BARBARA J. HOUSER, Bankruptcy Judge.
Plaintiff/Trustee Daniel J. Sherman ("
The Defendants are entitled to summary judgment and the Trustee's motion for partial summary judgment will be denied.
The Trustee filed an extensive objection
The Defendants respond that undefined terms rendered the documents ambiguous and that parol evidence is essential to determine the parties' true intentions concerning the challenged transfers.
Two capitalized but undefined terms—"Debt to be Repaid" and "Loan Parties"—appeared in the loan documents
Accordingly, Trustee's Objections Nos. 4-37 were overruled at trial after which the Defendants introduced evidence—deposition testimony, electronic mail and bank statements—to support their contention that the disputed funds were designated ("earmarked") to satisfy TBK's debt as a condition precedent to DAS's receipt of the rest of the ADESA loan proceeds.
The few remaining evidentiary objections, all of which relate to the Declaration of James B. Allin, TBK's Senior Vice President,
DAS was a vehicle transport company that contracted both with individuals and with corporate customers. It filed chapter 11 on December 21, 2016 (the "
Individual customers paid DAS when they hired the company to transport their vehicles but the debtor would bill corporate customers, issuing invoices payable within thirty days.
The economic downturn in 2009 led to a significant decline in DAS's revenues. DAS required additional funding so it pursued investors to fund approximately $5.3 million in senior secured notes. DAS also entered into a factoring agreement (the "
The day DAS filed chapter 11 it owed TBK $755,906.00, comprising $706,268.37 for purchased accounts
When the additional funding proved insufficient due to unanticipated accounting errors related to DAS's expenses, a steady decline in its revenue and its increased debt, equity holders infused an additional $3 million with the intention of luring significant corporate accounts back to DAS. Unfortunately, DAS's top ten largest corporate accounts suspended service in early April and May 2016, resulting in the company's loss of more than 80% of the prior year's revenue and leaving DAS unable to sustain its debt load.
When it became apparent that DAS's business was declining, its vice president, Timothy Higgins, contacted one of the company's largest vendors, ADESA, Inc. ("
Communications among ADESA, DAS and TBK reflect the parties' understanding that ADESA's funding would occur through a multi-step transaction. First, ADESA would loan money to DAS, some of which would be used to pay TBK and Schiff, with the balance to satisfy other outstanding debt.
As one of the first steps in this series of transactions, ADESA's December 16, 2016 email specifically asked DAS to obtain written confirmation from TBK of the amount needed to repay its debt and its lawyers' fees (the "
Three days before TBK executed the Payoff Letter, on December 16, 2016, DAS entered into a credit agreement with ADESA (the "
The Trustee sued TBK and Schiff to avoid and recover the Transfers as preferential and fraudulent transfers under Bankruptcy Code §§ 547(b) and 548(a)(1). The Defendants' answer asserted defenses, among them that the Transfers were not avoidable because they were made with earmarked funds that a new lender provided.
The Trustee now seeks summary judgment
The District Court for the Northern District of Texas has subject matter jurisdiction over DAS's bankruptcy case and this adversary proceeding under 28 U.S.C. § 1334. Venue is proper in this district under 28 U.S.C. § 1409. The claims among the parties are core proceedings under 28 U.S.C. § 157(b)(2)(C), (H) and (O). The District Court has referred DAS's bankruptcy case and all core and non-core proceedings in the bankruptcy case to this court under the August 3, 1984 Order of Reference of Bankruptcy Cases and Proceedings Nunc Pro Tunc.
In deciding a motion for summary judgment, a court must determine whether the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law. FED. R. CIV. P. 56, made applicable by FED. R. BANKR. P. 7056. In deciding whether a fact issue has been raised, the facts and inferences drawn from the evidence must be viewed in the light most favorable to the non-moving party. Berquist v. Washington Mut. Bank, 500 F.3d 344, 349 (5th Cir. 2007). A court's role at the summary judgment stage is not to weigh the evidence or determine the truth of the matter, but rather to determine only whether a genuine issue of material fact exists for trial. Peel & Co., Inc. v. The Rug Market, 238 F.3d 391, 394 (5th Cir. 2001) ("the court must review all of the evidence in the record, but make no credibility determinations or weigh any evidence") (citing Reeves v. Sanderson Plumbing Prods, Inc., 530 U.S. 133, 135 (2000)). A genuine issue of material fact exists "if the evidence is such that a reasonable jury could return a verdict for the nonmoving party." Pylant v. Hartford Life and Acc. Ins. Co., 497 F.3d 536, 538 (5th Cir. 2007) (quoting Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986)).
