The elements of a voidable preference are enumerated in §547(b) of the Bankruptcy Code and well known to practitioners. The trustee must prove that the transfer in question (1) was to or for the benefit of a creditor, (2) was for or on account of an antecedent debt owed by the debtor before such transfer was made, (3) was made while the debtor was insolvent, (4) was made on or within 90 days before the bankruptcy filing date, or within one year for insiders, if the creditor was an "insider" at the time of the transfer, and (5) enabled the creditor to receive a greater percentage of its claim than the creditor would have received had the transfer not taken place and the debtor's assets liquidated in a chapter 7 case. 11 U.S.C. §547(b); Union Bank v. Wolas, 502 U.S. 151 (1991).

In addition to the specifically enumerated elements above, the trustee must also prove that there was a transfer of "an interest of the debtor in property...." 11 U.S.C. §547(b). Although not specifically identified along with the other elements of a voidable preference, there is ample authority supporting this additional requirement.¹ Indeed, the requirement is clearly housed in the prefatory language of §547(b).

Elements of Earmarking Doctrine

A creature of judicial invention, the earmarking doctrine provides an equitable defense for a creditor in a preference action. Essentially, the earmarking doctrine provides that the debtor's use of borrowed funds to satisfy a pre-existing debt is not deemed a transfer of property of the debtor, and therefore, it is not avoidable as a preference.² Under the earmarking doctrine, if a third party provides funds for the specific purpose of paying a creditor of the debtor, the funds may not be recoverable as a preferential transfer because the funds never become part of the debtor's estate.³

Courts uniformly agree that three requirements must be met in order to apply the earmarking doctrine as a defense to a preference action: (1) there must be an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt; (2) performance of that agreement must be made according to its terms; and (3) the transaction viewed as a whole (including the transfer in of the new funds and the transfer out to the old creditor) must not result in any diminution of the bankruptcy estate.⁴

While the earmarking doctrine is routinely accepted as a valid defense to a preference action, courts are divided on the applicability of earmarking as a defense to a voidable preference action in a "refinance" situation where the new lender is tardy in perfecting its security interest in accordance with §547(e). The atypical scenario involves a debtor that borrows funds from a new lender to satisfy an antecedent secured debt whereby the lender pays the funds directly to the debtor's pre-existing secured creditor. The debtor then grants a lien in favor of the new lender in the same property now serving as collateral for the new loan. However, the new lender fails to timely perfect its security interest in the refinanced property as prescribed in §547(e).⁵ Courts generally agree that the earmarking defense insulates from preference recovery, the receipt of funds by the pre-existing creditor from the new lender. Yet courts are divided as to whether the earmarking defense applies to insulate the new lender from preference exposure for the untimely perfection of its lien. This disagreement stems largely from competing views regarding the classification of a refinancing transaction.

One view holds that the refinancing transaction consists of two separate and distinct transfers. The first transfer consists of the initial disbursement of funds to the pre-existing creditor from the new lender; this transfer does not result in a transfer of an interest in the debtor in property and is not preferential. The second transfer occurs when the debtor grants a security interest in the refinanced property to the new lender, which, if not timely perfected, results in a preferential transfer.

The opposing theory reasons that a refinancing transaction must be viewed as one large cohesive transaction. Thus, when applying the earmarking doctrine, no transfer of an interest of the debtor in property occurs, and the net result is one where a secured creditor is merely replaced by another, such that no diminution of the estate occurs.

