Court Opinion

ID: 3024446
Source: CourtListenerOpinion
Date Created: 2015-10-13 22:31:24.782383+00
Date Added: 2024-06-11T08:53:09.601238
License: Public Domain

United States Bankruptcy Appellate Panel
                                 FOR THE EIGHTH CIRCUIT

                                       No. 99-6083 WM

In re: Libby International, Inc., Libby       *
Holdings, Inc.,                               *
                                              *
                      Debtors.                *
                                              *
Mark G. Stingley, Chapter 11 Trustee,         *      Appeal from the United States
                                              *      Bankruptcy Court for the
                      Appellee,               *      Western District of Missouri
                                              *
       v.                                     *
                                              *
AlliedSignal, Inc.,                           *
                                              *
                      Appellant,              *

                                  Submitted: March 21, 2000
                                      Filed: April 28, 2000

Before KRESSEL, SCHERMER and SCOTT, Bankruptcy Judges.

SCOTT, Bankruptcy Judge.

                                              I

       Debtor Libby International, Inc. (“Libby”), which manufactured portable electric
generating equipment for the United States Air Force, contracted with AlliedSignal, Inc. to
obtain engines suitable for use in generators manufactured by Libby International. In March
1998, Libby International owed AlliedSignal over eight million dollars on the contracts for
engines. In light of this high debt and in order to facilitate payment, an escrow account was
established with First Trust National Association (“the bank”). In April 23, 1998, Libby
submitted a form to the Air Force to have payments under its contract with the Air Force
deposited directly to the escrow account rather than to Libby. Because of an account error,
however, this was not initially effected and a $500,000 check was sent directly to Libby.
Libby, however, in compliance with its agreement with AlliedSignal, deposited the $500,000
into the escrow account on May 22, 1998. The accounting error was rectified so that the
next payment from the U.S. Air Force was electronically transferred directly into the escrow
account. Thus, on June 23, 1998, the U.S. Air Force deposited $56,577.30 into the escrow
account.

        On June 29, 1998, Libby was in default under its contract with AlliedSignal causing
AlliedSignal to advise the bank to send it the funds in the escrow account in the amount of
$56,577.30, and the bank did so. Two other deposits and transfers to AlliedSignal were also
made within the ninety day period prior to the filing of the chapter 11 case. AlliedSignal
received $325,319.45 from the escrow account during this ninety day period. On September
10, 1998, Libby commenced a chapter 11 bankruptcy case. On the date of the chapter 11
filing, Libby owed AlliedSignal $7,855,899.91 under a note and $2,406.191.30 under a
purchase order, all unsecured.

       The trustee commenced an adversary proceeding under section 547(b) to avoid the
preferential transfers and recover $325,319.45 from AlliedSignal under section 550.
AlliedSignal defended the action on the basis that the earmarking doctrine precluded
recovery by the trustee. The parties submitted stipulated facts and crossmotions for summary
judgment whereupon the bankruptcy court1 determined that earmarking did not apply and
entered judgment for the trustee. AlliedSignal appealed and we affirm the decision of the
bankruptcy court.

       1
        The Honorable Jerry W. Venters, United States Bankruptcy Judge for the Western
District of Missouri.

                                             2
                                               II
Section 547(b) provides for avoidance of a transfer of an interest of the debtor in property,
Brown v. First National Bank of Little Rock, 748 F.2d 490, 491 (8th Cir. 1984), and provides
in pertinent part:
        (b) Except as provided in subsection (c) of this section, the trustee may avoid
        any transfer of an interest of the debtor in property --

              (1) to and 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 ninety 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.

                                             ***
       (f) For the purposes of this section, the debtor is presumed to have been insolvent on
       and during the 90 days immediately preceding the date of the filing of the petition.

        (g) For the purposes of this section, the trustee has the burden of proving the
       avoidability of a transfer under subsection (b) of this section, and the creditor or party

                                               3
       in interest against whom recovery or avoidance is sought has the burden of proving
       the nonavoidability of a transfer under subsection (c) of this section.

