The Earmarking Doctrine: Borrowing From Peter to Pay Paul

The requirements to establish that a pre-bankruptcy asset transfer can be avoided as a preference by a trustee or chapter 11 debtor-in-possession (“DIP”) are well known to bankruptcy practitioners. Any transfer made by a debtor to a creditor within a certain time frame prior to the debtor’s bankruptcy filing will come under scrutiny to determine whether it can be avoided, as a means of maximizing the assets in the bankruptcy estate and ensuring that one creditor (or group of creditors) is not unfairly preferred over the body of general creditors. Preferential transfer issues affect both unsecured and (to a lesser extent) secured creditors and can be the source of intense litigation.

The elements of a voidable preference are spelled out in section 547 of the Bankruptcy Code. Section 547(b) provides in substance that transfers of property to (or for the benefit of) creditors made on account of an antecedent debt within the 90 days before a bankruptcy filing (or up to one year for “insiders”) while the debtor was insolvent can be avoided by a trustee or DIP, if the transferee received as a result a greater recovery on its claim than it would have received had the transfer not taken place and the debtor’s assets been liquidated in a chapter 7 case. However, there are exceptions to the rules—certain transactions have been given safe haven (by statute or otherwise) despite facially being voidable preferences.

One such safe haven is the earmarking doctrine, a judicially created doctrine that is most frequently invoked in the context of a refinancing that occurs within the 90 days prior to a bankruptcy filing. By closely following the requirements of the doctrine, lenders can help refinance troubled debtors, and prior mortgage holders can be relieved of their debt without fear of the transfer being attacked as a preference. However, courts have made clear in a number of recent rulings just how cautious creditors seeking to invoke the doctrine must be to ensure that the safe haven offered by the earmarking doctrine does not prove to be illusory.

Elements of the Earmarking Doctrine

A creature of judicial invention, the earmarking doctrine provides an equitable defense for a creditor in a preference action. The earmarking doctrine provides that the debtor’s use of borrowed funds to satisfy a pre-existing debt is not deemed a transfer of property of the debtor and therefore is not avoidable as a preference. If a third party provides funds for the specific purpose of paying a creditor of the debtor, hence “earmarking” them for that purpose, the funds may not be recoverable as a preferential transfer. The doctrine rests on the idea that the funds are not within control of the debtor, and because one debt effectively is exchanged for another, there is no diminution of the debtor’s bankruptcy estate.

Three requirements have been uniformly established as the criteria necessary to apply the earmarking doctrine as a defense to a preference action: (i) there must be an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt; (ii) the agreement must be performed according to its terms; and (iii) the transaction viewed as a whole (including the transfer in of the new funds and the transfer out to the old creditor) must not result in any diminution of the bankruptcy estate.

While the earmarking doctrine is frequently accepted as a valid defense to a preference action, courts are divided on the applicability of the doctrine to a preference action in a “refinance” situation where the new lender delays perfection of its security interest under the circumstances described in section 547(e) of the Bankruptcy Code, which provides a lien perfection grace period to secured creditors. Not wanting to punish a pre-existing creditor for the inaction of the new creditor, courts generally agree that the earmarking defense insulates from preference recovery the receipt of funds by the pre-existing creditor from the new lender. But courts disagree as to whether the earmarking defense insulates the new lender from preference exposure following its failure to perfect in a timely fashion. This unusual scenario was recently addressed by a Sixth Circuit bankruptcy appellate panel in Baker v. Mortgage Electronic Registration Systems, Inc. (In re King), where the court aligned itself with courts that refuse to insulate the tardy new lender by strictly following the guidance provided by the Sixth Circuit Court of Appeals in Chase Manhattan Mortgage Corp v. Shapiro (In re Lee).