Case Law on the Earmarking Defense

The courts that have held that the earmarking doctrine may be employed as a defense by a refinancing creditor that is untimely in perfecting its security interest generally base their reasoning on the absence of a transfer of an interest of the debtor in property and the "net result" of the refinancing transaction viewed as a whole. These courts are willing to apply the earmarking doctrine as a defense even where there is a substantial delay in the perfection of the new refinanced security interest within the time required in §547(e). As noted in Kaler v. Community First National Bank (In re Heitkamp), 137 F.3d 1087 (8th Cir. 1998), the trustee brought an adversary proceeding to avoid the chapter 7 debtors' second mortgage interest in their home. The debtors borrowed additional funds from a new lender to satisfy subcontractors' liens upon the property. The funds were paid directly to the subcontractors by the new lender, and in return, the debtors granted the new lender a second mortgage. However, due to an oversight, the second mortgage held by the new lender was not perfected until several months later. The court applied the earmarking doctrine protecting the new lender's security interest despite the considerable delay in perfecting its security interest. The Eighth Circuit noted: "Because the transfer of the mortgage interest to the bank merely replaced the subcontractors' security interest, there was no transfer of the [debtors'] property interest avoidable under §547(b)." Id. at 1089. Heitkamp and its progeny contend that if the new creditor's funds are earmarked to pay off an existing obligation, the funds never became part of the debtor's estate. Accordingly, in a refinance situation, no avoidable preference occurs even with the untimely perfection of the refinancing creditor's security interest, since there was no transfer of an interest of the debtor in property.⁶

In further applying earmarking as a defense, the Heitkamp view asserts that a refinancing situation should be viewed as one cohesive transaction where the refinancing creditor's lien has merely replaced the original creditor's lien. Accordingly, no diminution of the estate occurs, and in effect, the debtor's assets and net obligations remain the same. Although not decided under the earmarking doctrine, the court in Burton v. Community Credit Co. (In re Biggers), 248 B.R. 873, 875 (Bankr. M.D. Tenn. 2000), focused on whether the estate was diminished by virtue of an untimely perfection of a non-purchase money security interest in a refinance situation. The court held that no preferential transfer had occurred. The court recognized that a refinancing transaction involves several different transactions (i.e., the execution of a new note and disbursement of funds to the pre-existing creditor, and the perfection of the new creditor's security interest). Yet the court noted that a refinancing transaction was better viewed as one whole transaction. The court stated: "Looking only at the 'trees' and parsing each component of the refinancing, it is easy to conclude that the transfer allowed the [refinancing creditor] to receive more than it would have in a chapter 7 case." Id. at 877. As it further noted, however, "in transactions that involve collateral substitution or renewal of a lien or security interest, many courts have measured the transaction as a whole to determine whether the estate was diminished." Id. at 877. Similarly, the court in Ward held that "preference attacks on transfers to new creditors in earmarking situations must be analyzed in terms of this net result rule to determine if there has been a transfer of property of the debtor." In re Ward, 230 B.R. 115, 120 (8th Cir. 1998). Consequently, courts aligning with the Heitkamp view assert that for a transfer to constitute a preference, there must be some resulting diminution of the estate, and when viewing a refinancing transaction as a whole, no such diminution occurs.

The counterargument posits that the earmarking doctrine does not apply to insulate a refinancing creditor from preference recovery that belatedly perfects its security interest during the preference period. This view asserts that a refinancing transaction involves two separate and distinct transfers. The first transfer involves the distribution of funds between the new and old creditor, of which the earmarking doctrine applies to such transfer insulating the old creditor from preference recovery. The second transfer involves the debtor granting a security interest in favor of the new creditor, which, if not timely perfected as prescribed by §547(e), is not protected by the earmarking doctrine.⁷

The Messamore view purports that this second transfer, which occurs with the perfection of the refinancing creditor's security interest, is clearly a transfer of the debtor's interest in property, as it depends on the debtor's granting of a security interest to the refinancing creditor. As noted, "although earmarking is appropriate in a refinancing situation as a defense for the old creditor who receives borrowed funds as payment on an antecedent debt, it is illogical to say there was no transfer of the debtor's interest in property to the new creditor when the debtor has granted a security interest to that creditor." In re Messamore, 250 B.R. 913, 918, 919 (Bankr. S.D. Ill. 2000). As it further noted, "the [Heitkamp court's] analysis failed to distinguish between the transfer of borrowed funds to the original creditor and the subsequent transfer that occurred when the new creditor belatedly perfected its security interest in the debtor's property. The earmarking doctrine, while appropriate to prevent avoidance of the transfer of borrowed funds to the original creditor, was wrongly invoked as a defense for the new creditor's tardy perfection." Id. at 917, 918.

