the trustee

had established the elements of an avoidable preference set forth in subsections (b)(1), (b)(3) and

(b)(4) of § 547. Id. at 467. The court of appeals explained that under subsection (b)(2), the trustee

must demonstrate that the transfer was made “for or on account of an antecedent debt owed by the

debtor before such transfer was made.” Id. at 464 (quoting § 547(b)(2)). 

A debt is antecedent if it is incurred before the transfer in question. In the context of

a loan, the borrower incurs the debt at the time the lender disburses the loan

proceeds. Therefore, lenders who advance loan proceeds prior to the recording of the

mortgage are undertaking a transfer of an interest in the subject property for purposes

of § 547. Such transfers are subject to preferential transfer liability.

Id. at 464-65 (internal citations and quotations omitted).

The court of appeals noted that this potential problem for lenders is addressed by § 547(e)

of the Code by providing a grace period for perfecting a security interest.

As long as the mortgage is recorded within the 10-day time period, the associated

mortgage debt will not be deemed antecedent. On the other hand if perfection occurs
 In pertinent part, § 547(e)(2) provides:

3

For the purposes of this section, . . . , a transfer is made—

(A) at the time such transfer takes effect between the transferor and the transferee, if such transfer is

perfected at, or within 10 days after, such time, . . . ; [or]

(B) at the time such transfer is perfected, if such transfer is perfected after such 10 days.

 The court observed that BAPCPA increased the grace period from 10 days to 30 days, but noted that in the 4

case before it, Chase’s new mortgage was recorded well outside even the new 30-day grace period, such that the result

would be the same under either version of the law. In re Lee, 530 F.3d at 465 n.2. 

 Under § 547(e)(1)(A), “a transfer of real property . . . is perfected when a bona fide purchaser of such property

5

from the debtor against whom applicable law permits such transfer to be perfected cannot acquire an interest that is

superior to the interest of the transferee[.]” “Applicable law” in Lee was Michigan law since the debtor’s residence was

located there. In re Lee, 530 F.3d at 466.

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more than ten days after the transfer takes effect, the transfer occurs at the time of the

perfection, and the debt thus will be an antecedent one.”3

Id. at 465 (internal citations and footnote omitted). Under Michigan law, perfection occurs upon 4

recording. Because Chase’s new mortgage was recorded 72 days after the loan proceeds were 5

disbursed, well outside the 10-day grace period, the transfer was made on account of an antecedent

debt. Id. at 466.

The Lee court explained that Chase’s arguments regarding earmarking and lack of diminution

of the estate come into play with respect to the two remaining elements of a preference. The first

is the requirement imposed by the prefatory language of § 547(b) that the transfer be property of the

debtor. Under the judicially-crafted earmarking doctrine, where a debtor uses borrowed funds

“specifically earmarked by the lender for payment to a designated creditor, there is held to be no

transfer of property of the debtor even if the funds pass through the debtor’s hands in getting to the

selected creditor.” Id. The second is the § 547(b)(5)’s improvement-in-position provision, which

is generally understood to require that the transfer impair or diminish the estate. Id. at 464.

In order for the earmarking doctrine to apply, three conditions must be met: (a) an agreement

between a new creditor and the debtor for the payment of a specific antecedent debt; (b) performance

of the agreement according to its terms; and (c) the transaction does not result in a diminution of the

debtor’s estate. Id. at 466 (citing McCuskey v. Nat’l Bank of Waterloo (In re Bohlen Enters., Ltd.),

859 F. 2d 561, 566 (8th Cir. 1988)). The Lee court concluded that none of these conditions were

satisfied in the facts before it. The court of appeals observed that the transfer that the trustee was

seeking to avoid was the grant of the new mortgage rather than the payment of the new loan proceeds
 The record in the instant case does not establish when the Original Mortgages were released, although 6

Appellants state in their brief that “[t]here is no evidence in the record that the Property was ever unencumbered.”

(Appellants’ Br. at 4.) Lee informs us that this fact is irrelevant to our holding.

