Opinion ID: 1189483
Heading Depth: 3
Heading Rank: 2

Heading: The Earmarking DoctrineTransfer of an Interest of the Debtor in Property

Text: When the other elements of a preferential transfer are established, § 547(b)'s prefatory language sweeps into the bankruptcy estate any transfer of an interest of the debtor in property. Although this provision has a potentially expansive reach, it is not without limits. In addition to the exceptions to preference liability set forth in § 547(c)none of which are at issue herethis Court adopted another limitation on § 547(b), the judicially-crafted earmarking doctrine: [T]here is an important exception to the general rule that the use of borrowed funds to discharge the debt constitutes a transfer of property of the debtor: where the borrowed funds have been 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. See In re Hartley, 825 F.2d at 1070; In re Smith, 966 F.2d [1527, 1533 (7th Cir.1992)]; In re Bohlen Enters., Ltd., 859 F.2d 561, 564-66 (8th Cir.1988). The courts have said that even when the lender's new earmarked funds are placed in the debtor's possession before payment to the old creditor, they are not within the debtor's `control.' Bohlen, 859 F.2d at 565 (citing cases). McLemore v. Third Nat'l Bank in Nashville (In re Montgomery), 983 F.2d 1389, 1395 (6th Cir.1993). The earmarking doctrine applies whenever a third party transfers property to a designated creditor of the debtor for the agreed-upon purpose of paying that creditor. See In re Hartley, 825 F.2d at 1070. Under such circumstances, the property is said to be earmarked for the designated creditor. As a result, there is deemed to have been no transfer of an interest of the debtor in property, even if the property passes through the hands of the debtor on its way to the creditor. In re Montgomery, 983 F.2d at 1395. The earmarking doctrine, then, is a judicially-created defense that may be invoked by a defendant to a preference action in an attempt to negate § 547(b)'s threshold requirementa transfer of an interest of the debtor in property. In order for the doctrine to apply, however, it must be that: (a) the agreement is between a new creditor and the debtor for the payment of a specific antecedent debt; (b) the agreement is performed according to its terms; and (c) the transaction according to the agreement does not result in a diminution of the debtor's estate. In re Bohlen Enters., 859 F.2d at 566.
When applying the earmarking doctrine in the context of a refinancing transaction, courts have split over whether to characterize the refinancing as a single unitary transaction or as a number of parts. [7] Although Chase suggests that the multiple-transfer approach adopted by the First Circuit in In re Lazarus has been followed only by a small minority of bankruptcy courts, it is in fact the prevailing view. See Encore Credit Corp. v. Lim, 373 B.R. 7, 17 (E.D.Mich.2007); George v. Argent Mortgage Co. (In re Radbil), 364 B.R. 355, 358 (Bankr.E.D.Wis.2007); Baker v. Mortgage Elec. Registration Sys., Inc. (In re King), 372 B.R. 337, 341 (Bankr.E.D.Ky. 2007); Peters v. Wray State Bank (In re Kerst), 347 B.R. 418, 422 (Bankr.D.Colo. 2006); Gold v. Interstate Fin. Corp. (In re Schmiel), 319 B.R. 520, 528 (Bankr. E.D.Mich.2005); Scaffidi v. Kenosha City Credit Union (In re Moeri), 300 B.R. 326, 329-30 (Bankr.E.D.Wisc.2003); Strauss v. Chrysler Fin. Co. (In re Prindle), 270 B.R. 743, 746-47 (Bankr.W.D.Mo.2001); Sheehan v. Valley Nat'l Bank (In re Shreves), 272 B.R. 614, 625 (Bankr.N.D.W.Va.2001); Vieira v. Anna Nat'l Bank (In re Messamore), 250 B.R. 913, 916 (Bankr.S.D.Ill. 2000). See also Goodman v. S. Horizon Bank (In re Norsworthy), 373 B.R. 194, 200 n. 3 (Bankr.N.D.Ga.2007) (Many courts have held that the `earmarking doctrine' is not properly applied in the case of the transfer of a security interest.). In actuality, the case upon which Chase relies, In re Heitkamp, 137 F.3d 1087, represents the minority view. As far as we are aware, the only courts that have followed it are lower courts in the Eighth Circuit, the lower courts in In re Lazarus, and the district court here. [8]
In In re Lazarus, the court recognized that a financing transaction involves several distinct transfers. See In re Lazarus, 478 F.3d at 15-16. There, the debtor refinanced her residential mortgage loan which had been held by Washington Mutual Bank with Greater Atlantic Mortgage Corporation (GAMC) within 90 days prior to filing her Chapter 7 petition. Id. at 13. The new mortgage was not recorded until 14 days after GAMC disbursed funds to Washington Mutual Bank. And, as in the case before us, the mortgage discharge was not recorded until even later. Id. The Chapter 7 trustee sought to avoid the new mortgage as a preferential transfer due to the delayed perfection. Id. In response, GAMC argued that under the earmarking doctrine, the new mortgage did not result in a transfer of an interest of the debtor in property. The bankruptcy court and district court held in favor of GAMC. [9] Id. at 14. The In re Lazarus court, however, sided with the trustee, holding that because the [filing of the mortgage] occurred 14 days after the initial transfer of funds, section 547(e) requires that the transfer be deemed to have occurred on the date of perfection. The mortgage, therefore, secured a debt antecedent to the transfer rather than simultaneous with it. Id. at 15. The First Circuit reasoned: [I]n refinancing there are multiple transactions, including a new loan to the debtor, a mortgage back from the debtor to the new lender, a pre-arranged use of the proceeds of the loan to pay off the old loan and the release of the old mortgage. Id. at 15-16. The court then rejected GAMC's contention that the transferred property interest was not that of the debtor, holding that the earmarking doctrine did not shield the transfer challenged by the trusteethe recording of the mortgagefrom avoidance. Id.
