The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:
A bankruptcy court in New York has held that a group of term lenders who received payment under a debtor-in-possession order could not invoke an earmarking defense to the estate’s avoidance claims because the order itself authorized the estate to prosecute those claims. [In re Motors Liquidation Co., 2019 Westlaw 367170 (Bankr. S.D.N.Y.).]
Facts: A group of term lenders made a $1.5 billion loan to General Motors; unfortunately, a termination statement was erroneously filed, leaving the security interest unperfected. Following the bankruptcy filing of General Motors, the company obtained debtor-in-possession financing from the United States and Canadian governments. Under the terms of the order authorizing that financing, the term lenders were paid. The order also preserved the estate’s right to pursue avoidance claims against the term lenders.
The estate’s avoidance trust, acting on behalf of the creditors’ committee, challenged the perfection of the term lenders’ security interest due to the filing of the termination statement. The Second Circuit eventually ruled that the security interest had been terminated.
The creditors’ committee then asserted that the transfer of money from the DIP financing to the term lenders constituted an improper postpetition transfer under 11 U.S.C. § 549. The term lenders asserted that under the “earmarking” defense, the money used to pay them had never belonged to the bankruptcy estate in the first place, since it was derived from the DIP financing. The committee brought a motion for partial summary judgment, arguing that the “earmarking” defense was inapplicable.
Reasoning: The bankruptcy court ruled in favor of the committee. The court first set out the basis of the “earmarking” doctrine:
The earmarking doctrine is traditionally raised in response to claims brought under section 547. Under that section, a transfer can only be avoided if it is of “an interest of the debtor in property . . . .” The earmarking doctrine recognizes that this element of a preference action is not satisfied where a third party lends money to a debtor for the specific purpose of paying a particular creditor.
The court held that the “earmarking” defense should not be applied in this context:
The filing of the erroneous UCC-3 Termination Statement was known by the Term Lenders and the Committee before the Final DIP Order was negotiated and entered. The Term Lenders were able to flex their leverage to threaten the Debtors’ ability to complete a prompt section 363 sale of substantially all of the Debtors’ assets unless the Term Lenders were repaid in full. Repayment, however, was expressly subject to the Committee’s right to seek to claw back the amount repaid. The repayment enabled the Term Lenders to recover more than they would have recovered as undersecured creditors, and substantially more than unsecured creditors were likely to recover many years later. The repayment to the Term Lenders violated a fundamental principle of bankruptcy—equality of distribution. Only the clearest statement in the Final DIP Order preserving the equitable earmarking defense would justify such a result.
The term lenders then argued that the DIP order did include language showing that the funds were earmarked. That order provided that the debtors were “authorized to apply and shall apply the proceeds of the DIP Credit Facility to repay amounts outstanding under the Prepetition Senior Facilities . . . .” But the court rejected that argument, holding that the term lenders’ reading of the order would have contradicted the “clawback” language contained within Paragraph 19 of the same order:
Paragraph 19 of the Final DIP Order provides that Old GM shall use the DIP proceeds to repay the Term Lenders, subject to the AAT’s right to challenge that transfer after the fact. It is nonsensical to read paragraph 19 as creating a clear obligation upon which an earmarking defense can be based. The earmarking doctrine prevents a transfer from being successfully challenged. If paragraph 19(a) gave rise to an earmarking defense, then the reservation of rights in paragraph 19(d) would serve no purpose. It would be a perversion of the equitable earmarking doctrine to apply it in the circumstances of this case absent a clear statement in the Final DIP Order preserving the earmarking defense when DIP Loan proceeds were used to repay the Term Lenders subject to an express challenge provision.
Author’s Comment: I have doubts about the court’s reasoning. The “clawback” provision contained in the DIP order can be viewed in two different ways: either it simply confers standing on the estate to pursue avoidance actions, or it determines in advance the merits of those avoidance claims. In holding that earmarking could not be asserted against the estate, the court in essence held that the DIP order had already determined the merits of the avoidance claims.
Given that the erroneous termination statement was already a known problem when the DIP order was entered, it does make sense to view the “clawback” language as a provision that preserved the estate’s standing to challenge the perfection of the lien following the filing of the UCC-3. But it makes less sense to hold that the “clawback” authorization totally precluded the “earmarking” issue, since the DIP order itself expressly earmarked the money for the benefit of the term lenders.
In hindsight, perhaps it would have been better if the DIP order had said that although the estate’s avoidance claims were deemed preserved and could be asserted later, the preservation of the estate’s right to assert those claims was not a determination of the merits of those claims.
From a policy standpoint, the court’s statement about “equality of distribution” rings hollow. Let us not forget that if the committee ultimately prevails, the unsecured creditors will receive a $1.5 billion windfall from the secured creditors, all because some clerk filled out a form incorrectly. This has nothing to do with equality; it is just a high-stakes game of “gotcha!”
For a discussion of the Second Circuit’s earlier opinion in this case, see 2015-04 Comm. Fin. News. NL 8, Lender Inadvertently Authorized Filing of Erroneous Termination Statement, Invalidating $1.5 Billion Security Interest.
These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.