Daily Development for Thursday, January 27, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; PREFERENCES; REFINANCING:  Rate and term refinance a preference in bankruptcy in Michigan, but not a preference elsewhere

Gold v. Interstate Financial Corporation (In re Schmiel) 2005 WL 110466 (1/20/05)

Interstate refinanced a Wells Fargo loan for the Schmeils. The mortgage was submitted for recording on the day of disbursement, but the Register of Deeds did not "record" the mortgage for three months. The borrowers filed bankrutpcy within 90 days after the recording of the mortgage. The Bankruptcy Court held that there were two transactions - the payoff of the Wells Fargo mortgage, and the granting of the Interstate mortgage. The Trustee in bankruptcy sought to overturn the recording of the mortgage, claiming that this was a preference. The lender claimed that the "earmark"doctrine protected Interstate. Under this doctrine, the borrower never has control over the funds from the refinance transaction, and the new mortgage merely substitutes one creditor for another - the borrower's estate is not diminished.

The Bankruptcy Court agreed with the Trustee, and interpreted the "earmark" doctrine narrowly. The Court held that the doctrine protects Wells Fargo from having to return the proceeds, but it does not protect Interstate:

This Court agrees with the Messamore court’s finding that there are two “separate and distinct” transfers at issue in the context of refinancing and granting a new mortgage. Even if the funds paid to Wells Fargo were “earmarked” for Wells Fargo, that does not insulate Interstate from the Trustee’s action to avoid the transfer of a mortgage lien to it. The earmarking doctrine simply does not apply to this transfer. There were no funds transferred to Interstate that could be earmarked. The granting of the security interest was not done by a third party, but by the Debtors. The granting of the security interest to Interstate diminished the bankruptcy estate by encumbering the Truwood property and there is a loss to creditors because the non-exempt equity in that property was no longer available for the Trustee to administer for the benefit of creditors. The wire transfer of funds from Interstate to Wells Fargo in paying off the original mortgage is a “separate and distinct tran!

 sfer,”
 which is not the subject of this adversary proceeding.

The Court concludes that Interstate wrongly invokes the earmarking doctrine. This analysis is consistent with the analysis employed in Bohlen. That court recognized that the beneficiary of the earmarking doctrine is the old creditor, for whom the funds were earmarked, not the debtor, or the new creditor who provided such funds. Bohlen, 859 F.2d. at 565. Whether the policy of protecting the old creditor for whose benefit the funds are earmarked is a prudent policy is not to say. The salient point is that the doctrine, if applicable at all in this case, would operate to protect Wells Fargo, the recipient of the earmarked funds, not Interstate, the creditor who loaned the funds and who received a transfer (i.e., the mortgage) that was not earmarked for it by some third party.

In the final analysis, Interstate asks the Court to rescue it from an untimely perfection of its mortgage by application of the earmarking doctrine to it even though it did not receive any earmarked funds. That is an expansion of the earmarking doctrine. Interstate received no transfer of any interest in property that was earmarked for it. To accept its argument would undermine the requirement to timely perfect its mortgage and would improperly expand the ten day safe harbor that § 547(e)(2)(A) provides to those secured creditors who perfect within ten days after the time that the transfer takes effect between the transferor and the transferee. The ten day safe harbor provision simply would have no meaning if a secured creditor could perfect its interest at any time after the ten days and then depend upon the earmarking doctrine to somehow avoid the operation of the statute when its mortgage was later perfected.

Comment: The Reporter expects this decision to be reversed if appealed. First, the Bankruptcy Court wrongly assumed that the mortgage was not perfected when it was submitted to the register of deed. Recording occurs when the mortgage is submitted to the register of deeds, not when the register of deeds gets around to indexing the document. In Central Ceiling and Partition, Inc. v. Dept. of Commerce, 683 N.W. 2d 142 (Mich. 2004) the Michigan Supreme Court recognized that a document is deemed recorded when presented for recording. The fact that the register of deeds does not perform its statutory duty does not diminish the perfection of the mortgage. Hence, the Interstate mortgage was "recorded" prior to the preference period.

Second, the split transaction analysis used by the Court is a subterfuge for overturning the "earmark" doctrine. In another recent bankrutpcy case,  Shapiro v. Homecomings Financial Network, Inc. (In re Davis) 318 B.R. 119 (Bkrtcy. E.D. Mich. 12/13/04) (the DIRT DD for 1/7/05), one of the borrowers (the husband) declared bankruptcy within 90 days after refinancing his home mortgage. The bankruptcy trustee could not seize and sell the property owned by husband and wife to satisfy the debts of the husband alone. Hence, the Trustee tried the novel idea to seize Homecomings' loan and sell it to an investor because the Homecomings note was a "preference" under Section 547(b) of the Bankruptcy Code.