"After the movant has presented a properly supported motion for summary judgment, the burden then shifts to the nonmoving party to show with `significant probative evidence' that there exists a genuine issue of material fact." Hamilton v. Segue Software Inc., 232 F.3d 473, 477 (5th Cir. 2000) (internal citation omitted). When parties file cross-motions for summary judgment, the court must review each party's motion independently, viewing the evidence and inferences in the light most favorable to the nonmoving party. Green v. Life Ins. Co. of N. Am., 754 F.3d 324, 329 (5th Cir. 2014).
Bankruptcy Code § 547 authorizes a trustee to avoid and recover a debtor's pre-bankruptcy preferential transfers of property. To recover a preferential transfer under 11 U.S.C. § 547(b), the Trustee must prove:
Union Bank v. Wolas, 502 U.S. 151, 154-55, 112 S.Ct. 527, 116 L.Ed.2d 514 (1991) (emphasis added); 11 U.S.C. § 547(b).
Trustees may also recover a debtor's pre-bankruptcy property transfers that were constructively fraudulent. To prevail on a claim for a fraudulent transfer under Bankruptcy Code § 548(a)(1)(B), the Trustee must prove:
11 U.S.C. § 548 (emphasis added).
The Trustee contends that because the ADESA Agreement did not explicitly obligate DAS to use the ADESA Funds to repay TBK, DAS had dominion over the money and with it unfettered discretion to pay any creditor of its choosing. The Trustee believes these facts are sufficient to negate the Defendants' earmarking defense and show the ADESA Funds became "property of the debtor" for avoidance purposes. The Defendants, in contrast, argue that the ADESA Funds were earmarked to pay off DAS's debt to TBK, a condition precedent to ADESA's providing post-petition funding to DAS.
The Defendants also moved for summary judgment on the Trustee's claims against them. They contend that the ADESA Funds were never property that would have been part of the estate had it not been transferred before the commencement of the bankruptcy. Accordingly, they argue that the Trustee cannot prove an indispensable element for recovery under both §§ 547 and 548: that the transferred property be "of an interest of the debtor in property." They also assert in the alternative that because TBK held a security interest in collateral worth more than DAS's debt to it, its claim was fully secured. As a result, they reason that DAS's pre-bankruptcy transfer of ADESA Funds did not enable TBK to receive more than it would have had DAS liquidated under chapter 7 and so was not a preference under 11 U.S.C. § 547.
A trustee cannot use 11 U.S.C. §§ 547 or 548 to recover a third party's money that was used to pay a debtor's creditor before bankruptcy if the debtor had no interest in the property. See, e.g., Coral Petro. Inc. v. Banque Paribas-London, 797 F.2d 1351, 1356 (5th Cir. 1986). The Bankruptcy Code does not define the term "interest of the debtor in property" but the Supreme Court has interpreted it as "property that would have been part of the estate had it not been transferred before the commencement of bankruptcy proceedings."
The earmarking doctrine is a judicially created defense to this statutory requirement that a voidable preference or fraudulent conveyance include a transfer of an interest of the debtor in property. Where the doctrine applies, the debtor's use of borrowed funds to satisfy a pre-existing debt is not deemed a pre-petition transfer of the debtor's property and therefore is not avoidable as a preference or fraudulent transfer. The theory underlying the defense is that funds a third party advances to a debtor to pay a specific debt never become property of the debtor—they are merely entrusted to the debtor for payment to a creditor.
The doctrine acknowledges that funds may have been in an entity's bank account prepetition yet still beyond its control—and therefore not part of the bankruptcy estate post-petition. See Coral Petroleum, Inc., 797 F.2d at 1356 (Where "a third person makes a loan to a debtor specifically to enable him to satisfy the claim of a designated creditor, the proceeds never become part of the debtor's assets."); Smith v. Suarez (In re IFS Fin. Corp.), 417 B.R. 419, 435-36 (Bankr. S.D. Tex. 2009), aff'd, 669 F.3d 255 (5th Cir. 2012) ("The earmarking doctrine is widely accepted in the bankruptcy courts as a valid defense against a preference claim, primarily because the assets from the third party were never in the control of the debtor and therefore payment of these assets to a creditor in no way diminishes the debtor's estate.").