Chase primarily relies upon In re Heitkamp in support of its earmarking argument. In In re Heitkamp, the debtors were in the business of constructing and selling houses. 137 F.3d at 1088. In connection with their business, the debtors maintained lines of credit with several subcontractors and took out a loan with a bank secured by a mortgage on one of the houses built by the debtors. While the loan remained outstanding, the bank agreed to loan additional funds to the debtor secured by a second mortgage. Id. But instead of paying the funds directly to the debtors, the bank agreed with the debtors that it would issue cashier's checks to specified subcontractors who had already performed work for, or provided goods to, the debtors. In exchange for the checks, the subcontractors waived their mechanic's liens on the property against which the bank held the mortgages. The bank's second mortgage remained unrecorded for over three months and ultimately was recorded three days before the debtors commenced their Chapter 7 case. The trustee sought to avoid the second mortgage. The bankruptcy court authorized the trustee to avoid the second mortgage, and the district court affirmed. Id. On appeal, the Eighth Circuit reversed, concluding that the three-prong Bohlen test was satisfied and holding that the earmarking doctrine applied to protect the second mortgage from avoidance: The bank and the Heitkamps agreed the secured funds would be used to pay specific preexisting debts, the agreement was performed, and the transfer of the mortgage interest did not diminish the amount available for distribution to the Heitkamps' creditors.... The Heitkamps' assets and net obligations remained the same. Essentially, the bank took over the subcontractors' security interest in the house. In re Heitkamp, 137 F.3d at 1089 (citations omitted).
As an initial matter, we note that Chase is not a new creditor, and that this alone precludes it from successfully invoking the earmarking doctrine. Because Chase refinanced its own loan with the Debtor, it cannot establish this preliminary element of the earmarking defense. See, e.g., In re Lazarus, 334 B.R. at 549 (The earmarking doctrine requires three specific parties: the `debtor,' an `old creditor,' and a `new creditor' who pays the debtor's obligation to the old creditor.); In re Bohlen Enters., 859 F.2d at 565 (same). Yet even if we were to deem Chase to be a new creditor, the earmarking doctrine would not shield it from preference liability under the circumstances of this case. As did the First Circuit in In re Lazarus and the clear majority of courts that have decided the issue, we conclude that the earmarking doctrine does not protect the late-perfecting refinancer from preference exposure. We reach this conclusion because we find the analysis in In re Lazarus persuasive, and because we find In re Heitkamp 's unitary-transaction approach to be fundamentally flawed in several respects. First, In re Heitkamp 's unitary-transaction theory ignores the plain meaning of the Bankruptcy Code. The common theme in the Supreme Court's bankruptcy jurisprudence over the past two decades is that courts must apply the plain meaning of the Code unless its literal application would produce a result demonstrably at odds with the intent of Congress. See, e.g., Hartford Underwriters Ins. Co. v. Union Planters Bank, Nat'l Ass'n, 530 U.S. 1, 6, 120 S.Ct. 1942, 147 L.Ed.2d 1 (2000) ([W]hen the statute's language is plain, the sole function of the courtsat least where the disposition required by the text is not absurdis to enforce it according to its terms.) (quotations omitted); Connecticut Nat'l Bank v. Germain, 503 U.S. 249, 253-54, 112 S.Ct. 1146, 117 L.Ed.2d 391 (1992) ([I]n interpreting a statute a court should always turn first to one, cardinal canon before all others. We have stated time and again that courts must presume that a legislature says in a statute what it means and means in a statute what it says there. When the words of a statute are unambiguous, then, this first canon is also the last: judicial inquiry is complete.) (citations and quotations omitted); United States v. Ron Pair Enters., Inc., 489 U.S. 235, 241, 109 S.Ct. 1026, 103 L.Ed.2d 290 (1989) ([W]here, as here, the statute's language is plain, the sole function of the courts is to enforce it according to its terms.) (citations and quotations omitted). [10] In re Heitkamp's extension of the earmarking defense to a debtor's transfer of a lien interest has been rightly criticized as a violation of this cardinal principle. See