The only thing worse than writing off a bad debt from a customer's bankruptcy is paying that same customer in its bankruptcy case because your company received a preferential transfer.² This epitomizes the expression of "throwing good money after bad," since you are increasing your loss well after the fact. No credit manager ever wants to be in this position.

Adversary proceedings challenging preferential transfers are becoming more common. Understanding a preference's elements (both those written in the Bankruptcy Code and those created by the courts) and the theory behind each can give you the upper hand.

The Bankruptcy Code's list of preference elements is in §547(b) and is summarized as a transfer of property of the debtor (which occurred within 90 days before the bankruptcy filing, or one year if it is to an insider) to or for the benefit of a creditor on account of an existing debt while the debtor was insolvent and that allows the creditor to receive more than it would have received in a chapter 7 liquidation.

While §547(c) lists the standard defenses to a preference action (including the "ordinary course of business" and "subsequent new value" defenses most commonly available to unsecured creditors), we will concentrate on the first element: a transfer of property of the debtor. The fact that it is an element of the trustee's case (instead of being a defense) is an important procedural point. The trustee has the burden of pleading and proving the element and will lose if that burden is not met.

The theory behind this element is that transferring the property diminished (took property away from) the bankruptcy estate that would have otherwise been equitably distributed among all creditors. If payment left the debtor's balance sheet essentially unchanged, there would be no diminution and should be no preferential transfer.³ You ask, "How could a payment be made that does not affect the debtor's balance sheet?" Here's where the "greater fool theory" comes into play.

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[S]ince the "earmarking doctrine" is not listed in the Code itself, its limitations likewise cannot be found there.

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If the payment was actually funded by a new creditor loaning money to pay the old creditor, the only change to the debtor's balance sheet is the creditor's name; the amounts would not be changed. This is the essence of the "earmarking doctrine," a "defense" that is not listed in the Code. "[T]he earmarking doctrine applies 'when a third party lends money to a debtor for the specific purpose of paying a selected creditor.'"⁴ Of course, the "new lender" in this scenario becomes the "greater fool" when it becomes the creditor instead of the creditor it replaced.

A number of circuit courts recognized the earmarking doctrine as a way creditors can win a preference suit. However, there are limits to what will qualify as an appropriate "earmarking" to prevail over the trustee. Predictably, since the "earmarking doctrine" is not listed in the Code itself, its limitations likewise cannot be found there.

The most notable exception is that the "greater fool's" debt (that is, the "new creditor's" claim) may have at most the same priority as the debt it replaced. "Where a debtor transfers a security interest to the new creditor in return for the loan, the payment is voidable to the extent of the new value of the collateral transferred by the debtor."⁵

What if the payment comes from the buyer's loan proceeds of a loan buyer of the debtor's assets? Could this be another earmarking situation? Probably not, because the buyer would most likely consider the payment to the debtor's "old creditor" as part of the purchase price. Since the loan was made to the buyer (not debtor) and the price was paid to the old creditor instead of the debtor, the earmarking doctrine's elements would not be met.⁶

A recent case also evaluated the scenario where a "new creditor" was repaid with the money it loaned to repay another creditor when the old creditor had its debt paid from another source.⁷ When the new creditor was sued, it could not squeeze itself into the earmarking doctrine since its loan proceeds never went to pay the old creditor's debt and instead only repaid the new creditor's debt.

Not to worry: The McDowell court turned to the doctrine of constructive trusts to find that since the debtor was never authorized to use those loan proceeds for anything other than paying the "old creditor," the proceeds were not property of the debtor because the debtor held them in trust and was required to refund them once the trust's purpose was defeated (that is, the money could not pay the then-repaid old creditor's debt). Since property held in trust is not property of a bankruptcy estate under 11 U.S.C. §541(d), the trustee could not set aside the payment back to the new creditor.

Admittedly, since a "greater fool" does not come along every day to take your place at the bankruptcy table, this "defense" will not always be available. However, if you thoroughly investigate your case and the debtor's pre-bankruptcy transactions, you just might find a way to use it to your advantage.

Executive Editor's Note: For the first time since the Last in Line column was launched almost five years ago, one of its four contributing editors is rotating off of the column. I am pleased to announce that Bruce Nathan of Davidoff & Malito in New York will now take what had been my place in the Last in Line rotation from its beginning.

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Footnotes

¹ The "greater fool theory" has been defined as a "belief held by one who makes a questionable investment, with the assumption that he/she will be able to sell it later to a bigger fool." http://www.investorwords.com. Return to article

² Technically, the payment in this instance would be to the customer as a debtor-in-possession which, in a chapter 11 case, has all of the powers of a trustee. 11 U.S.C. §1107(a). While the preference suit could be brought by a trustee, if one is appointed, most credit managers will agree that sending money back to the debtor is worse than paying an independent trustee appointed after the debtor's financial problems brought it to the bankruptcy court. Return to article

³ In the accounting world, a balance sheet lists a business's assets and liabilities. Return to article

⁴ See In re Kemp Pacific Fisheries Inc., 16 F.3d 313, 316 (9th Cir. 1994) (quoting In re Smith, 966 F.2d 1527, 1533 (7th Cir. 1992)); see, also, In re Bohlen, 859 F.2d 561, 566 (8th Cir. 1988) (holding that the earmarking doctrine requires "(1) the existence of 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 according to its terms and (3) that the transaction viewed as a whole...does not result in an diminution of the estate." In re Superior Stamp & Coin Co. Inc., 223 F.3d 1004, 1008 (9th Cir. 2000). Return to article

⁵ In re Superior Stamp & Coin Co. Inc., 223 F.3d at 1008, n. 3, citing In re Kelton Motors Inc., 97 F.3d 22, 28 (2nd Cir. 1996), and In re Hartley, 825 F.2d 1067, 1071 (6th Cir. 1987). If a new secured creditor loans money to be paid to satisfy the lien of an existing secured creditor, that payment is probably not avoidable under either the "earmarking doctrine" or the trustee's inability to show that the payment was more than the old secured creditor would have received on its secured claim. See In re Heitkamp, 137 F.3d 1087, 1089 (8th Cir. 1998). Return to article

⁶ In re Interior Wood Products Co., 986 F.2d 228, 232 (8th Cir. 1993). Return to article

⁷ In re McDowell, 258 B.R. 296 (Bankr. M.D. Ga. 2001). Return to article