Debt Paid by Mother Pre-Bankruptcy Not Preferential Transfer

Posted by NCBRC - October 30, 2020

When the debtor’s mother made a direct payment to one of the debtor’s creditors from an account over which the debtor had no interest or control, the transfer was not an avoidable preferential transfer under section 547(b). Walters v. Stevens, Littman, Biddison, Tharp and Weinberg, LLC. (In re Wagenknecht), No. 19-1206 (10th Cir. Aug. 24, 2020).

Prior to filing for chapter 7 bankruptcy, the debtor incurred over $20,000 in legal fees owed to the law firm of Steven, Littman, Biddison, Tharp and Weinberg, LLC, (the law firm). The debtor asked for and obtained a loan from his mother solely for the purpose of paying the legal fees. The debtor’s mother paid the law firm directly with her own funds. When the debtor later filed for bankruptcy, the trustee sought turnover of the funds paid to the law firm on the theory that the payment was a preferential transfer avoidable under sections 547 and 550. The bankruptcy court agreed, and the BAP for the Tenth Circuit affirmed. The law firm appealed to the Tenth Circuit.

Section 547(b) permits a trustee to avoid the “transfer of an interest of the debtor in property” if the payment was made within 90 days of the bankruptcy filing, while the debtor was insolvent, to repay an antecedent debt. The payment must give the creditor more than he would have received in a chapter 7 bankruptcy. Because the payment was made by the debtor’s mother directly to the law firm, the only issue on appeal was whether the payment to the law firm constituted a transfer of an interest of the debtor in property.

In the absence of a definition in the Code for “an interest of the debtor in property,” the Supreme Court in Begier v. IRS, 496 U.S. 53, 58–59 (1990), held that the phrase is “coextensive with property of the estate as defined in 11 U.S.C. § 541(a)(1).” In Parks v. FIA Card Servs., N.A. (In re Marshall), 550 F.3d 1251, 1255 (10th Cir. 2008), the court found that property of the estate under section 541(a)(1) is broadly defined to include “all legal or equitable interests of the debtor in property as of the commencement of the [bankruptcy] case wherever located and by whomever held.” The Marshall court established two tests to determine whether property is part of the estate: 1. The dominion/control test, and 2. The diminution of the estate test. The former test looks to whether the debtor exercised control over the transferred asset. The latter test looks to whether the transfer of the property diminished the assets of the estate which would otherwise have been available for distribution to creditors.

In Marshall the court found that there had been a preferential transfer under both tests. There, the debtors directed their credit card lender to pay a pre-petition debt to a different credit card lender. The court found that even though the debtors never physically possessed the transferred funds, they used their discretion to borrow the funds and direct the payment to the creditor. The court further found that, once the debtors drew on their line of credit, the funds became part of the bankruptcy estate and, when transferred to the creditor, diminished the estate.

Turning to the facts of this case, the court found that, unlike the debtors in Marshall, the debtor never exercised control over the funds. The debtor’s mother averred that she offered the funds solely for the purpose of paying the legal fees and would not have allowed their use for any other purpose. In fact, she paid the law firm directly without the debtor’s involvement. Because the debtor had no discretion to direct the use of the funds, the court found that he did not exercise dominion or control over them and the first Marshall test was not met. In so holding, the court distinguished cases cited by the dissent in which one creditor gave the debtor money earmarked for the purpose of paying off another creditor. The majority found those cases involved situations in which funds actually passed through or became part of the debtor’s estate prior to being transferred to the ultimate recipient.

The court next looked at whether the transfer diminished the property of the estate and found that it did not. The check the debtor’s mother used to pay the law firm came from her own account in which the debtor had no interest. She paid the law firm directly so the funds never entered the debtor’s possession. Had she not made the transfer, the funds would not have been available to the debtor’s creditors. The Note the debtor signed did not create an estate asset, but rather, memorialized an obligation to his mother. Therefore, the second Marshall test was not met.

The court reversed and remanded.

In a dissenting opinion, Judge Briscoe argued that the bankruptcy correctly treated the transfer as an avoidable preferential transfer. Judge Briscoe argued that, rather than bypassing the bankruptcy estate altogether, when the debtor asked for the loan to pay his creditor and executed a note reflecting that loan, his bankruptcy estate increased by the amount of the loan and his debts increased by the same amount. Essentially, the dissent opined that the debtor effectively and constructively transferred the money himself.

Judge Briscoe also challenged what she deemed an implicit adoption of the earmarking doctrine under which a codebtor on a debt lends the debtor money to pay off the debt. The majority explicitly disavowed application of that doctrine to this case because the law firm did not raise it as an issue on appeal.

Wagenknecht 10th Cir Aug 2020





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