The Earmarking Doctrine’s Viability as a Defense to Preference Actions Involving Home-Loan Refinancing Transactions
By: Michael Benzaki
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Recently, in In re Flannery,[i] the bankruptcy court held that the earmarking doctrine was not an appropriate defense to a preference action seeking to avoid a late-filed mortgage that was granted as part of a home-loan refinancing.[ii] In Flannery, the debtors financed the purchase of their home through an initial home-mortgage loan, which was secured by a mortgage. Further, within a year of granting the first mortgage, the debtors also granted a second-priority mortgage to secure a home equity line of credit. Subsequently, a new bank acquired both loans and mortgages from the initial lender.[iii] In 2012, the debtors refinanced the initial loan with the new bank through the Home Affordable Refinancing Program (“HARP”).[iv] In connection with the refinancing loan, the debtors granted the new bank a new mortgage against their property and the new bank executed a subordination of mortgage, subordinating the home equity mortgage to the new mortgage.[v] The proceeds from the refinancing loan were used to pay off the initial loan on January 25, 2012, and a discharge of the initial mortgage was recorded on February 21, 2012.[vi] However, the new mortgage was not recorded until April 18, 2012.[vii] Subsequently, on June 28, 2012, less than ninety days later, the debtors filed for bankruptcy under chapter 7 of the Bankruptcy Code. Since the mortgage was recorded within ninety days of the bankruptcy filing, the chapter 7 trustee for the debtors sought to avoid the refinance mortgage as a preference pursuant to section 547 of the Bankruptcy Code.[viii] Ultimately, the court rejected the new bank’s argument that, given the facts of the case at hand, the earmarking doctrine successfully defended the transaction in question from being designated an avoidable preference.[ix]
Strictly a product of judicial construction, the earmarking doctrine is a defense to preference claims.[x] The earmarking doctrine applies when “new funds are provided by [a] new creditor to or for the benefit of [a] debtor for the purpose of paying the obligation owed to the old creditor.”[xi] Essentially, the earmarking doctrine posits that such transactions cause no diminution to the bankrupt estate because the funds from a new creditor are merely passing through the debtor to payoff an antecedent debt.[xii] There is a circuit split, however, over whether new creditors can successfully invoke the earmarking doctrine to protect a late-recorded mortgage granted in connection with a home-loan refinancing. On one side of the split, the Eight Circuit[xiii] held that under the earmarking doctrine, the process undertaken to refinance mortgages should be viewed as a “single [unitary] transaction, consisting of multiple steps.”[xiv] The Eighth Circuit adopted this view because the timeframe in which mortgages are recorded do not, in any way, diminish the value of the bankrupt estate.[xv] Conversely, expressing the majority view, the First Circuit held that the various steps necessary to complete the refinancing of a mortgage should be viewed as distinct multiple transactions.[xvi] Thus, those adhering to this approach argue that there are two independent transactions that occur when refinancing a mortgage,[xvii] and if the second transaction occurs within ninety days of a Chapter 7 bankruptcy then it must be considered an avoidable preference.[xviii]
With the case at hand, the Flannery court was bound by the First Circuit, which adopted the multiple transaction rule.[xix] Therefore, because of the nature of the various transactions, the Flannery court concluded that “[t]he [d]ebtors clearly did not act merely as bailees with the 2004 Mortgage passing from “Chase to Chase.””[xx] Furthermore, the court held that the mere fact that the refinance in question occurred as a part of HARP was inconsequential.[xxi] Thus, the court ultimately held that the transactions regarding the refinance-mortgage constituted a voidable preference.[xxii]
The Flannery decision brings to light a number of implications that future lenders must take into consideration when dealing with refinanced mortgages. First, the Flannery decision highlights the fact that new lenders must minimize the number of independent transactions when refinancing mortgages. Therefore, a new lender should take an assignment of the original mortgage from the old lender and then enter into a modification agreement with the debtor. Although such a scenario has yet to be litigated, it is likely that implementing such a procedure would lead a court, including a court that follows the majority rule, to conclude that the assignment would not be an avoidable preference because the “debtor would be acting as bailee when passing the mortgage from one creditor to another.”[xxiii] Accordingly, the new lender would be able to successfully assert the earmarking doctrine if a chapter 7 trustee seeks to avoid the assigned mortgage as a preference. Second, Flannery demonstrates that, given the appropriate circumstances, the majority of bankruptcy courts will permit chapter 7 trustees to avoid a belatedly perfected mortgage as a preference notwithstanding the earmarking doctrine. Consequently, a lender should promptly record a mortgage granted in connection with a refinancing, if possible,[xxiv] because doing so decreases the likelihood of the new mortgage being recorded during the 90 day preference period. Finally, lenders should be aware that there are other defenses to preference actions in. In particular, lenders may be able to successfully assert the doctrine of equitable subrogation[xxv] or, depending on the sequence of the mortgages and the particular facts of a case, the doctrine of inquiry notice to defeat a chapter 7 trustee’s preference action.[xxvi]
[i] 513 B.R. 1 (Bankr. D. Mass. 2014).