The first issue in determining whether the Defendants are entitled to the earmarking defense is whether DAS had "control" over the ADESA Funds before they were transferred to TBK and Schiff.
The Defendants argue that the court must consider the "totality of the circumstances" surrounding the transfer in order to determine if the debtor had control over the disposition of funds.
The Trustee's effort to distinguish Coral Petroleum is not persuasive for two reasons. First, the pledge agreements and book entries at issue in Coral Petroleum were not ambiguous. In contrast, the loan documents' ambiguity here necessitated resort to extrinsic evidence. Second, the absence of a single contract underlying the transaction in Coral Petroleum does not govern the outcome here. Coral Petroleum and its progeny
In implementing the "substance over form approach" to assess claims of the earmarking defense, the Fifth Circuit repeatedly has considered extrinsic evidence to determine the degree of debtor's control over the monies allegedly earmarked. See, e.g., Coral Petroleum, 797 F.2d 1351 (considering testimony and telexes between the parties to determine whether deposits into the debtor's general account were subject to restrictions); In re Entringer Bakeries, Inc., 548 F.3d 344, 352 (5th Cir. 2008) (placing significant weight on testimony from loan officers in analyzing debtor's degree of control over funds deposited into its general operating account). Accordingly, because the transaction challenged here involves documents with ambiguities, determining the parties' intent is essential to application of the Fifth Circuit's "control test."
Application of the totality of the circumstances approach to the evidence supports a finding and conclusion that the parties intended that DAS transfer the ADESA Funds directly to TBK, notwithstanding ADESA Agreement § 13.10 and the absence of an explicit provision earmarking the proceeds. An examination of the entire transaction reveals that DAS likewise never had any control over the $1.2 million but was required to repay TBK with the initial ADESA loan proceeds. The evidence supporting this includes:
This evidence establishes that the ADESA loan was structured so that TBK's debt had to be satisfied before ADESA would advance additional funds to DAS.
The Trustee also argues that once the ADESA Funds were deposited and commingled with other funds in DAS's BB&T account, DAS's unfettered control over the money negated the earmarking defense because DAS could use it to pay other creditors. He relies on a specific provision in the ADESA Agreement:
The Trustee ignores evidence conclusively establishing that the ADESA Agreement deprived DAS of dominion over the ADESA Funds. That evidence leaves no room to dispute that the company had to satisfy the TBK debt to receive continued financing under the ADESA Agreement. ADESA Agreement § 10 governed the lender's conditions precedent to making the loan. It recites in relevant part:
Although "Debt to be Repaid" is undefined, parol evidence established that the debt included the TBK debt. Thus, DAS was obligated to use initial proceeds of the ADESA loan to repay TBK so that ADESA would replace it as DAS's senior secured lender. It is not disputed that ADESA would not extend additional financing unless and until TBK was paid off. Putting substance over form, DAS was a mere conduit to facilitate repayment of the TBK loan; all that really occurred was a substitution of one creditor for another—ADESA for TBK. It is irrelevant that the funds "hit the Debtor's operating account" for approximately forty-five minutes as long as the debt owed to TBK was eliminated.
The Trustee's argument that DAS controlled the ADESA Funds because of its momentary possession of the money in its BB&T bank account ignores the Fifth Circuit's holding that control, and not simple possession, determines the availability of the earmarking defense and whether funds are property of a debtor for purposes of avoidance actions. See In re Entringer, 548 F.3d at 349 (employing the Fifth Circuit's "`control test' to determine if a payment was a preference because the money was property of the estate, or if instead the parties `earmarked' the funds for a particular creditor."). See also Coral Petroleum, 797 F.2d at 1356 ("The earmarking doctrine is widely accepted in the bankruptcy courts as a valid defense against a preference claim, primarily because the assets from the third party were never in the control of the debtor and therefore payment of these assets to a creditor in no way diminishes the debtor's estate.") (emphasis added); In re Jazzland, Inc., 161 F. App'x 436, 437 (5th Cir. 2006) (unpublished opinion) (in a preference action, funds in the debtor's bank account were properly excluded from the debtor's estate where the debtor's "only position" as to the funds "was to serve as a conduit to pay the money over to Broadmoor upon satisfaction of all contractual conditions," hence it had no interest in the funds "[b]eyond its role as a delivery vehicle").
