Daily Development for Friday, July 7, 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

The following is taken from a memo sent in by DIRTer Pat Mears of Barnes and Thornburg of Grand Rapids, Michigan.  The memo was written by John Gregg of Pat’s office.

BANKRUPTCY; PREFERENCES; REFINANCING: “Earmarking doctrine” provides defense to preferential transfers arising from mortgage refinancing transactions.”

Shapiro v. Homecomings Financial Network, Inc., et al. (In re Davis), Case No. 04- 45710 (Bankr. E.D. Mich. Dec. 13, 2004)

Debtor and his non-debtor wife borrowed funds from the defendant Lender in order to refinance an existing mortgage on certain real property. The borrowed funds were used exclusively to pay off the Debtor’s original mortgage, which was discharged shortly thereafter. The loan from the new lender was evidenced by a note, secured by a mortgage on the same property and Lender properly recorded the mortgage.

Debtor filed for Chapter 7 bankruptcy within ninety days of the refinancing, the bankruptcy trustee commenced an action seeking to avoid the new mortgage.

In considering cross motions for summary judgment, the bankruptcy court noted that in order for a preferential transfer to exist, .an interest of the debtor in property. must be transferred. Therefore, the court emphasized, 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.”  According to the court, because such money is not considered property of the estate, the transfer of such money does not constitute a preferential transfer.  The court found that the new lender “earmarked” the loaned money to the debtor for the specific purpose of paying off the mortgage held by the prior lender, and therefore the new mortgage did not constitute a preference.  Therefore, the money never became property of the estate, precluding the transfer of an .interest of the debtor in property.

The court also held that a preferential transfer did not occur because neither the property owner nor the creditors were in a worse position due to the refinancing. The court noted that if the new lender had improved its position in any way over the old lender, a preferential transfer

may be deemed to have occurred to the extent that the new mortgage encumbered the property in a great amount than the old mortgage. The court distinguished the facts in Shapiro, however, and found that because the new mortgage stands in the shoes of [the] old mortgage, diminution

of the estate had not occurred.

Reporter’s Comment: In many jurisdictions, trustees will routinely seek to avoid, as a preferential transfer, mortgages granted to a lender by the debtor where the transaction between the debtor and creditor constitutes a refinancing of a previous arrangement between the debtor and a third party.  The “earmarking doctrine” approved here provides a defense in such situations .  It is esserntially a judicially-created defense to the estate’s attempt to avoid transfers where a new creditor pays a debtor’s existing debt to an old creditor.  See Mandross v. Peoples Banking Company, 825 F.2d 1067, 1070 (6th Cir. 1987); Grubb v. General Contract Purchase Corp., 94 F.2d 70 (2d Cir. 1938). The decision also suggests that where diminution of the estate has not occurred, the elements required for a preferential transfer cannot be satisfied.  See Gregory v. Community Credit Co. (In re Biggers), 249 B.R. 873, 878-79 (M.D. Tenn. 2000)


The earmarking doctrine is not a new defense to preferential transfers. Generally, courts have employed three tests to determine if funds are earmarked. The first test focuses onwhether the new creditor and the debtor intended the funds to satisfy the claim of the old creditor. Under this .intent. test, the following elements must be satisfied:

(i) 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;

(ii) Performance of that agreement according to its terms; and

(iii) The transaction, viewed as a whole (including the transfer of the new funds and the transfer to the old creditor) does not result in any diminution of the estate.  See, e.g., In re Heitkamp, 137 F.3d 1087 (8th Cir. 1998); In re Kumar Bavishi & Associates, 906 F.2d 942 (3d Cir. 1990); In re Bohlen Enters, Ltd., 859 F.2d 561 (8th Cir. 1988)

The second test examines whether the debtor exercised dominion and control over the loan proceeds. In determining control, courts typically review whether physical control was exerted over the funds, and whether the debtor had the ability to direct to whom the funds would be paid. See, e.g., In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004 (9th Cir. 2000); In re Montgomery, 983 F.2d 1389 (6th Cir. 1993).

Finally, the third test, as more fully described in the discussion of Shapiro above, examines whether diminution of the estate occurred as a result of the alleged preferential  transfer.See, e.g., Biggers, 249 B.R. at 873; In re Kelton Motors, Inc., 153 B.R. 417 (Bankr. D. Vt. 1993)

The Shapiro court seems to have utilized aspects of all three tests. In preparing a defense based on the earmarking doctrine, it is therefore advisable to consider elements of all three tests.

In situations where one test by itself might not entirely be satisfied, a court may find a combination of elements persuasive.

Editor’s Comment: How is the transfer to the new creditor a preference anyway?  The new creditor is not a preexisting creditor.  It demanded a mortgage in exchange for a new extension of credit.

In the editor’s view, the prepayment of the old mortgage is the arguable transfer, but the earmarking doctrine nevertheless would work to address that problem.

Editor’s Comment 2:   Isn’t there another analysis to watch out for?   What about costs of the new lending?  Shouldn’t those be taken into account in determining whether indeed the net impact on the bankruptcy estate is a push?  Or should these be discounted because they do not constitute payments on the old loan?

Typically refinancings result in more attractive terms for the debtor - such as lower interest rates or longer payoff periods and, in either case, smaller payments.  But a debtor who is struggling just prior to bankruptcy may in fact be refinancing in order to stave off the first creditor from foreclosing, and may even be agreeing to higher payments to the second creditor.  Are payments made under such a more onerous schedule “payments in the regular course of business,” or are they preferences to the extent they exceed what was payable before?

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