Thursday, November 06, 2008

Fifth Circuit Explains Earmarking

In order for a payment to be recovered as a preference under 11 U.S.C. Sec. 547, there must be a transfer of "an interest of the debtor in property." The earmarking doctrine provides a means to negate this element where the debtor never had control over the transferred property. The Fifth Circuit re-affirmed the earmarking doctrine in Matter of Entringer Bakeries, Inc., No. 07-30499 (5th Cir. 11/6/08), but found that it did not apply in the specific case.

In Entringer Bakeries, First Bank and Trust made a short term bridge loan to the debtor with the expectation that the debtor would obtain permanent SBA-backed financing. When the debtor obtained its new financing, it deposited the funds into its account and then wrote a check to FBT to pay off the old debt. The decision to extend the new financing proved unwise for the second lender, since the debtor filed bankruptcy about six weeks later.

The Trustee sued to recover the payoff to FBT as a preferential transfer. The bank defended the claim asserting that the new financing was intended to pay off its debt so that the payment was protected under the earmarking doctrine. The Fifth Circuit agreed that earmarking was still a viable defense, but found that it did not apply in the specific case. The relevant inquiry in earmarking is whether the debtor obtains control over the funds being transferred. If the debtor has control such that it can use the funds for whatever purposes it chooses, then earmarking does not apply regardless of the subjective intent of the parties.

The court made the following critical findings:

Here, Entringer had dispositive control over the Whitney loan proceeds; the money was Entringer's property once Whitney deposited the funds into Entringer's general account. . . . That is, Entringer could have done anything it wanted to do with the money from the Whitney loan, meaning that the parties did not "earmark" it to pay off the FBT debt. Gary Lorio, Whitney's loan officer, testified that Whitney did not control the money once it went into Entringer's bank account and that Entringer could have paid any of its creditors with that money. Mark Leunissen, Entringer's chief executive officer, agreed that the money from the Whitney loan was Entringer's money once it entered Entringer's general account.

Opinion at 9.

Thus, earmarking is not alchemy which transmutes a transfer into a non-transfer based on the intent of the parties. Instead, it only applies to cases where the debtor lacked the ability to affect the manner in which the funds were applied.

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