In re Lazarus, 478 F.3d at 16. (Although [ In re Heitkamp ] supports the bankruptcy judge's use of the earmarking doctrine in a like case, this approach has been justly opposed on the ground that it amounts to ignoring the statutory language.) (citations omitted); Encore Credit, 373 B.R. at 16 ( Heitkamp has been justly criticized because it ignores the statutory language.). Specifically, In re Heitkamp 's unitary-transaction approach ignores the definition of transfer set forth in § 101(54), as supplemented by § 547(e). Application of this definition to Lee's refinancing transaction with Chase leads to the inescapable conclusion that it was comprised of two transfers by the Debtora transfer of the proceeds of the New Loan to Chase to pay off the Original Loan and the grant of the New Mortgage to Chase to secure his obligation to repay the New Loan. Chase urges us to follow In re Heitkamp and turn a blind eye to the plain meaning of the term transfer contained in §§ 101(54) and 547(e). We decline Chase's invitation to conflate the two transfers made by Lee in the refinancing transaction and treat them as one for purposes of applying the earmarking defense. To do so would ignore what actually occurred in the transaction and disregard the Bankruptcy Code's plain meaning. See In re Lazarus, 478 F.3d at 16 ([T]he earmarking concept does not provide [the refinancer] an escape from the plain language of [the Bankruptcy Code] in the case of a belatedly-perfected transfer of a security interest.). See also In re Lewis, 398 F.3d at 746 (The recording of a mortgage constitutes a transfer of an interest in the subject property for purposes of § 547.). Second, applying earmarking to the transfer of a lien interestas opposed to a transfer of fundsextends the doctrine beyond its logical limits. A debtor's grant of a mortgage lien in a refinancing transaction does not involve a transfer of earmarked property. Here, Lee did not serve as a conduit for the transfer of property from a third party to Chase. Rather, the transfer challenged by the Trustee Lee's grant of a mortgage to Chasewas most assuredly that of a property interest owned and controlled by the Debtor. See In re Lazarus, 478 F.3d at 15 ([U]se of the earmarking doctrine in this case is not conceptually similar to the guarantor or new creditor cases where it could plausibly be argued that there was merely an arrangement between third parties with no property transfer by the debtor.); In re Schmiel, 319 B.R. at 528 ([A]lthough the debtor's transfer to [the refinancing creditor] arose in the context of a refinancing arrangement, it did not involve the payment of funds by a third party or, indeed, the payment of borrowed funds at all. For this reason, the earmarking doctrine has no logical relevance to such transfer.) (quoting Messamore, 250 B.R. at 917); David Gray Carlson & William H. Widen, The Earmarking Defense to Voidable Preference Liability: A Reconceptualization, 73 Am. Bankr.L.J. 591, 602 n. 63 (Summer 1999) ([ In re Heitkamp ] wrongly invoked earmarking in a context in which the concept does not fit.). Third, to successfully invoke the earmarking defense, a preference defendant must demonstrate that the transfer in question did not result in a diminution of the debtor's bankruptcy estate. Although Chase claims no diminution, it arrives at this conclusion by pointing to its status at the inception of the refinancing transaction, a time when it indisputably had a perfected mortgage on the Property, and its status at the conclusion of the transactionwhen it again had a perfected mortgageand ignoring everything that happened in between. But focusing on the actual transfer at issue, Chase's perfection of the New Mortgage, clearly reveals that Lee's bankruptcy estate was in fact diminished. From the point that the New Loan was made and the Original Mortgage discharged up until such time as the New Mortgage was recorded, Chase did not hold a perfected lien interest. Thus, 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. Finally, applying the earmarking doctrine to 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. By enacting § 547(e) and establishing a definite and firm 10-day time period for lien perfection (now expanded to 30 days by BAPCPA), Congress sought to promote the Bankruptcy Code's policy of discouraging secret liens on property of the estate. See In re Lazarus, 478 F.3d at 18; In re Arnett, 731 F.2d at 363. For all these reasons, we conclude that the earmarking doctrine does not protect Chase from preference liability.