The next time you negotiate a settlement payment with a financially troubled party, you may want to keep in mind an ancient term related to livestock herding: earmarking. The concept may be somewhat antiquated, but the Second Circuit has recently confirmed that it is still viable – and can help you keep the settlement payment if the other party later files for bankruptcy.

The term “earmarking” originated in the 16th century and referred to cuts or marks in the ears of cattle and other livestock for the purpose of identifying an animal’s owner. But as is often the case with the English language, the term has taken on new if not altogether unrelated meanings since its origins in Shakespeare’s England. Indeed, “earmarking” is used in the fields of public finance and politics to refer to funds that are directed for a particular use or project rather than being generally available to the spender.

Similarly, in the world of debtor-creditor relations, “earmarking” refers to funds provided to a debtor by a third party for a specific use, usually for payment to an identified creditor. In Cadle Co. v. Mangan (In re Flanagan),1 the Second Circuit confirmed that a payment made by the debtor to a prepetition creditor was partially protected from avoidance in the debtor’s later bankruptcy by the earmarking doctrine. This decision represents a significant reinforcement of the earmarking doctrine defense and provides guidance for the doctrine’s legal and practical limitations. In particular, Flanagan makes clear that, although earmarking certain payments to prepetition creditors may shield some or all of those payments from an avoidance action, “the [earmarking] doctrine will only protect a transfer from avoidance to the extent it did not diminish the debtor’s estate.”2 And thus, “[w]here a debtor replaces an unsecured obligation with a secured obligation, the payment is voidable to the extent of the collateral transferred by the debtor.”3

Factual and Procedural Background

As the Second Circuit remarked in quoting Sir Walter Scott’s iconic image of the “tangled web we weave,” the Flanagan case presents its readers with an intricate set of facts.4 Prior to Flanagan’s bankruptcy filing in February 1999, Cadle Company and D.A.N. Joint Venture L.P. (collectively, the “Cadle Creditors”) obtained numerous judgments in state and federal court against Flanagan, including a judgment rendered by Judge Cavello of the United States District for the District of Connecticut in the amount of $90,747.87 in March 1997 (the “Federal Judgment”).

At the time of the Federal Judgment, Flanagan held a fifty-percent equity interest in Thompson & Peck, Inc. and Flanagan/Prymus Insurance Group, Inc. (collectively, “Thompson & Peck”), which was evidenced by stock certificates in his possession and valued in excess of $100,000. Six months after the Federal Judgment, Flanagan transferred the Thompson & Peck certificates to Socrates Babacas (“Babacas”) to secure an $85,000 loan (the “Babacas Loan”).

In their effort to collect on the Federal Judgment, the Cadle Creditors subpoenaed Flanagan to appear before Judge Cavello and to produce documents and other communications evidencing Flanagan’s equity interest in Thompson & Peck. Flanagan appeared, but failed to produce the subpoenaed documents. As a result, the Cadle Creditors sought and Judge Cavello granted an order requiring Flanagan to turn over all evidence of his ownership interest in Thompson & Peck, including any and all stock certificates in his possession or under his control (the “Turnover Order”). Flanagan, however, continued to ignore his obligation to produce documents and other relevant evidence. As a result, after a show-cause hearing, Judge Cavello found Flanagan in contempt of court for his willful and intentional refusal to comply with the Turnover Order, and ordered him committed to the Bureau of Prisons until he complied.

In light of his son’s predicament, Flanagan’s father loaned him $100,222.87 “for the purpose of satisfying the [F]ederal [J]udgment” (the “Family Loan”) in order to keep his son out of jail and protect the family name.5 Importantly, the Family Loan was secured by a lien in the Thompson & Peck stock certificates, which were transferred from Babacas to Flanagan’s father shortly after Flanagan received the Family Loan. On November 20, 1998, Flanagan’s lawyer deposited the funds received from the Family Loan in the district court registry, and the Cadle Creditors received the $99,542.87 payment on December 3, 1998 in satisfaction of the Federal Judgment (the “Payment”).

Flanagan filed a chapter 11 bankruptcy petition in February 1999, and initiated an adversary proceeding against the Cadle Creditors to avoid and recover the Payment (the “Preference Action”). Flanagan’s bankruptcy was subsequently converted to a chapter 7 case, and the chapter 7 trustee (the “Trustee”) assumed the prosecution of the Preference Action.

