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Earmarking Does Not Protect Balance Transfers

By: Jenny J. Huang
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
In bankruptcy, “one of the most controversial and frequently litigated of the avoidance powers” is the debtor or trustee’s ability to recover preferential transfers under 11 U.S.C. § 547(b).[1] The twin purposes of section 547(b) are to “prevent[] individual creditors from dismembering the assets of the debtor in a manner that negatively impacts other creditors, and [to allow] all creditors to obtain a more equitable distribution of the assets of the debtor.”[2] Recently, in Parks v. FIA Card Services (In re Marshall), the Tenth Circuit addressed how courts should adhere to these twin purposes in a landscape where nearly instantaneous electronic transfers pose a new problem for the court’s analysis.[3] 
In In re Marshall, the debtors carried outstanding balances on two MBNA credit card accounts.[4] Within ninety days before debtors filed for chapter 7 relief, they directed Capital One, through which they had extensive available lines of credit, to pay each of the outstanding balances on the MBNA cards via an electronic transfer.[5] Since the code permits a trustee to avoid transfers “of an interest of the debtor in property” that were “made . . . within 90 days before the date of the filing of the petition,” [6] the trustee sought to avoid these electronic payments as preferential transfers.[7]
At its core, In re Marshall concerned whether a balance transfer, directed by a debtor to a credit card company, is “a transfer of an interest of the debtor in property” within the meaning of section 547(b).[8] Since the Bankruptcy Code does not define “interest of the debtor in property,” courts have looked to the Supreme Court decision of Begier v. IRS,which held the term 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.”[9] To make this determination, courts have developed two tests. The control test looks to see whether “the debtor exercised dominion or control over the transferred property.”[10] The diminution of the estate test examines whether the transfer “deprives the bankruptcy estate of resources which would otherwise have been used to satisfy the claim of creditors.”[11]
The bankruptcy court held that because Capital One made the payments to MBNA, there was merely a “substitution of creditors which had no impact on either the property of the estate or the value of the claims asserted against the estate.”[12] The district court affirmed the bankruptcy court decision but analyzed the case under the earmarking doctrine, which provides that if the debtor uses funds that were given for paying a specific debt, the trustee cannot avoid those transfers as preferential.[13] Regardless, the court held that the debtors did not have control over the funds that Capital One transferred to MBNA because “the debtors never possessed a check or proceeds of a loan” and Capital One was not obligated to make the payments.[14] Thus, there was only a substitution of creditors.[15] The Tenth Circuit, disagreeing with both the bankruptcy court and the district court, held that the transfers were preferential.[16]
Under both the control and diminution of the estate tests, the Tenth Circuit held that the electronic balance transfers were transfers of “an interest of [Debtors] in property.”[17] In its analysis, the court first broke down the sequence of events: “[1] Debtors drew on their Capital One line of credit; [2] that draw converted available credit into a loan; [3] Debtors directed Capital One to use the loan proceeds to pay MBNA; [4] and Capital One complied.”[18] The court reasoned that this was analogous to a clearly preferential situation where debtors drew on their Capital One line of credit, “deposited the proceeds into an account within their control, and then wrote a check to MBNA.”[19] In applying the control test, the court found dispositive the fact that the debtors had the ability to direct to whom Capital One could transfer the funds.[20] Although the debtors interest in the loan proceeds was “only fleeting” because the electronic transfer was nearly instantaneous in comparison to a physical deposit slip and check, the court stated that “[a]n ability to control, made manifest, must equate to physical control.”[21] Additionally, the diminution of the estate test was satisfied because, as the court states: “The Capital One loan proceeds were an asset of the estate for at least an instant before they were preferentially transferred to MBNA.”[22]
Here, the court’s analysis provides a clarifying opinion consistent with the twin policies of section 547(b) in the context of a purely electronic transfer. The court notes that it does not matter “how fleeting [the estate assets] presence in the bankrupt’s estate” during the ninety-day preference period, the statute clearly provides that such transfers “should be ratably apportioned among qualified creditors” and not “permitted to benefit only a preferred creditor.”[23]

[1] 4 Norton Bankruptcy Law and Practice 3d § 66:1, at 66-4 (Hon. William L. Norton, Jr. ed., 2009) [hereinafter Norton].
[2] Bailey v. Big Sky Motors, Ltd. (In re Ogden), 314 F.3d 1190, 1196 (10th Cir. 2002); see Norton, supra note 1, at 66-6 to 66-7.
[3] 550 F.3d 1251 (10th Cir. 2008).
[4] Id. at 1253.
[5] Id. MBNA’s successor-in-interest, FIA Card Services, was later substituted as the defendant.
[6] 11 U.S.C. § 547(b)(4)(A).
[7] In re Marshall, 550 F.3d at 1253.
[8] 1254.
[9] 496 U.S. 53, 58–59 (1990).
[10] In re Marshall, 550 F.3d at 1255–56.
[11] Id.
[12] Id. at 1254.
[13] Id.
[14] Id.
[15] Id.
[16] 1257–58.
[17] Id. at 1256–58.
[18] Id. at 1256.
[19] Id.
[20] Id. at 1257 (“The Debtors’ exercise of their ability to control the disposition of the loan proceeds is the essence of this case.”).
[21] Id.
[22] 1258.
[23] Id.