As the Fifth Circuit noted, "physical control is not the sole indicator of whether the parties earmarked the money for a particular creditor." Entringer, 548 F.3d at 350. DAS's agreement with ADESA, which required use of the ADESA Funds to pay the Defendants, limited the debtor's use of the money.
In summary, the earmarking defense applies to the Trustee's avoidance actions because DAS did not retain control over the ADESA Funds used to repay TBK. The transfer of the $755,906.00 from ADESA to Defendants was not a "transfer of an interest of the debtor in property" within the meaning of §§ 547(b) and 548(a)(1). The transaction merely substituted one secured lender for another: it resulted in no diminution in assets available to pay DAS's creditors. Accordingly, the Defendants are entitled to summary judgment.
Assuming for the sake of argument that the Defendants did not make out a case for the earmarking defense, the next issue is whether DAS's payments to them were preferential transfers. To prevail on that claim, the Trustee must prove among other things that the Defendants received more than they would had DAS liquidated under chapter 7 of the Bankruptcy Code. 11 U.S.C. § 547(b). See also Braniff Airways, Inc. v. Exxon Co., U.S.A. (In re Braniff Airways, Inc.), 814 F.2d 1030, 1034 (5th Cir. 1987) (Trustee bears the burden of proof). The Defendants have moved for summary judgment alleging that the Trustee cannot meet this burden.
Whether the Defendants received a preference depends on whether the transfers enabled them to receive more than the amount of TBK's secured claim. That in turn depends on the value of TBK's collateral. See 11 U.S.C. § 506(a) (amount of secured claim limited to value of collateral); Dewsnup v. Timm, 502 U.S. 410, 426, 112 S.Ct. 773, 782, 116 L. Ed. 2d 903 (1992) ("An allowed claim of a creditor secured by a lien . . . is a secured claim to the extent . . .") (citing § 506(a)).
The parties do not dispute that TBK held a senior first priority security interest in DAS's accounts and general intangibles as of the date of the Transfers;
The Trustee argues that the Defendants were undersecured—that is, that the amount DAS owed them exceeded the value of their collateral—on the date of the Transfers. The Trustee argues that $499,868.05 of DAS's accounts receivable were uncollectible,
The Defendants insist that TBK was fully secured as of the date of the Transfers. They submitted a DAS accounts receivable aging report into evidence showing the accounts receivable with a value of $1,035,662.25 as of December 19, 2016, two days before the bankruptcy filing.
The best evidence of the value of TBK's collateral is the amount of the debtor's accounts receivable actually collected, rather than a hypothetical value. Although the Fifth Circuit has not specifically addressed this issue, its application of the "after-the-fact determination of value" in Wilson v. First Nat'l Bank, Lubbock Tex. (In re Missionary Baptist Found. of Am., Inc.), 796 F.2d 752, 761-62 (5th Cir. 1986) is persuasive.
Although Missionary Baptist used "after-the-fact" valuation of collateral in applying the ordinary course of business defense under 11 U.S.C. § 547(c)(2), rather than § 547(b)(5), its pragmatic reasoning applies equally here. The evidence of the actual amount of DAS's accounts receivables collected post-petition established the value of the receivables for the purpose of determining the amount of TBK's secured claim.
The Defendants are entitled to summary judgment on their earmarking defense and each of the Trustee's claims.
Counsel for the parties shall confer on a form of judgment consistent with this ruling, to be submitted within ten days of the entry of this Memorandum Opinion on the docket. If they cannot reach an agreement, each party shall submit a proposed judgment on or before the tenth day after entry of this Memorandum Opinion on the docket accompanied by an explanation of why the opponent's proposed order is improper.
Citations to "BC No. ___" refers to documents filed in DAS's underlying bankruptcy case, while citations to "AP No. ___" refers to documents filed in the adversary proceeding.
Trustee's Ex. B [AP No. 51].