Business Law

Montoya v. Goldstein (In re Chuza Oil), ___ F. 4th ___, 2023 WL 8588589 (10th Cir. Dec. 12, 2023)

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The Tenth Circuit Court of Appeals (the Circuit Court) recently applied the earmarking doctrine to determine that a debtor did not have an interest in funds that were used to pay subordinated debt, in contradiction to the terms of a chapter 11 plan.  The decision reversed the Tenth Circuit Bankruptcy Appellate Panel (the BAP), which had reversed the original decision of the bankruptcy court.  Montoya v. Goldstein (In re Chuza Oil), ___ F. 4th ___, 2023 WL 8588589 (10th Cir. Dec. 12, 2023). To view the opinion, click here.

FACTS

Chuza Oil Co. (Chuza or the debtor) was a New Mexico petroleum production company controlled by shareholder, CEO, and director Bobby Goldstein.  Goldstein also operated another company, Bobby Goldstein Productions, Inc. (BGPI) which he used to help run Chuza. In 2012 Goldstein’s father loaned Chuza $500,000 under a note guaranteed by Goldstein and BGPI. The one year note could be extended and was on such extension when the bankruptcy was filed.  After the father died, Goldstein’s mother Paula held the note.

In 2014 Chuza filed chapter 11.  The bankruptcy court confirmed the plan in March 2018, which subordinated Paula’s note because of her insider status. With business still faltering, between September 2016 and December 2017, Goldstein and BGPI made a series of loans to Chuza, totaling $500,000.  Contrary to plan terms, from the funds paid to Chuza, the debtor paid $46,885 to Paula (the Funds).  Per the uncontradicted testimony of Goldstein, the loans in 2016-2017 were conditioned on Paula receiving the sums then due on the note.

In July 2018 the case was converted to chapter 7.  Philip Montoy was appointed chapter 7 trustee (the Trustee), who filed an adversary proceeding against Goldstein, Paula, and BGPI alleging the payments to Paula were preferential and fraudulent transfers.  The bankruptcy court ruled for the defendants, concluding that Chuza never had a cognizable interest in the Funds because they were earmarked for Paula.  On the preferential transfer claim, it also found the transfers were part of a contemporaneous exchange for value.  The BAP reversed, finding that Chuza had an interest in the Funds because the transfers diminished the estate.

The defendants appealed to the Circuit Court, which reversed the BAP and reinstated the bankruptcy court’s judgment.

REASONING

The defendants asserted that the Funds were never the debtor’s property because they were earmarked to pay Paula’s note. The Circuit Court recognized that the earmarking doctrine is a judicially created mechanism to determine whether a debtor had an interest in transferred property.  It allows a debtor to borrow money to pay an existing creditor without the payments being avoided because the funds were “earmarked” to pay only that creditor and never belonged to the debtor. The Circuit Court has traditionally applied two criteria to determine whether a debtor retained an interest in the transferred property.  First it applies the dominion test, determining whether the debtor retained control over the property.  Second, it examines whether the transfer diminished the size of the bankruptcy estate.

Here, although the Funds briefly passed through Chuza’s bank account, the Circuit Court concluded that the debtor had no control over the use of them.  The bankruptcy court made a factual finding that Goldstein had placed a valid condition on the money he loaned to the debtor that payments go directly to Paul on her note.  This finding, which was not clearly erroneous, meant that Chuza could not use the Funds for any purpose other than paying Paula, so it did not control them.

To apply the diminution of the estate test, the Circuit Court considered the entirety of the loan transactions, not the isolated payment to Paula.  It noted that the specific transfer to Paula paid a subordinated debt and as to that sum, the debt was replaced by a priority debt for repayment under the plan.  However, Goldstein and BGPI had infused almost $500,000 into the estate which they would not have done without the condition that Paula be paid.  This net infusion into Chuza led to the reasonable conclusion that the transfer did not diminish the estate.

Both the fraudulent transfer claim and the preferential transfer claim required that the transfer be of the debtor’s property.  Because Chuza had no cognizable interest in the Funds, they were not property of the estate.  In addition, since the transfer did not diminish the estate, the earmarking doctrine protected the transfers to Paula.

The Circuit Court also addressed the defendants’ alternative argument that the transfers were part of a contemporaneous exchange for value.  It considered again the totality of the loans from Goldstein and BGPI and the testimony of Goldstein that his intent was to pay the entire $500,000 to Chuza in exchange for its promise to repay some of it to Paula.  The entire loan qualified as the contemporaneous exchange for value, defeating the preferential and fraudulent transfer claims.

AUTHOR’S COMMENTS

The test for earmarking used by the Circuit Court is similar to the test in many other jurisdictions.  The interesting part of this ruling is the manner by which it addressed whether the transfer diminished the estate, as the BAP had ruled.  Its approach was grounded in reality based on these facts, where the shareholder testified that he would not have made any of the $500,000 loans if his mother was not paid.  Anyone tasked with protecting a transfer with the earmarking doctrine should be prepared to satisfy the two part test.  However, a practitioner can think creatively when it comes to the second prong, as was done here. 

[The Commercial Financial Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section.  This article was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, CD CA, ret.), a member of the ad hoc group.  The opinions contained herein are strictly those of the author.]


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