11 U.S.C. § 547(b), (f), (g).

       Thus, the trustee thus bears the burden of proving the elements of avoidability under
section 547(b). Nordberg v. Arab Banking Corporation (In re Chase & Sanborn
Corporation), 904 F.2d 588, 595 n.15 (11th Cir. 1990). Each of these elements must be
proven by a preponderance of the evidence. Pembroke Development Corporation v.
Commonwealth Savings & Loan Association (In re Pembroke Development Corporation),
124 B.R. 398, 401 (Bankr. S.D. Fla. 1991). The burden then shifts and the creditor or
transferee bears the burden of providing any affirmative defenses pursuant to section 547(c).
Nordberg, 904 F.2d at 595 n.15. In order to recover the $325,000 from AlliedSignal, the
trustee was required to demonstrate that a transfer—

       (1)    of an interest in property of Libby occurred;
       (2)    was to and for the benefit of AlliedSignal;
       (3)    for or on account of an antecedent debt;
       (4)    made while Libby was insolvent;
       (5)    within ninety days prior to the commencement of the case; and
       (6)    AlliedSignal was left better off than if the transfer had not been made and
              AlliedSignal asserted its claim in a Chapter 7 liquidation.

See Buckley v. Jeld-Wen, Inc. (In re Interior Wood Products Company), 986 F.2d 228 (8th
Cir. 1993). The enumerated elements were not significantly in dispute below and are not the
subject on appeal. The parties dispute whether there was a transfer of an interest of the
debtor.

        While the Bankruptcy Code does not define "property of the debtor," the Supreme
Court has indicated that "'property of the debtor' subject to the preferential transfer provision
is best understood as that property that would have been part of the estate had it not been
transferred before the commencement of bankruptcy proceedings." Begier v. Internal
Revenue Service, 496 U.S. 53, 110 S. Ct. 2258, 2263 (1990). For example, a debtor has no
interest in property that it holds in trust for another, or in which it has no legal or equitable

                                               4
interest. Id. This maxim holds true for payments that are made by a third party to reduce
a debt. No transfer of property of the debtor occurs when a third party pays the creditor
directly. Vadnais Lumber Supply, Inc. v. Byrne (In re Vadnais Lumber Supply, Inc.), 100
B.R. 127, 133 (Bankr. D. Mass. 1989).

       The earmarking doctrine is based upon the element of proof that requires that an
interest of the debtor be transferred in order for a preference to occur. The doctrine was
originally based upon the rationale that since the funds were provided by a third party for the
specific purpose of paying a selected creditor, the debtor had no actual control over
disbursement. Thus, because the estate was not diminished by the payment, the payee should
not be required to return the funds. See generally Buckley v. Jeld-Wen, Inc. (In re Interior
Wood Products Co.), 986 F.2d 228 (8th Cir. 1993); Dubis v. Heritage Bank & Trust Co. (In
re Kenosha Liquidation Corp.), 158 B.R. 774 (Bankr. E.D. Wis. 1993). If the result of the
transaction is merely to substitute one creditor for another, the estate is not diminished.
Brown v. First National Bank of Little Rock, 748 F.2d 490, 491 (8th Cir. 1984). The
earmarking doctrine is not strictly an affirmative defense under Section 547(c), under which
the defendant has the burden of proof, 11 U.S.C. § 547(g), but, rather, is an argument arising
out of the language in section 547(b) which requires that, as an element of the trustee’s
proof, recovery be based upon a transfer of an interest of the debtor. Thus, the earmarking
doctrine is derived from an element of the plaintiff’s proof rather than an affirmative defense.
See Kaler v. Community First National Bank (In re Heitkamp), 137 F.3d 1087 (8th Cir.
1998).

       AlliedSignal urges that the doctrine be applied here because the funds were entrusted
to another, the bank, with instructions under a specific agreement to pay the debtor's
obligation on a particular antecedent debt, citing Herzog v. Sunarhauserman (In re Nework
90, Inc.), 126 B.R. 990 (N.D. Ill. 1991). See generally McCuskey v. National Bank of
Waterloo (In re Bohlen Enterprises, Ltd.), 859 F.2d 561, 566 (8th Cir. 1988)(describing
history of the doctrine).

        The doctrine has also been extended to situations in which the new creditor is a lender
rather than a guarantor. Id. at 566. Although in Bohlen, the Eighth Circuit criticized this

                                               5
earlier extension of the doctrine, it did not specifically reject it. Instead, in Bohlen, the
Eighth Circuit established the specific elements for application of the earmarking doctrine:

       (1)    There exists an agreement between the new lender and the debtor that the new
              funds will be used to pay a specified antecedent debt;
       (2)    The terms are actually performed; and
       (3)    The transaction, viewed as a whole, does not result in any diminution of the
              estate.

