Can another vain attempt to mitigate a $1.5 billion mistake provide the occasion for a thorough review of the doctrine of earmarking? It did for Southern District Bankruptcy Judge Martin Glenn in the long tail on the General Motors bankruptcy case.

The old General Motors Corporation, later known as Motors Liquidation Company, filed its Chapter 11 petition on June 1, 2009. At the time it was believed that a group of banks that had made term loans to GM had a perfected security interest in a substantial amount of GM’s assets. It was discovered shortly after the petition date that, shortly before the petition date, a termination statement terminating the perfection of the banks’ main security interest had been filed in error. Arrangements were made to allow GM’s reorganization to proceed with DIP financing from the governments of the United States and Canada unimpeded by a struggle over the effects of the inadvertent termination statement, and that struggle has now continued for almost an entire decade.

This post will not be burdened with a summary of the struggles of that decade.[1] Most recently, the Bankruptcy Court decided a motion for partial summary judgment in the adversary proceeding being pursued by the Avoidance Action Trust (“ATT”)[2] against the banks under Section 549[3] to recover the $1.5 billion, as an improper post-petition transfer (because the termination statement rendered the banks’ main security interest unperfected), that had been paid to the banks out of the proceeds of the DIP financing. The banks had asserted a defense under the so-called “earmarking” doctrine, and the ATT moved to dismiss that defense. Judge Glenn granted the motion. [4]

In granting the motion, Judge Glenn restated the basis and elements of the earmarking doctrine, along with the Second Circuit precedents, more thoroughly than one usually sees in earmarking cases. He began,

The earmarking doctrine is a judge-made equitable doctrine that does not appear in the Bankruptcy Code. The doctrine protects a transfer from avoidance where a debtor receives funds subject to a clear obligation to use the money to pay off a preexisting debt, the funds are in fact used for that purpose, and the transfer does not diminish the debtor's estate. If these elements are proven, the funds do not become part of the debtor's estate and the transfer cannot be avoided in bankruptcy. In the usual circumstance where an earmarking defense is recognized, one debt is substituted for another with the same priority, and, therefore, no other creditors are worse off.[5]

Judge Glenn held that the earmarking requirement of “a clear obligation to use the money to pay off the preexisting debt” was not satisfied because the DIP loan agreement permitted use of loan proceeds generally for “working capital needs, capital expenditures, the payment of warranty claims and other general corporate purposes.”[6] He rejected the banks’ argument that the order approving the DIP financing preempted the loan agreement and satisfied the “clear obligation” requirement. The DIP order merely “authorized” such use and did not clearly require it.[7] Judge Glenn also brushed off the argument that the clear obligation was found in the DIP loan agreement’s requirement that the loan proceeds be applied “in a manner generally consistent with” an agreed budget which included payment of the banks.[8] If that argument were accepted, wrote Judge Glenn,

it would lead to the absurd result that an earmarking defense would be available in almost every case involving a DIP loan. The Court declines to permit such a significant expansion of the earmarking doctrine.[9]

Judge Glenn also held that the requirement “the transfer does not diminish the debtor's estate” was also unsatisfied. Second Circuit and other precedent established, he said, that the use of the proceeds of a secured loan to pay off an unsecured loan diminishes the debtor’s estate, apparently as a matter of law.[10] Here, the proceeds of the secured, super-priority DIP loan were used to satisfy the unsecured or undersecured loans of the banks--unsecured or undersecured because of the prepetition termination statement and the operation of Section 544 that avoids unperfected security interests, thereby resulting in a diminution of the debtor’s estate.[11]

So much is at stake for the banks that the struggle is likely to continue, and earmarking may re-appear as an issue on an eventual appeal.