The debtors in King refinanced their home in 2005, obtaining a new mortgage to pay off the two original mortgages they had obtained in 2004. They executed a mortgage in favor of the new lender, Mortgage Electronic Registration Systems, Inc. (“MERS”), but MERS did not record the new mortgage until 28 days later. The debtors filed a chapter 7 petition in Kentucky less than 90 days following the refinancing transaction (and one day before the effective date of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”)). The chapter 7 trustee sued to avoid the new mortgage as a preference. The bankruptcy court ruled that the new mortgage was avoidable, finding that: (i) because MERS failed to perfect its lien within the grace period specified in section 547(e), the obligation incurred by the debtors in the form of the new mortgage was “on account of an antecedent debt,” as required by section 547(b); and (ii) the earmarking doctrine did not insulate the transfer from avoidance because the challenged transfer did not involve repayment of the original mortgage, but incurrence of the new mortgage obligation, and because MERS’ perfection of its mortgage after expiration of the statutory grace period resulted in diminution of the estate. MERS appealed to the bankruptcy appellate panel.

The appellate panel affirmed in an unpublished opinion. Noting that the facts of this case differed from those present in the Sixth Circuit’s decision in Lee only in the respect that Lee involved a refinancing with a single lender, while two separate lenders were involved in King, the court found the two cases otherwise indistinguishable and reached the same legal conclusion. MERS’ failure to perfect its mortgage until 28 days after funding the new loan (after expiration of the statutory grace period for perfection), the court emphasized, was fatal to its efforts to establish that it was entitled to the safe haven of either the earmarking doctrine or the statutory exception to avoidance specified in section 547(c)(1), which protects from avoidance a transfer involving “a contemporaneous exchange for new value.” According to the court, had MERS perfected its mortgage within the 10-day grace period specified in section 547(e) (increased to 30 days by BAPCPA), MERS would have simply stepped into the shoes of the pre-existing lender, there would not have been any antecedent debt, and the debtor’s estates would not have been diminished in any way by incurring a new obligation within the preference period. Because it failed to do so, the court reasoned, perfection of the new mortgage was an avoidable preference.

Betty’s Homes

An Arkansas bankruptcy court refused to shield a transfer under the earmarking doctrine under a different theory in Betty’s Homes, Inc. v. Cooper Homes, Inc. (In re Betty’s Homes, Inc.). Betty’s Homes, Inc., was a homebuilder and received a variety of materials to build homes from Cooper Homes, Inc. When Cooper Homes informed Betty’s Homes that it would be filing materialman’s liens on several homes, Betty’s Homes went to Community First Bank (“CFB”) and was able to draw down $200,000 on its existing construction loan with CFB, which Betty’s Homes then used to pay Cooper Homes. CFB maintained its previously perfected security interest in the properties. After Betty’s Homes filed for chapter 11 protection in 2006, the trustee under the company’s liquidating chapter 11 plan sued Cooper Homes to recover the $200,000 payment.

The bankruptcy court, applying the three elements of the earmarking doctrine, found that there was an agreement that the funds would be used to pay Cooper Homes, and the funds were in fact used that way. However, it concluded that the transaction, when viewed as a whole, resulted in diminution of the bankruptcy estate. Any claims secured by liens that Cooper Homes threatened to file before Betty’s Homes borrowed money to pay them, the court emphasized, were unsecured because Cooper Homes had not perfected those liens at the time the debtor made the payment. Thus, the court explained, Betty’s Homes swapped unsecured debt for secured debt during the statutory preference period, and the earmarking doctrine could not save the payment from avoidance. According to the court, “[b]ecause this is not simply a substitution of a creditor in a class for another creditor in the same class, the earmarking doctrine is not applicable.”


Section 547(b) of the Bankruptcy Code expressly provides that the trustee may avoid “any transfer of an interest of the debtor in property” if the conditions enumerated in the remainder of the section are satisfied. At its core, the earmarking doctrine relies on the premise that property transferred is never the debtor’s property because it was merely entrusted to the debtor for payment to a creditor. The first two requirements of the earmarking-doctrine test address the “property of the debtor” issue to an extent, but a ruling recently handed down by the Fifth Circuit Court of Appeals in Caillouet v. First Bank and Trust (In re Entringer Bakeries, Inc.), 548 F.3d 344 (5th Cir. 2008), brings the importance of this requirement into focus.