McCuskey v. National Bank of Waterloo (In re Bohlen Enterprises, Ltd.), 859 F.2d 561, 566
(8th Cir. 1988). The Eighth Circuit revisited the doctrine in Kaler v. Community First
National Bank (In re Heitkamp), 137 F.3d 1087 (8th Cir. 1998), and, in the context of
determining whether the substitution of one secured creditor for another fell within the
doctrine, determined that the doctrine extends to situations where a secured third party pays
a debt of the debtor and the payment has no effect on the estate of the debtor. The ultimate
analytical result of Heitkamp is that earmarking situations are analyzed in terms of the net
result of the transaction, i.e., whether there is a diminution of the debtor’s estate. See
(Krigel v. Sterling National Bank) In re Ward, 230 B.R. 115, 119 (B.A.P. 8th Cir. 1999).

                                              III
       The facts in this case present a classic preference with no earmarking implications.
Libby owed a large debt and was not timely making payments to AlliedSignal, prompting the
creditor to institute measures to ensure collection. These actions are precisely of the type
the preference provisions are meant to reverse in order to promote equality of treatment
among the unsecured creditors. The parties agreed that an income source of the debtor
would be directed through a bank to AlliedSignal, rather than through Libby. For preference
purposes, the only alteration that was made to the agreement between the parties was a
change in the address to which one of the debtor’s sources of income was to send its checks.
There was no substitution of creditors nor any other change that would affect the analysis
with regard to property of the estate. Before the address change, Libby owed $8,000,000 to
AlliedSignal and, theoretically at least, periodically sent its payments on the debt when it
received its payments from the U.S. Air Force. After the address change, Libby owed

                                             6
$8,000,000 to AlliedSignal but the U.S. Air Force was directed to send checks directly to an
escrow account for ultimate payment to AlliedSignal. Before the address change, Libby was
entitled to receive funds from the U.S. Air Force and it was, under its agreement with
AlliedSignal, obligated to make payments on its debt to AlliedSignal. After the address
change, Libby was still entitled to payments from the U.S. Air Force but entered into
agreements for the funds to be sent directly to AlliedSignal. Libby’s property interest is the
same under either scenario.

        Under the earmarking doctrine, the substitution of one creditor for another should not
result in a diminution of the debtor's estate. In this case, however, there was no substitution
of a creditor, no new creditor, no secondarily liable creditor, nor was there a third party who
paid down a debt of the debtor. There is only one creditor which altered its original payment
terms with a defaulting debtor so that it would begin receiving funds from the debtor’s
income source, through a bank escrow agreement, rather than directly from the debtor. The
receipt of those funds depleted the assets of the estate in the same manner as if Libby had
received the funds from the U.S. Air Force and transmitted them to AlliedSignal itself.
Earmarking has no application in this situation.

        AlliedSignal also urges that since it continued to supply Libby with engines, the “net
result” is that the debtor received property and was able to produce income such that there
was an enhancement of the estate. Again, AlliedSignal misinterprets the nature of the
doctrine and the net result rule. In applying the earmarking doctrine, courts analyze whether
particular payments resulted in a diminution of the estate or whether, taken as a whole, one
creditor was merely substituted for another. Kaler v. Community First National Bank (In re
Heitkamp), 137 F.3d 1087 (8th Cir. 1998) is a classic example of the operation of the
doctrine: earmarking applied because one creditor was merely substituted for another. In
Heitcamp, the trustee sought to set aside a second mortgage granted by the debtors to a bank.
Prior to obtaining the second mortgage, the debtors owed subcontractors $40,000 secured by
the house. The bank paid the subcontractors and obtained the second mortgage. Before the
loan, the debtors owed a $40,000 secured debt to several creditors; after the loan, the debtors
owed the same $40,000 secured debt but only to one secured creditor. There was no
alteration to the assets or liabilities of the estate, i.e., the net result was that there was no
change other than the identity of the secured parties. Thus, although Heitcamp extended the

                                               7
earmarking doctrine to secured interests, it serves to illustrate the proper application of the
doctrine and further emphasizes that, in the Eighth Circuit, the focus of analysis is upon the
effect of the transaction upon the estate.

        In this case there was no substitution of creditors: money was simply paid to a creditor
on an antecedent debt within the ninety days prior to bankruptcy. The fact that AlliedSignal
continued to supply the debtor does not factor into the earmarking doctrine.2 The net result,
that the specific payments diminished the funds ultimately available to pay to all creditors,
is not altered by the fact that AlliedSignal continued to supply the debtor with engines.