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to discharge the original loan and thus did not involve a transfer of “earmarked” funds. The court

refused to conflate the two transfers and treat them as one for purposes of applying the earmarking

defense, observing that to do so would ignore what actually occurred in the transaction and disregard

the Bankruptcy Code’s plain meaning. Id. at 471. As to the third component of the earmarking

doctrine that necessitates a showing that the transaction did not result in a diminution of the estate,

the court of appeals again refused to look at the transaction as a whole, rejecting Chase’s argument

that because the loan in question was simply a refinancing the debtor’s estate had not been impaired

or diminished. The court noted that from the point the old loan was paid off until such time as the

new mortgage was recorded, Chase did not hold a perfected lien interest, even though Chase’s old

mortgage was still of record and was not discharged until January 16, 2004, a date after the new

mortgage was recorded on December 17, 2003, such that there was never a time that Chase did not

have a recorded mortgage. Id. at 472. As explained by the court of appeals: 

The fact that the discharge was not recorded until after the recording of the new

Mortgage is of no moment. There was no debt to be secured under the Original

Mortgage once the Original Loan was paid. Even if the Discharge was not timely

recorded by the Register of Deeds (and it was not), there was no debt and a bona-fide

purchaser could have relied on the fact that the Original Mortgage had been released

when the Original Loan was paid.

Id. at 467. Due to Chase’s lack of a perfected lien interest, “Chase’s subsequent perfection of the

New Mortgage diminished Lee’s estate because the non-exempt equity in the Property that otherwise

would have been available for distribution to Lee’s unsecured creditors became encumbered, and

unavailable to unsecured creditors, by the New Mortgage that Chase received.” Id. at 472. For this

6

same reason, the court also concluded that the § 547(b)(5) element of a preference had been

established. Id. 

The court of appeals rejected Chase’s policy argument that imposing preference liability

would be unfair because the refinancing transaction involved a mere substitution of its new mortgage

for its original mortgage and ultimately benefitted the debtor’s other creditors rather than Chase by

lowering the debtor’s monthly mortgage payments. Id. at 473. Observing that a bankruptcy court’s

equitable powers must be exercised within the confines of the BankruptcyCode, the court noted that
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“[t]o insulate Chase from preference liability would essentially write § 547(e) out of the Bankruptcy

Code and, in the process, defeat the sound policy the statute was intended to promote—the

discouragement of secret liens.” Id. at 472. The court explained that Chase’s suggested equitable

approach to determining the appropriate timing for perfection would not only lead to

unpredictability, but would also substitute a court’s judgment for that of Congress, who “by enacting

§ 547(e)(2), has already determined the appropriate length of time between a creditor’s transfer of

value and perfection.” Id. at 473. Lastly, the court suggested that the equities did not lie in Chase’s

favor since as a sophisticated lender it could have prevented the problem by timely perfecting its

security interest within the Bankruptcy Code’s long-established 10-day grace period. “We simply

are not at liberty to rewrite the Code’s preference provision under the rubric of doing equity to

protect late-perfecting secured creditors.” Id. at 474.

2. The Case Sub Judice

Applying Lee to the instant case results in the inescapable conclusion that the New Mortgage

granted to MERS by the Debtors is avoidable as a preferential transfer under § 547(b). The only

factual distinction between Lee and this case is that Lee involved a refinancing by the same creditor,

while in this case the refinancing by a new creditor. This difference is irrelevant and has no bearing

on the outcome of the Trustee’s preference action. With regard to the specific elements of an

avoidable preference, the Appellants herein, as in Lee, did not dispute that the Trustee had

established subsections (b)(1), (b)(3) and (b)(4) of § 547. As to subsection (b)(2) that the transfer

be on account of an antecedent debt, it must be noted that, under the law of the state of Kentucky

where the Debtors’ residence is located, perfection of a mortgage occurs upon recording. See Ky.

Rev. Stat. Ann.§ 382.270. Because the New Mortgage granted to MERS was recorded on August

26, 2005, more than 10 days after the new loan proceeds were disbursed on July 28, 2005, the

transfer was “for or on account of an antecedent debt owed by the debtor before such transfer was

made.” § 547(b)(2). For the reasons set forth in Lee, the transfer was an interest of property of the

Debtors, the earmarking doctrine is inapplicable, and § 547(b)(5)’s diminution of the estate element

is established. Accordingly, the Debtors’ transfer of the New Mortgage to MERS satisfies all five

required elements of § 547(b), and is avoidable as a preference unless the contemporaneous

exchange exception of § 547(c)(1) applies.
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B. 11 U.S.C. § 547(c)(1)

Under § 547(c)(1) of the Bankruptcy Code:

The trustee may not avoid under this section a transfer—

(1) to the extent that such transfer was—

(A) intended by the debtor and the creditor to or for whose benefit such

transfer was made to be a contemporaneous exchange for new value given to

the debtor; and

(B) in fact a substantially contemporaneous exchange[.]

