The earmarking defense in bankruptcy is a judicially created exception to the statutory power of the bankruptcy trustee under 11 U.S.C.S. § 547 to avoid or set aside an otherwise preferential transfer of assets. The earmarking defense applies when a third person makes a loan to a debtor specifically to enable that debtor to satisfy the claim of a designated creditor. The proceeds of such an "earmarked" loan never become part of the debtor's assets and therefore no preference is created because the transfer does not diminish the value of the debtor's estate. As a judicially created exception to a statutory rule, the earmarking defense must be narrowly construed.
The Trustee in bankruptcy of ESA Environmental Specialists, Inc. ("ESA") appeals from the affirmance by the district court of the award of summary judgment by the bankruptcy court to The Hanover Insurance Co. ("Hanover"). The bankruptcy court concluded that ESA's transfer of $1.375 million to Hanover within 90 days of ESA's filing a petition for bankruptcy was not an avoidable preference.
Did the lower court err in applying the earmarking defense?
The Court held that a critical element for earmarking was lacking: the funds were not used to pay an antecedent debt. The debtor received the funds from the lender, placed them in its own account, and only later deposited them with a bank to secure the surety. The debtor borrowed from the lender, incurring new debt, and used it the money to collateralize both existing obligations to the surety and new bonds. Applying the earmarking defense was error. But, the debtor received new value in the form of its new government contracts (NGC) as a result of the transfer of funds (from the lender to the debtor to the bank to the surety), in excess of the transfer. Nothing contradicted the debtor's former officer's affidavit that the NGCs' face amount exceeded $3.9 million and the new bonds provided the debtor with the ability to proceed with the NGCs and earn revenues in excess of $1.375 million — the face amount of the letter of credit issued by the bank to secure the surety's bonds. The NGCs had a value in and of themselves in excess of $1.375 million. The flow of funds from the lender to the debtor to the bank (for the surety) and the NGCs award was in fact a substantially contemporaneous exchange.