[ii] Id. at 5.
[iii] Id. at 3.
[iv] See Nick Timiraos, Mortgage Program Pans Out, Wall St. J.L., http://online.wsj.com/news/articles/SB1000142405270230475350457928285321... (last updated Dec. 31, 2013) (explaining that HARP, a program initiated by the Obama administration in 2009, “was designed to help borrowers who were current on their mortgages but unable to refinance because their home values had dropped.”). In re Flannery, 513 B.R. at 3.
[viii] Id. at 4; See 11 U.S.C. § 547(b)(4) (stipulating that a “trustee may avoid any transfer of an interest of the debtor in property on or within 90 days before the date of the filing of the petition”).
[ix] In re Flannery, 513 B.R. at 7.
[x] See Kevin M. Baum, Note, Apparently, "No Good Deed Goes Unpunished": The Earmarking Doctrine, Equitable Subrogation, and Inquiry Notice Are Necessary Protections When Refinancing Consumer Mortgages in an Uncertain Credit Market, 83 St. John's L. Rev. 1361, 1374–75 (2009).
[xi] McCuskey v. Nat’l Bank of Waterloo (In re Bohlen Enterprises, Ltd.), 859 F.2d 561, 565 (8th Cir. 1988). For the doctrine to apply, the new creditor must prove that (1) an agreement existed between the new creditor and the debtor stipulating that new funds will be used to pay a particular antecedent debt; (2) the agreement was fulfilled according to its terms; and (3) the transaction, when taken in its entirety, did not result in a diminution of the estate in question. See also Baum, Supra note 12 at 1375 (explaining the use of the earmarking doctrine as a defense in preference actions).
[xii] See Kaler v. Cmty. First Nat’l Bank (In re Heitkamp), 137 F.3d 1087, 1089 (8th Cir. 1998) (holding that the earmarking doctrine “extends to situations where any third party … pays down a debt of the debtor … because [the] payments … would have no effect on the estate of the debtor.”).
[xiii] See In re Heitkamp, 137 F.3d at 1089 (8th Cir. 1998) (holding that “the [earmarking] doctrine applies when a security interest is given for funds used to pay secured debts”).
[xiv] Baum, Supra note 13 at 1377.
[xv] Id. In this case, the debtor owed subcontractors $40,000. Unable to pay this debt, the debtor obtained the funds necessary to satisfy the antecedent debt through a loan from a new creditor, which was secured by a mortgage. The new creditor specifically designated the loan to pay the debt to the creditors. As part of this agreement, the subcontractors waived their mechanics lien on the property in question. Although the mortgage was only recorded about five months after the transaction occurred, the court held that earmarking doctrine should apply. They reasoned, “[b]efore the loan, the [debtors] owed subcontractors $40,000 secured by the house for goods and services rendered. Afterwards, the [debtors] owed the bank $40,000 secured by the house for a cash loan used to pay the subcontractors. The [debtor’s] assets and net obligations remained the same. Essentially, the bank took over the subcontractors' security interest in the house.”
[xvi] See Collins v. Greater Atl. Corp. (In re Lazarus), 478 F.3d 12, 15–16 (explaining that in 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); See also Baum Supra note 21 at 1378–79.
[xvii] See Baum, Supra note 16 at 1378. The two transactions that occur during refinances of mortgages are: “(1) the payment by the new creditor for the antecedent debt, and (2) the debtor granting the new creditor a security interest in the debtor's property.”
[xviii] See id.
[xix] In re Flannery, 513 B.R. at 5.
[xxii] Id. at 7.
[xxiii] Baum, Supra note 24 at 1384.
[xxiv] See In re Flannery, 513 B.R. at 7 (commenting that issue of delayed recordings of refinanced mortgages a relatively frequent issue in preference actions).
[xxv] Baum, Supra note 25 at 1391.
[xxvi] See Id. at 1396–97.