AB&C Group Inc.

OCR transcription for search; preserved printed pages are authoritative

IN THE UNITED STATES BANKRUPTCY COURT
FOR THE NORTHERN DISTRICT OF WEST VIRGINIA

IN RE:

)
)
AB&C Group, Inc. ) Case No. 08-482
)
Debtor. )

Chapter 7

MEMORANDUM OPINION

Before having an involuntary Chapter 7 bankruptcy petition filed against it, AB&C Group,
Inc. (the Debtor”), caused its secured lender, Sovereign Bank, to deposit $309,226 in its account for
the purpose of paying the wages of its employees. The Debtor’s Chapter 7 trustee asserts that the
money is property of the Debtor’s bankruptcy estate. The Debtor and Sovereign Bank request that
the money be immediately paid to the Debtor’s employees as they had originally intended.

For the reasons stated herein, the court finds that the money is property of the Debtor’s
bankruptcy estate and may be used by the Trustee in the administration of the Debtor’s estate.
Before addressing the merits of the parties’ arguments, however, and for the benefit of the non-
lawyer parties that have expressed an interest in this issue, a brief overview of the bankruptcy
process is helpful to understand the impact of the court’s decision.

When a Chapter 7 bankruptcy case is filed, alt legal and equitable interests of the bankrupt
debtor in property becomes property of the debtor’s bankruptcy estate. 11 U.S.C. § 541 (aj). A
Chapter 7 trustee is appointed, and is charged with the task of collecting and reducing to money the
property of the debtor “as expeditiously as is compatible with the best interests of the parties in
interest.” § 704(a)(1). In fulfilling the trustee’s duties, the trustee may elect to hire professionals
to investigate the assets and liabilities of the debtor, and the trustee is given special powers under
the Bankruptcy Code to bring certain legal actions against parties that have dealt with the debtor in

an effort to maximize the assets of the bankruptcy estate. §§ 327, 544, 547, 548.
1

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
. 3 Document Page 1 of 16

~

In the main, the Bankruptcy Code aims to secure equal distribution among the debtor’s
creditors. Howard Delivery Service, Inc. v. Zurich Am. Ins. Co., 547 U.S. 651, 655 (2006). Not ail
creditors, however, are treated equally. Congress created certain classes of priority creditors that are
entitled to be paid, in full, before lower ranking priority creditors are paid, and all priority claims
must be fully satisfied before the general unsecured creditors of a debtor receive any distribution
from the bankruptcy estate. Most bankruptcy cases do not generate sufficient funds to pay all
creditors in full, and many bankruptcy cases do not generate sufficient funds to pay priority creditors
in full.

In general, the first creditors to be paid out of assets of the debtor’s bankruptcy estate are
those lenders who have taken a security interest in collateral that the trustee has sold. After the
satisfaction of liens secured by the value of property sold by the trustee, unsecured creditors of the
bankruptcy estate are paid in order of priority. The first group of unsecured claimants to be paid are
those owed domestic support obligations. 11 U.S.C. §§ 507(a)(1), 726(a)(1). A corporate debtor,
tike the Debtor in this case, will not owe any domestic support obligations, but it may be obligated
to make those payments on behalf of its former employees. '

The second group of claimants to be paid are those who are owed administrative expenses.
§ 507(a)(2). Administrative expense claimants are those who render services to the bankruptcy
estate, or who incur expenses preserving the estate. In this case, the fees and costs of the Debtor’s
Chapter 7 trustee, and of any professionals he hires, will likely constitute administrative clatms
entitled to second priority status. These administrative claims must be fully paid before any other
unsecured, priority creditor can receive payment.

Third in order of priority are creditors whose claims against the debtor arose after the filing
of an involuntary bankruptcy petition, but before the appointment of the Chapter 7 trustee. §

507(a)(3). In this case, an involuntary petition was filed against the Debtor on April 4, 2008, and

' The Bureau of Child Support and Enforcement has filed a motion for the payment of
domestic support obligations. (Document No. 73). According to the motion, the Bureau
received 16 dishonored checks written by the Debtor on behalf of those employees that owe
domestic support obligations. The Trustee has objected to the motion, and its resolution is still
pending before the court.

2

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 2 of 16

the Chapter 7 trustee was appointed on April 24, 2008.2 It remains unclear whether any creditor
exists in this case that is entitled to priority treatment under § 507(a)(3).

Fourth, and of primary importance in this case, “allowed unsecured claims ... to the extent
of $10,950 for... wages, salaries, or commissions, including vacation, severance, and sick leave pay
earned by an individual” must be paid from assets of the estate. Apparently, no employee of the
Debtor in this case is owed more than $10,950. In the ordinary course of the administration of the
Debtor’s bankruptcy case, all employee wage claims must be fully paid before any other lower
priority creditor is entitled to receive a penny.

With this understanding of the larger bankruptcy process, four different tensions are affected
by the court’s decision in this case. The first concerns the timing of payment to the Debtor’s
employees, Ifthe Debtor and Sovereign Bank are successful, the employees would receive payment
of their wage claims quickly. If the Trustee is successful, however, payment would not be made to
the employees until such time as the Trustee is assured that enough funds exist in the bankruptcy
estate to fully pay higher ranking priority creditors. Depending on how quickly the Trustee can
identify and liquidate unencumbered assets of the bankruptcy estate, the delay in the payment of the
employees’ wages could be lengthy.

The second tension in the case concerns whether, after investigation and the hiring of
professionals, the Trustee will be able to liquidate any property for the benefit of the bankruptcy
estate’s creditors. The Trustee may spend a substantial amount of money investigating the Debtor,
and its transaction with third parties, only to find that nothing exists to liquidate. In such an event,
the $309,226 currently available to pay employee wage claims may be substantially reduced (or even
eliminated) by the estate’s administrative expenses, resulting in the employees receiving less than
the full amount of their wage claims.