In Entringer, Entringer Bakeries, Inc. (“Entringer”), sought a loan from Whitney National Bank (“Whitney”) to repay a loan provided by First Bank and Trust (“FBT”) that was secured by a guaranty and pledge of a personal brokerage account owned by one of Entringer’s principals, but not by any of the company’s assets. Whitney agreed to loan the debtor the money necessary to pay off the FBT loan and in doing so deposited the funds needed to repay FBT into Entringer’s general bank account (approximately $180,000), but with no written restrictions on how the money was to be used. Entringer used the money the following day to repay the FBT loan. After Entringer filed for chapter 7 protection in 2001 in Louisiana, the bankruptcy trustee sued to avoid the payment to FBT as a preference. Applying the earmarking doctrine, the bankruptcy court held that the payments to FBT were not transfers of Entringer’s property. However, it ruled that payment of earmarked funds to an unsecured creditor, such as FBT, were avoidable as a preference to the extent of the value of the collateral given to the new lender, Whitney. Thus, the court entered a judgment in favor of the trustee for just over $74,000, the value of the collateral pledged to secure the Whitney loan. FBT appealed to the district court, which affirmed, and then to the Fifth Circuit.

The court of appeals affirmed, but only in part. Rejecting the trustee’s argument that “the earmarking doctrine is no longer a viable exception to a preferential transfer under § 547(b),” the Fifth Circuit concluded that the doctrine did not apply because the funds transferred were never “earmarked” for payment, as Entringer had dispositive control over the loan proceeds and could have done anything it wanted with the funds. Although not dispositive, the court found it “particularly relevant” that no formal agreement existed between the debtor and Whitney to ensure that the money was paid to FBT. The intent of the parties had no bearing on the applicability of the doctrine. Finally, the court of appeals faulted the bankruptcy court’s calculation of damages, vacating the award and directing that judgment should be awarded in favor of the trustee for the full amount of the $180,000 payment made to FBT, not merely the value of the collateral pledged by Entringer to secure the Whitney loan.


These rulings are a cautionary tale for creditors intent upon minimizing preference exposure by relying upon the earmarking doctrine as a defense. Underpinning all of them is the reluctance of bankruptcy courts to recognize exceptions (especially nonstatutory exceptions) to a trustee’s power to avoid transfers that unfairly prefer a single creditor. If a financially strapped company discloses to a creditor that it intends to borrow money to pay off its debt, the creditor should insist upon strict compliance with the requirements of the earmarking doctrine, including a written agreement explaining the purpose of the loan and directing that the borrower may use the loan proceeds only to repay the existing debt.

By way of a postscript, the need for strict compliance with the requirements of the earmarking doctrine in avoidance litigation was the message conveyed unequivocally in a ruling handed down at the very end of 2008 by the Tenth Circuit Court of Appeals. In Parks v. FIA Card Services, N.A. (In re Marshall), the court became the first federal circuit court of appeals to rule that using one credit card to pay off another within 90 days of a bankruptcy filing is an avoidable preferential transfer to the bank that was paid off. Reversing the lower courts’ rulings on the issue, the Tenth Circuit concluded that the so-called earmarking defense shields a payment from avoidance as a preference only “when the lender requires the funds be used to pay a specific debt.”


Baker v. Mortgage Electronic Registration Systems, Inc. (In re King), 397 B.R. 544 (Bankr. 6th Cir. 2008).

Chase Manhattan Mortgage Corp v. Shapiro (In re Lee), 530 F.3d 458 (6th Cir. 2008).

Betty’s Homes, Inc. v. Cooper Homes, Inc. (In re Betty’s Homes, Inc.), 393 B.R. 671 (Bankr. W.D. Ark. 2008).

Caillouet v. First Bank and Trust (In re Entringer Bakeries, Inc.), 548 F.3d 344 (5th Cir. 2008).

Parks v. FIA Card Services, N.A. (In re Marshall), 2008 WL 5401418 (10th Cir. Dec. 30, 2008).