Opinion ID: 1189483
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Heading: The Earmarking Defense Applied to Refinancing Transactions

Text: 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).