The Bankruptcy Court disagreed. The loan proceeds were "earmarked" to pay off the prior lender and, therefore, the loan proceeds were never owned by the husband. If the husband never received the money, the note to Homecomings never reduced the husband's estate, and there was nothing to avoid. The court stated:

“Section 547(b) requires that there be “an interest of the debtor in property”. When a third party lends money to a debtor for the specific purpose of paying off a designated creditor, that money is not “an interest of the Debtor in property” and, therefore, is not property of the estate. Accordingly, the transfer of that money cannot be a preferential transfer. Grubb v. General Contract Purchase Corp., 94 F.2d 70, 72 (2d Cir. 1938); Mandross v. Peoples Banking Company (In re Hartley), 825 F.2d 1067, 1070 (6th Cir. 1987); In re Bohlen Ltd., 859 F.2d 561 (8th Cir. 1988). In this case, Homecomings Financial Network loaned money to the Debtor for the specific purpose of paying off the Creve Coeur mortgage, and all of the proceeds did, in fact, go to Creve Coeur. The Debtor received no funds. Therefore, to the extent that the money was used to pay off that mortgage, that money never became property of the estate.

This rule, which was later to be termed the “earmarking doctrine”, was originally set forth in Grubb v. General Contract Purchase Corp., 94 F.2d 70 (2d Cir. 1938). In Grubb, the debtor owed the defendant $25,000. The debtor borrowed money from a third party to pay the defendant. The third party made a check out to the defendant, paying him directly. After the debtor went bankrupt, the trustee challenged the payment as a preferential transfer, voidable under section 60 of the former Bankruptcy Act. The Grubb court, in a decision written by Judge Learned Hand, held that the payment was not preferential because the funds did not belong to the debtor because the debtor never controlled the money and the money never became a part of the debtor’s assets. Id., at 72. The transaction merely substituted one creditor for another without loss to the estate. See also, In re Bohlen Ltd., 859 F.2d 561 (8th Cir. 1988) (the three requirements that a transaction must meet in order to qualify!

  for t
he earmarking doctrine are: (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) the transaction viewed as a whole (including transfer in of new funds and the transfer out of the old creditor) does not result in any diminution of the estate.)”

The Court stated that any cash out received by the borrower could be a preference, but in this case the borrower did not receive any cash from the refinancing.

The court also held that selling the loan to another investor and using the funds to pay off the creditors was inconsistent with the purposes of the Bankruptcy Code. The stipulated order in this case would obligate the non-bankrupt spouse (also a borrower) to pay Homecomings on the loan, even though the bankrupt borrower would no longer be liable on the debt. The Court stated:

“The Court is unsure whether the promissory note to Homecomings Financial Network would still be in effect, thus still binding the Debtor’s non-filing spouse to Homecomings Financial Network for the amount loaned. The language of the stipulated Order Resolving Trustee’s Objections to Debtor’s Amended Exemptions appears to obligate the Debtor under the mortgage regardless of the Trustee’s actions. If the Debtor is so obligated, then the non-filing spouse would be liable on the note to Homecoming Financial Network, the property remains encumbered by the original mortgage, and the Debtor and his non-filing spouse could be obligated on additional mortgages. If the language in the stipulated Order Resolving Trustee’s Objections to Debtor’s Amended Exemptions does not bind the Debtor on the mortgage to Homecomings Financial Network then, after the Debtor receives his discharge, the Debtor would only be liable on the new mortgage but the Debtor’s non-filing spouse would be liable o!

 n the
entire amount owing to Homecomings Financial Network as well as on the new mortgage. These scenarios appear to penalize the Homecomings Financial Network, the Debtor and the Debtor’s spouse in ways that do nothing to promote the policies behind §547(b), those being to provide equality of treatment to creditors and to deter a race to the courthouse. Neither of these policies are served in this case by allowing the Trustee to sell the mortgage and note, when the Trustee admits that it cannot sell the real estate. While there might be facts which would justify the court authorizing the sale of the mortgage independently of the sale of the real estate, this case does present such a scenario. Without authority for the Trustee’s position, this court finds no reason to step into this quagmire.”

This issue is likely to arise again as trustees continue to try creative ways to enlarge a bankrupt borrower's estate.

The Reporter for this item was Howard Lax of Michigan, writing in the Mortgage Banking Newsletter.

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