In response, the Cadle Creditors initiated their own adversary proceeding (the “Constructive Trust Action”) and asserted a two-pronged defense against the Preference Action. First, the Cadle Creditors alleged that they were fully secured creditors by virtue of a constructive trust over the Thompson & Peck stock certificates, which, they alleged, they had been unable to execute upon because of Flanagan’s wrongful concealment of his interest in the stock. As fully secured creditors, their receipt of the Payment could not have been a preference. In their second defense, the Cadle Creditors argued that the funds from the Family Loan had been earmarked by Flanagan’s father for the specific purpose of paying the Federal Judgment, and thus, the funds from the Family Loan did not constitute property of the estate for purposes of section 547(b) of the Bankruptcy Code.

The Bankruptcy Court denied the Cadle Creditors’ constructive trust claim and rejected their preference defense based on that ground, noting that the creditors only possessed “an expectation of the potential fruits of execution [on the stock]” and not a clearly vested or indefeasible property right in the stock.6 The Bankruptcy Court went on to hold that the Payment was protected from avoidance by the earmarking doctrine because the Family Loan was made for the “sole and specific purpose of enabling Flanagan to satisfy the [F]ederal [J]udgment.”7. However, the Bankruptcy Court held that the earmarking doctrine defense was limited to the extent that a secured obligation was substituted for an unsecured obligation “because it caused a diminution to Flanagan’s personal estate.”8 After the United States District Court for the District of Connecticut affirmed the decisions of the Bankruptcy Court in the consolidated appeal of the Preference Action and the Constructive Trust Action, the Cadle Creditors and the Trustee filed appeals and cross-appeals to the Second Circuit.

The Legal Standard for Avoiding Preferences

Under section 547(b) of the Bankruptcy Code, a trustee in bankruptcy may set aside a prepetition transfer if it is a 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 the transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the filing of the petition; and (5) that enables the creditor to receive more than the creditor would have received if (A) the case were a case under chapter 7; (B) the transfer had not been made; and (C) the creditor received payment of the debt in accordance with the Bankruptcy Code.

The Cadle Creditors did not contest most of the factors, but argued only that (i) the Payment of funds from the Family Loan did not constitute a transfer of an interest of the debtor in property, and that (ii) the Payment did not enable the Cadle Creditors to obtain more than they otherwise would receive under a chapter 7 liquidation.

Did the creditor receive more than in a chapter 7?

The Cadle Creditors’ argument that the Payment was not a preference because it did not enable them to receive more than they would have received in the chapter 7 bankruptcy centered on their assertion that they were secured by the Thompson & Peck stock: As fully-secured creditors, they would have been paid in full in the chapter 7, and so any funds received prior to the bankruptcy would not have been preferential transfers.

The Second Circuit agreed with the refusal of the Bankruptcy Court and District Court to impose a constructive trust over the Thompson & Peck stock. The Court noted that under Connecticut law, constructive trusts are imposed “to restore to the plaintiff property of which he has been unjustly deprived.”9

Although the Court acknowledged that Flanagan’s misconduct in concealing his ownership interest could potentially give rise to a constructive trust under other circumstances, the Court reasoned that “the Cadle Creditors were never entitled to an ownership interest in the Thompson & Peck stock,” because “under Connecticut’s post-judgment remedy statute the [T]urnover [O]rder only entitled appellants to gain possession of the stock as the first of several steps in executing a levy upon it.”10 Accordingly, the Court rejected the Cadle Creditors’ claim to a constructive trust over the stock, noting as well that a number of courts have described constructive trusts as “anathema to the equities of bankruptcy.”11 Because the Cadle Creditors were not fully secured by the Thompson & Peck stock, the Payment could not be insulated from preference avoidance on that ground.

Was the payment a transfer of the debtor’s interest in property?