        AlliedSignal urges adoption of the conclusions in Herzog v. Sunarhauserman (In re
Network 90E, Inc.), 126 B.R. 990 (N.D. Ill. 1991), but we do not believe it should be
followed because, as noted by the bankruptcy court, it is not consistent with the earmarking
doctrine as enunciated by the Eighth Circuit. First, the court in Network 90E rested it
decision largely on the fact that the debtor had no control over the funds such that the funds
never became property of the estate. This analysis errs because it misapplies the doctrine
and ignores the effect upon the estate. In this case, like that in Network 90E, there is, in fact,
a diminution of the estate and a preferential payment made to one creditor over another. By
focusing solely upon the issue of control, a later step in the earmarking analysis, Network
90 misses the point that the earmarking analysis does not even apply when there is no new
creditor substituted for an old creditor and an asset of the estate is simply being channeled
differently. Earmarking applies when a third person makes a loan to a debtor specifically to
enable the debtor to satisfy the claim of a designated creditor. The proceeds in the
transaction never become part of the debtor’s assets and no preference is created even in
situations when the debtor has temporary custody of the funds.3 In this instance a creditor

       2
        Other preference provisions, such as the new value defense, exist to remedy those
situations. See generally 11 U.S.C. § 547(c)(1), (c)(4). Similarly, the transfers would not
be avoidable as preferences had AlliedSignal properly perfected its security interest.
       3
        See, e.g., Dubis v. Heritage Bank and Trust Co. (In re Kenosha Liquidation
Corp.), 158 B.R. 774 (Bankr. E.D. Wis. 1993)(borrowed funds were held in debtor’s desk
seven days and then deposited pursuant to agreement); In re Kelton Motors, Inc., 95 F.3d
22, 26-27 (2d Cir. 1996)(debtor had no control over check made payable to it).

                                                8
was not substituted, there was merely a diversion of an income source. The fact that the
debtor did not handle the checks does not compel the conclusion that it has no interest in
them. The situations are, for preference purposes, completely inapposite.

        Even if we apply the control test as urged by AlliedSignal, the result does not change
because Libby at all times had the ability to exercise control over the funds. First, the
stipulated facts belie AlliedSignal’s assertion that the debtor had no control over the funds
after implementation of the new agreement. Indeed, the stipulated facts indicate that even
after the amendments and agreement regarding the creation of the escrow account, funds
were sent by the U.S. Air Force directly to Libby. Cf. Amick v. Hoff Companies (In re
Amick), 163 B.R. 589 (Bankr. D. Idaho 1994)(debtor designated to whom check payable);
Wasserman v. Village Assoc.) (In re Freestate Management Serv., Inc.), 153 B.R. 972
(Bankr. D. Md. 1993). The fact that Libby complied with its contractual agreements with
AlliedSignal and deposited the funds into the escrow manually does not obviate its control.
 If the court adopted the rule urged by AlliedSignal, a creditor could avoid the preference
provisions simply by requiring a lockbox arrangement with the debtor, effectively nullifying
the provisions of 11 U.S.C. § 547 with regard to that debtor and creditor.

        Second, Libby in fact retained control over the funds because it had the legal ability
to alter the transmissions from the U.S. Air Force at any time. To direct funds into the
escrow account, it merely filled out a form, SF 3881, and transmitted it to the appropriate
defense department office. Although Libby was obligated under its contract with
AlliedSignal to direct the funds in a certain manner, Libby had the power and control to file
a new SF 3881 and direct the payments otherwise if it so chose. Indeed, the Debt
Restructure Agreement between Libby and AlliedSignal provided not only that Libby had
the ability to modify the payment instructions to the department of defense, but also required
Libby to provide AlliedSignal with assurance, if requested, that the payment instructions had
not been modified. Thus, the agreement contemplated that Libby would retain control of the
disposition of the funds due it from the U.S. Air Force. The fact that a change would
constitute a breach of contract does not obviate the power to effect the action.

                                              9
                                              IV
       The purpose of the section 547 avoidance statute is to place all unsecured creditors
on an equal basis for purposes of distribution of the debtor's assets. In re Bohlen, 859 F.2d
566 n.10 (“[T]he provision facilitates the prime bankruptcy policy of equality of distribution
among creditors of the debtor.”); accord Advo-System, Inc. v. Maxway Corp., 37 F.3d 1044,
1047 (4th Cir. 1994). Within the preference period, the 90-day time period Congress deemed
appropriate for equalizing distribution of estate assets to creditors, AlliedSignal, an
unsecured creditor in this bankruptcy case, received property of the debtor in payment of an
antecedent debt, more than it would have received under a chapter 7 case. The payments to
AlliedSignal not only fall demonstrably within the policy parameters of the statute, they meet
each of the statutory elements of a preference. Accordingly, the judgment of the bankruptcy
court is affirmed.

A true copy.

       Attest:

                 CLERK, U.S. BANKRUPTCY APPELLATE PANEL

                                             10