Preferences: When is a Payment Made by a Third Party Not Protected by the "Earmarking Doctrine?"
Case Note Re: Caillouet v. First Bank and Trust (In re Entringer Bakeries, Inc.), No. 07-30499, 2008 WL 4821613 (5th Cir. Nov. 6, 2008) The U.S. Court of Appeals for the Fifth Circuit in Caillouet v. First Bank and Trust (In re Entringer Bakeries, Inc.) reversed the district court's decision that otherwise preferential payments made by a third party on behalf of the debtor was not avoidable pursuant to the "earmarking doctrine," to the extent such payments did not diminish the estate. In concluding that the doctrine was inapplicable, the Fifth Circuit reasoned that the doctrine does not act as an exception to a preferential payment when a debtor had control over the funds before the payment was made. On September 29, 2000, Entringer Bakeries, Inc. (the "Debtor") borrowed $180,000 from First Bank and Trust ("FBT"). The short-term loan matured on December 29, 2000. The purpose of the loan was to allow Entringer time to arrange for long-term financing. Once Entringer obtained long-term financing, it intended to pay off the loan from FBT. Accordingly, Entringer sought a long-term loan from Whitney National Bank ("Whitney"). In negotiating the terms of the Whitney Loan, the Small Business Association (the "SBA") agreed to guarantee the loan but only if Entringer offered certain collateral to serve as security and received additional financing from various other institutions—a condition that delayed closing until after the FBT's maturity date expired. Aware of the circumstances causing the delay, FBT did not issue a notice of default but, rather, permitted Entringer to execute a second promissory note, which required an interest payment on March 5th and a final payment on March 30th. Although Entringer made an interest payment on March 6th, it failed to do so by March 30th, given the Whitney loan had yet to close. As a result, Entringer requested additional time to satisfy its debt. Because FBT understood that the Whitney loan would close in a matter of days, it allowed the loan to mature without issuing notice of default. On April 13th, Entringer delivered a check for $181,702.50 to FBT, satisfying the balance owed. On May 29, 2001, Entringer filed for Chapter 7 bankruptcy. Whitney received $74,381.04 in proceeds from the liquidated collateral. The Chapter 7 trustee then initiated an adversary proceeding to avoid the March 6th and April 13th payments to FBT as impermissible preferences pursuant to 11 U.S.C. § 547(b). Applying the earmarking doctrine, the bankruptcy court held that the payments were not transfers of Entringer's interest in property, but that the payments to FBT were still avoidable as a preference to the extent the payments diminished the value of the estate. As such, the bankruptcy court entered a judgment in favor of the trustee for the value of the collateral, $74,381.04. On appeal to the district court, FBT argued that, because the payment it received was only a fraction of the Whitney loan, its liability should be limited to a pro rata share of the $74,381.04. In contrast, the trustee argued that the earmarking doctrine had no application, and the bankruptcy court had erred in valuing the collateral. Acting in its appellate capacity, the district court affirmed the bankruptcy court's decision. And both parties appealed. The Fifth Circuit reversed the district court's decision. In doing so, it relied on its previous opinion in Coral Petroleum, Inc. v. Banque Paribas-London1and a well-known treatise,2 providing that though the earmarking doctrine is usually a valid defense to a third-party payment, when the debtor controlled the funds and could have paid them to anyone, a court should treat the money as having belonged to the debtor. Applying these principles, the Fifth Circuit held the earmarking doctrine did not apply in the case at bar because Entringer had control over the Whitney loan's proceeds, where the funds were deposited into Entringer's account, Entringer could have done anything it wanted to do with the funds, and Entringer never stipulated that it would use the funds to payoff the FBT loan. Because the Fifth Circuit concluded the earmarking doctrine did not apply, it vacated the bankruptcy court's award and rendered an award to the trustee for the full amount of the preferential payments to FBT. 1 797 F.2d 1351, 1355-56 (5th Cir. 1986). *This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express consent of the American Bar Association." |