The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA, Ret.), analyzing a recent decision of interest:
The Bankruptcy Appellate Panel for the Tenth Circuit (the BAP) rejected the bankruptcy court’s acceptance of the earmarking doctrine as a defense to a preference and fraudulent transfer action brought by a chapter 7 trustee against insiders of the corporate debtor. In a prior chapter 11 case, the confirmed plan had subordinated an insider note to full payment of all unsecured creditors of the estate, but the debtor had used some of the funds loaned and/or guaranteed by the insiders post-confirmation to pay part of the subordinated debt without paying the unsecureds in full. In a subsequent involuntary chapter 7 against the same debtor, the trustee sought to recover those payments, which the bankruptcy court denied but the BAP reversed. Montoya v Goldstein (In re Chuza Oil Company), 2022 WL 171907 (10 Cir. BAP May 27, 2022).
To view the opinion, click here.
Debtor Chuza Oil Co., Inc. was an unprofitable petroleum production company that filed chapter 11 in New Mexico in 2014. Under the terms of its confirmed plan, an insider note (the “Goldstein Note”, owed to the CEO’s father and subsequently payable to his mother Paula after his father’s death) was separately classified from general unsecured creditors, who were to be paid in full before payments were made on the Goldstein Note. After confirmation, the debtor remained unprofitable, causing Paula and the CEO and a related company, who had guaranteed the Goldstein Note, to make further substantial loans to the debtor. At the direction of the lenders, the debtor used some of those loaned funds to pay down the Goldstein Note despite the unsecured class not receiving payment in full.
These efforts to save the company did not succeed and an involuntary bankruptcy was filed in 2018, which resulted in the appointment of chapter 7 Trustee Philip Montoya. The Trustee filed an adversary proceeding against Paula and the guarantors to recover the payments made on the Goldstein Note as preferential transfers, as to some of the funds, and fraudulent transfers as to all. After trial, the bankruptcy court ruled for the defendants, applying the earmarking doctrine to determine that the money paid was not “an interest of the debtor in property” because the funds were directed for payment on the Goldstein Note. The bankruptcy court also found for defendants that they had given a contemporaneous exchange of new value.
The Trustee appealed to the BAP, which reversed, applying the dominion/control test and the diminution of the estate test to determine there had been a transfer of “an interest of the debtor in property.”
The primary issue before the BAP was whether the payments made on the Goldstein Note involved a “transfer of an interest of the debtor in property,” a necessary element to both a preference and a fraudulent transfer action. (Although the BAP also addressed whether there was a contemporaneous exchange for new value, concluding there was not, this review will focus only on the transfer issue.) In the Tenth Circuit and elsewhere, the earmarking doctrine has often been used to defeat the argument that the debtor/estate had such interest. The BAP did a thorough analysis of its circuit’s cases on the issue and concluded that it was not a favored defense. Instead, it should apply the “control test”, which reviews whether the debtor had control over the funds paid by the new creditor, and the “diminution of the estate test”, which asks whether the estate was diminished by the transfer. Both of these tests arise in the same context as earmarking, when a new creditor loans funds and directs that those funds may only be used to pay an old creditor, as happened here when the post-confirmation lenders specified that some of the funds repay the Goldstein Note.
Although the new loans were placed into the debtor’s bank account, that was done only on the condition that some of them be used to pay the Goldstein Note. The BAP determined those facts was not sufficient for the debtor to have control of the money. However, the inquiry did not end there, because the diminution of the estate test saved the Trustee. The BAP concluded that because the payments caused the replacement of subordinated debt with regular unsecured debt, it lessened the chance other unsecured creditors would be paid in full and therefore diminished the estate. It noted that controlling precedent instructs a court to “focus not on the funds entering the estate, but instead on the funds leaving the estate.” Here, each transfer left the estate saddled with regular unsecured debt instead of lower-priority subordinated debt. Moreover, “the court’s focus needs to be on each individual transfer of property, not on different loans that enabled the debtor to pay the noninsider creditors”, even if the loans also contributed to partial payment of the other unsecureds.
Under this diminution of the estate test, the BAP concluded the payments were both preferential as to some and constructively fraudulent as to all because no reasonably equivalent value was given. The Trustee was entitled to recover the payments made on the Goldstein Note.
I urge anyone interested in the application of the earmarking doctrine in general, as well as a defense to a recovery action, to read this analytical opinion. I do agree that in such actions the dominion/control and the diminution of the estate tests address primarily the same issue as does earmarking. Since courts more regularly apply those tests, their use here made sense. Although this is a harsh decision for the mother, it does uphold the dignity of the confirmed plan and compliance with its terms. That result is a definite plus for the bankruptcy system as a whole.
This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA, Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.