Preference suits and the earmarking doctrine
Summary: If before bankruptcy is filed the debtor pays some debts and not others, ie 'prefers' some creditors, the court may be able to get back those payments from the person or entity that received the funds. For insiders (relatives, business partners, others with a special relationship to the debtor) the court looks back at least one year for such payments, and may be able to look back over a much longer period to determine if the payment qualifies for recovery. One of the defenses to this doctrine is called the earmarking doctrine, if funds were specifically provided to the debtor conditioned on paying a specific debt.
Generally, if a debtor pays an unsecured creditor shortly (if not an insider, within 90 days) before a bankruptcy is filed, allowing the creditor to receive more than they would in the bankruptcy if no payment had been made, then the trustee can recover these funds. Courts have created an equitable exception to the preference right where funds were provided to the debtor by a third party to pay a specific debt, concluding that such funds are not recoverable as a preference because the funds were never property of the debtor, thus the transfer does not disadvantage any creditor. This doctrine was discussed regarding a motion for summary judgment in In re Barreto, 2018 Bankr. LEXIS 3504, Case #14-08712 (Bankr. D. Puerto Rico, 7 November 2018).
The debtor had paid $6,510 toward criminal restitution within 90 days of the filing of a chapter 7 bankruptcy. The debtor asserted that the source of these funds was money lent to him from his sister, which loan was conditioned on the use of the funds to pay the criminal restitution. The matter came up for summary judgement in the bankruptcy court, which the court denied finding there remained disputed issues of material fact. However, the court went in some detail as to the requirements to satisfy the earmarking doctrine.
The trustee initially has the burden of proof to show by a preponderance of the evidence that all elements of 11 U.S.C. §547(b). The statute provides that a trustee may avoid any transfer of an interest of the debtor in property-
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;
(3) made while the debtor was insolvent;
(A) on or within 90 days before the date of the filing of the petition; or
(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
(5) that enables such creditor to receive more than such creditor would receive if-
(A) the case were a case under chapter 7 of this [*9] title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title." 11 U.S.C. § 547(b).
If the trustee proves all these elements, then the defendant to whom the funds were paid can avoid paying the trustee if it can prove by a preponderance of the evidence that the transfer satisfies one of the exceptions contained in 11 U.S.C. 547(c). The fact that the payment was for nondischargeable restitution does not prevent recovery.
The critical issue is whether the transfer allowed the creditor to receive more than it would under a chapter 7 liquidation. Per the earmarking doctrine, if the funds were never under the control of the debtor, then the payment is not a preference as the money was never subject to an equitable interest of the debtor, and cannot be considered property of the estate under §541.1 The focus of the earmarking doctrine is not on what the creditor received, but what the debtor's estate has lost. If the debtor had no equitable interest in the property transferred, there can be no preference.
Where the debtor was found to have control and authority over the disposition of funds, resulting in a diminishing of the debtor's estate, the doctrine has been held not to apply.2 A hypothetical chapter 7 liquidation analysis must be filed as part of a motion for summary judgment. As an judicially created equitable exception the application of the ear marking doctrine must be narrowly construed.
The court found that if the facts showed that the sister lent the funds exclusively for the specific purpose of paying the restitution, the earmarking doctrine may be applicable, even though the funds came from an insider as defined in §101(31)(A)(1).
1 In re EUA Power Corporation, 147 B.R. 635, 640 (Bankr. D.N.H. 1992). See: In re Loggins, 513 B.R. 682, 701 (Bankr. E.D. Tex. 2014); Tabb, Law of Bankruptcy, Third Edition, 2013, § 6.11; 5 Collier on Bankruptcy, ¶ 2425547.03[a], Alan N. Resnick & Henry J. Sommer es., 16th ed. 2017).↩
2 In re Bankvest Capital Corp., 374 B.R. 333, 344 (Bankr. S.D. Fla. 2007).
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