Opinion ID: 2976985
Heading Depth: 5
Heading Rank: 1

Heading: The Lee Decision

Text: 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 -4- 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 -5- 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).4 Under Michigan law, perfection occurs upon recording.5 Because Chase’s new mortgage was recorded 72 days after the loan proceeds were 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 3 In pertinent part, § 547(e)(2) provides: 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. 4 The court observed that BAPCPA increased the grace period from 10 days to 30 days, but noted that in the 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. 5 Under § 547(e)(1)(A), “a transfer of real property . . . is perfected when a bona fide purchaser of such property 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. -6- 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 472.6 For this 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 Bankruptcy Code, the court noted that 6 The record in the instant case does not establish when the Original M ortgages were released, although 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. -7- “[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.