In Arnett, the Sixth Circuit Court of Appeals addressed this statute in the context of facts

similar to the instant case, although the case involved the refinancing of an automobile rather than

real property. In re Arnett, 731 F.2d at 359. As in the present case, the refinancing creditor failed

to timely perfect its security interest within § 547(e)(2)’s 10-day grace period; perfection did not take

place until 33 days after the creation of the security interest. Despite the untimely perfection, the

bankruptcy court ruled in the trustee’s preference action that the new creditor’s perfection was

“substantially contemporaneous” with the loan transaction and, therefore, the transaction fell with

the exception to the trustee’s avoidance powers found in § 547(c)(1). Ray v. Sec. Mut. Fin. Corp.

(In re Arnett), 13 B.R. 267 (Bankr. E.D. Tenn. 1981), aff’d 17 B.R. 912 (E.D. Tenn. 1982). Although

the district court affirmed, the court of appeals reversed.

The Sixth Circuit explained that § 547(c)(1) has two crucial elements: “(1) The parties must

intend the exchange to be substantially contemporaneous and (2) the exchange must in fact be

substantially contemporaneous.” In re Arnett, 731 F.2d at 362. As to the second element, the court

held that in order to be substantially contemporaneous in fact, perfection must take place within the

time period set forth in § 547(e)(2), i.e., 10 days under pre-BAPCPA. 

Section 547(e)(2)(B) explicitly provides that a security interest perfected more than

10 days after its creation does not relate back and is deemed to have occurred on the

date of perfection. The applicability of section 547(c)(1) to delayed perfection of

security interests is thus limited to 10 days.

Id. at 364. As explained by the court of appeals:

The particular problems posed by the delay between creation and perfection of

security interest were well recognized by Congress. One of the principal purposes

of the Bankruptcy Reform Act is to discourage the creation of “secret liens” by

invalidating all transfers occurring within 90 days prior to the filing of the petitions.

Thus, creditors are discouraged from waiting until the debtor’s financial troubles
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become all-too-manifest before recording security interests. Section 547(e)(2)(A)

and (B) reflect this concern by providing that a transfer of a security interest relates

back to the date of the underlying transaction if perfection occurs no more than 10

days afterwards; if perfection occurs more than 10 days later, the transfer is deemed

to occur at the date of perfection.

The lower courts’ broad reading of section 547(c)(1) effectively negates

section 547(e)(2). . . . [T]he evidentiary problems inherent in an expansive reading

of section 547(c)(1) embody a Pandora's box of evils, even if no risk of fraud or

misrepresentation was present in this case. 

. . . .

If the sole test is the intention of the parties as required in 11 U.S.C.

§ 547(c)(1)(A), then it would be necessary for the Court to conduct extensive factual

inquiries into situations which would lend themselves to collusion and the fabrication

of evidence, and perhaps render the preference section inoperable against all but the

most flagrant violations. The purpose of adding the requirement of 11 U.S.C.

§ 547(c)(1)(B) is to avoid the inherent evidentiary difficulties of 11 U.S.C.

§ 547(c)(1)(A) by requiring that the parties’ conduct bears out their intentions.

[citation omitted].

In light of the explicit grace periods provided for perfection of security

interest in sections 547(e)(2) and 547(c)(3), Congress has clearly struck the balance

in favor of repose in this area of the law. Case-by-case development of the

contemporaneous exchange exception would quickly result in uncertainty and

protracted litigation, delaying, not expediting, the satisfaction of creditors’ claims and

the debtor’s return to financial health. The policies of discouraging creditors “from

racing to the Courthouse to dismember the debtor during his slide into bankruptcy”

and facilitating equality of distribution would be severely eroded under the lower

courts’ construction of the statute . . . .

Id. at 363-64. 

Based on the unequivocal holding of the Sixth Circuit in Arnett, the assertion that the

preferential transfer to MERS is protected from avoidance by the contemporaneous exchange

exception of § 547(c)(1) must be rejected. 

V. CONCLUSION

The order of the bankruptcy court granting summary judgment in favor of the Trustee is

AFFIRMED in all respects. The Trustee established all of the elements of a preferential transfer

under § 547(b) of the Bankruptcy Code, and the transfer does not fall within the contemporaneous

exchange exception to avoidance under § 547(c)(1). Neither the earmarking doctrine nor the

assertion of no diminution of the estate protects a creditor that fails to timely perfect within the grace

period provided by § 547(e)(2), even though the transaction arises in the context of a refinancing.