The Messamore camp reasons that it is this second transfer (i.e., the debtor's granting of a security interest to the refinancing creditor) that results in a transfer of an interest of the debtor in property, ultimately diminishing the estate. This view holds that until the refinancing creditor perfects its security interest, it remains an unsecured creditor. Therefore, the transfer of the debtor's property does not occur until the refinancing creditor perfects its security interest. If such perfection does not occur within the safe-harbor period prescribed by §547(e), but instead is completed belatedly during the 90-day preference period, it is deemed preferential. See 11 U.S.C. §547(e). The untimely perfection creates a diminution of the estate because the delay results in a transfer made for or on account of an antecedent debt. This, in turn, diminishes the estate by encumbering the equity in the refinanced property resulting in a loss to the creditors.

The Messamore view also asserts that insulating this second transfer from preference recovery undermines the requirement that a refinancing creditor perfect its security interest within the time prescribed in §547(e). In addition, it would improperly expand the safe-harbor time period provided in §547(e), effectively allowing a refinancing secured creditor to belatedly perfect its security interest and then rely on the earmarking doctrine as a defense to a voidable preference action. As the court in Schmiel held, "the 10-day safe harbor provision simply would have no meaning if a secured creditor could perfect its interest at any time after the 10 days and then depend upon the earmarking doctrine to somehow avoid the operation of the statute when its [security interest] was later perfected." In re Schmiel, 319 B.R. 520, 529 (Bankr. E.D. Mich. 2005). Therefore, the Messamore view reasons that once the safe-harbor time period to perfect in §547(e) elapses, the refinancing creditor is not protected from preference exposure.

Conclusion

As a result of this split, a refinancing creditor can take solace in knowing that a belated perfected security interest is not fatal when subject to a preference attack from a trustee. In addition, a trustee may encounter a daunting challenge establishing that there has been a transfer of an interest of the debtor in property and that there has been a diminution of the estate, before prevailing on its preference action in a refinance situation.

Footnotes

1 See, e.g., McLemore v. Third National Bank in Nashville (In re Montgomery), 983 F.2d 1389 (6th Cir. 1993); In re Safe-T-Brake of South Florida Inc., 162 B.R. 359 (Bankr. S.D. Fla. 1993).

2 See, e.g., National Bank of Newport v. National Herkimer County Bank, 225 U.S. 178, 32 S.Ct. 633, 56 L.Ed. 1042 (1912); Adams v. Anderson (In re Superior Stamp & Coin Co. Inc.), 223 F.3d 1004 (9th Cir. 2000) (discussing the history of the earmarking doctrine).

3 See, e.g., Brown v. First National Bank of Little Rock (In re Ark-La Materials Inc.), 748 F.2d 490 (8th Cir. 1984).

4 McCuskey v. National Bank of Waterloo (In re Bohlen Enterprises Ltd.), 859 F.2d 561 (8th Cir. 1988); In re McDowell, 258 B.R. 296 (Bankr. M.D. Ga. 2001).

5 Under the 2005 amendments to the Bankruptcy Code, the §547(e)(2) grace period was extended from 10 days to 30 days. BAPCPA, Pub.L. 109-8, Title IV, §403, 119 Stat. 23 (2005).

6 See, e.g., Krigel v. Sterling National Bank (In re Ward), 230 B.R. 115 (8th Cir. 1999); Luker v. Lewis Auto Glass Inc. (In re Francis), 252 B.R. 143 (Bankr. E.D. Ark. 2000); Collins v. Greater Atlantic Mortgage Corp. (In re Lazarus), 334 B.R. 542 (Bankr. D. Mass. 2005); Chase Manhattan Mortgage Corp. v. Shapiro (In re Lee), 2006 WL 563690 (Bankr. E.D. Mich. 2006).

7 See, e.g., Vieira v. Anna National Bank (In re Messamore), 250 B.R. 913 (Bankr. S.D. Ill. 2000); Sheehan v. Valley National Bank (In re Shreves), 272 B.R. 614 (Bankr. N.D. W.Va. 2001); Scaffidi v. Kenosha City Credit Union & State of Wisconsin (In re Moeri), 300 B.R. 326 (Bankr. E.D. Wis. 2003); Gold v. Interstate Financial Corp. (In re Schmiel), 319 B.R. 520 (Bankr. E.D. Mich. 2005).