The Cadle Creditors’ next defense turned on the earmarking doctrine. As the Court explained, “the earmarking doctrine applies ‘where a third party lends money to the debtor for the specific purpose of paying a selected creditor,’” and thus, “the loan funds are said to be ‘earmarked’ and the payment is held not to constitute a voidable preference.”12

Evolving since its days in livestock herding, the earmarking doctrine had been applied by courts when considering payments made to creditors by guarantors. These courts had concluded that the funds used to make these payments were the property of the guarantor, not the debtor, and thus the payment did not diminish the debtor’s estate in any way. The Flanagan Court noted that the doctrine has been extended to apply “whenever a third party provides funds to the debtor for the express purpose of enabling the debtor to pay a specified creditor, that is substituting a new creditor for an old creditor.”13

While it did not expressly say so, it appears that the Second Circuit adopted a standard that combines the two prevailing approaches in determining whether the earmarking doctrine applies to a particular payment. First, the Court outlined the Eighth Circuit’s test in McCuskey which requires: “(1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement according to its terms, and (3) the transaction viewed as a whole (including the transfer in of the new funds and the transfer out to the old creditor) does not result in any diminution of the estate.”14 Second, the Court highlighted the focus by other courts on the question of “whether the debtor lacked control over the funds supplied by the new creditor.”15

Looking at the facts in Flanagan, the Court found that there was no doubt that “Flanagan’s father provided the Family Loan for the specific purpose of paying the Federal Judgment,” and as such, the Bankruptcy Court’s determination that the Payment had been earmarked to pay the Federal Judgment was not clearly erroneous. 16 Additionally, the Court rejected the Trustee’s argument that Flanagan’s temporary possession of the funds from the Family Loan before it was deposited in the court registry converted those funds to property of the debtor’s estate and rendered the earmarking defense inapplicable. As the Court explained, the test for the proper application of the earmarking doctrine is not “whether the debtor temporarily obtains possession of new loan funds, but instead on whether the debtor is obligated to use those funds to pay an antecedent debt.”17 Indeed, Flanagan’s receipt of the Family Loan funds was conditioned upon their use to satisfy the Federal Judgment, and as a result Flanagan never had any actual control over those funds from the new loan. Accordingly, the Court agreed with both the Bankruptcy Court and the District Court that the earmarking defense did apply to the funds from the Family Loan.

The Court’s affirmation of the earmarking doctrine was not without limitation, however. As the Court noted, “the doctrine will only protect a transfer from avoidance to the extent it did not diminish the debtor’s estate,” so “where a debtor replaces an unsecured obligation with a secured obligation, the payment is voidable to the extent of the collateral transferred by the debtor.”18 Because Flanagan satisfied the unsecured Federal Judgment with the funds received from the Family Loan secured by the Thompson & Peck stock, the earmarking defense could have been rendered useless. Fortunately for the Cadle Creditors, the Court also agreed with the Bankruptcy Court’s finding that the lien obtained by Flanagan’s father in the Thompson & Peck stock supplanted Babacas’s lien in the stock, and thus, the net effect was to diminish the debtor’s estate by the $14,542.87 difference between the Babacas Loan and the Payment to the Cadle Creditors on the Federal Judgment. As a result, only this difference was preferential, and the balance of the Payment was not avoidable as a preference.

Conclusion

For legal trivia buffs, the Flanagan case represents a significant reaffirmation of the earmarking doctrine. While there previously was a fair degree of agreement in the circuit courts as to the existence of the doctrine, it would appear that there was not unanimity on what to call it, as the Flanagan Court itself noted that although the Second Circuit has recognized and applied the doctrine for many years, it was not known as the earmarking doctrine.

More importantly, however, the Flanagan case provides key insights on the scope of the earmarking doctrine. It illustrates that courts will respect this powerful defense to preference actions where there is a clear record that the funds from new loans were made available upon the condition that they be used to pay specific antecedent debts, and that the lending and payment transactions taken together do not diminish the debtor’s estate. Accordingly, whenever possible, creditors contemplating a deal in which they are receiving a settlement payment or being “taken out” by new credit should memorialize the intended purpose of the new funds – and the debtor’s limited ability to use them – to preserve the earmarking doctrine defense. Additionally, creditors should pay strict attention to the nature, mix and size of the new credit and existing debt in order to avoid limiting or even destroying the earmarking doctrine defense based upon the debtor’s replacement of unsecured obligations with secured ones, and the resulting diminution of the estate.