Third, and cynically, one could postulate that the Debtor may benefit from depriving the

Trustee of the financial resources necessary to launch a thorough, independent investigation into its

’ Claims entitled to third priority under § 507(a) are those that arose after the filing of the
involuntary petition but before the earlier of the appointment of a trustee or the entry of the order
for relief that commences the bankruptcy case. Here, the Trustee was appointed before the court
granted the involuntary petition on May 1, 2008.

3

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 3 of 16

financial affairs.’

The fourth tension concerns the interests of lower ranking priority creditors and the general
unsecured creditors of the Debtor’s bankruptcy estate. If the Debtor and Sovereign Bank are
successful, and if the Trustee is deprived of funds to launch an investigation into the Debtor’s
financial affairs, these lower ranking unsecured creditors may not receive any return on their claims.
On the other hand, these creditors have nothing to lose and everything to gain should the Trustee
have adequate resources to investigate the financial affairs of the Debtor.

Therefore, like most issues in bankruptcy court, there are no clear-cut equities; there are only
competing interests. With this understanding of the impact of the court’s decision in this matter, the
court turns to a review of the relevant history of this case, and the merits of the parties’ arguments.

I. BACKGROUND

The Debtor is a subsidiary of Blue Sky Brands, Inc. (“Blue Sky”). When it was in operation,
the Debtor provided catalogue order management for various companies. It maintained facilities in
Martinsburg and Ranson, West Virginia, and in Orange, Virginia. On March 21, 2006, the Debtor,
along with Blue Sky and certain other related entities,’ executed a Revolving Credit and Term Loan
Agreement with Sovereign Bank, Pursuant to that Agreement, Sovereign Bank purports to have a
lien on substantially all of the Debtor’s assets.

According to the Debtor, it defaulted on the March 21, 2006 Agreement, and it was a party
to a February 4, 2008 Forbearance Agreement with Sovereign Bank that terminated on March 15,
2008. When Sovereign Bank, Blue Sky, the Debtor, and related entities were unable to work out a
more permanent loan agreement, Sovereign Bank terminated its funding and swept the Debtor’s bank
accounts. As a result, the Debtor did not have sufficient funds to pay its employees their wages.

On March 27, 2008, the Debtor and related entities executed a Letter Agreement with
Sovereign Bank concerning the winding down of its business and the liquidation of its assets (the

“Letter Agreement”). The purpose of the Letter Agreement was to allow Sovereign Bank to conduct

* The Trustee stated to the court that he was unable to locate any other readily available
assets that he could use to pay for a thorough investigation of the Debtor’s financial affairs.

* The related entities are Bits and Pieces, Inc., The Paragon Gifts, Inc., The Paragon Gifts
Holdings, Inc., National Wildlife Direct, Inc., and Winterthur Direct, Inc.

4

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 4 of 16

a secured party liquidation of the Debtor and related entities, so that Sovereign Bank could collect
the proceeds. Not all the anticipated liquidation proceeds were immediately payable to Sovereign
Bank. The Letter Agreement allows Blue Sky, the Debtor, and related entities, access to 25% of the
first $1.4 million in proceeds, and greater percentage amounts for additional proceeds received, for
the purpose of paying certain “Scheduled Liabilities,” as defined in the Letter Agreement. The
Scheduled Liabilities included the $309,226 owed by the Debtor to its employees.

In anticipation of the receipt of liquidation proceeds, Sovereign Bank agreed to immediately
advance the $309,226 to the Debtor so that it could timely pay its employees. The $309,226 was
designated as the “Advance” under the Letter Agreement, and the money was sent by Sovereign
Bank to the Debtor’s bank account. The portions of the Letter Agreement relevant to the issues

before the court are as follows:

This letter is intended to set forth the terms on which Sovereign Bank (the ““Bank”’)
has reached agreement with the Borrowers! concerning a wind down of the
Borrowers’ businesses and the liquidation of the Borrowers’ assets for the benefit of
the creditors of the Borrowers, in the order of priority dictated by applicable law.

The context of his agreement is that the Bank has notified the Borrowers that they are
in default of their obligations to the Bank, and has ceased making loans and
advances to the Borrowers under their revolving credit facilities with the Bank (the
“Credit Facilities”). The Borrowers have ceased operations and have terminated the
employment of their employees. Numerous Habilities incurred by the Borrowers
have not been paid, the Borrowers have requested that the Bank make funds available
to pay certain of these liabilities as listed on Schedule A to this agreement (the
“Scheduled Liabilities”), and the Bank, subject to the provisions hereof, is willing to
make funds available to effectuate the payment of them.

Accordingly, the Bank and the Borrowers agree as follows:

7K

4. The Borrowers and the Bank intend that the Bank shall conduct the
Liquidation [of the Borrowers’ assets] in the exercise of its rights as a secured
creditor of the Borrowers (the “Secured Party Liquidation”), and the Bank shall

> The term “Borrowers” is defined in the Letter Agreement to include: Bits and Pieces,
Inc., The Paragon Gifts, Inc., The Paragon Gifts Holdings, Inc., National Wildlife Direct, Inc.,
and Winterthur Direct, Inc.

5

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 5 of 16

receive all proceeds thereof (the “SP Proceeds”). The Borrowers and the Bank
understand that the Bank may be prohibited or stayed from conducting a Secured
Party Liquidation, in whole or in part, and the Liquidation may be conducted, in
whole or in part by a third party, such as a Trustee in Bankruptcy....

5. The Borrower requests, and the Bank agrees, that from the gross proceeds
actually received by the Bank for a Secured Party Liquidation .. . the Bank shall
make available to or for the account of the Borrowers to pay the Scheduled
Liabilities, a total amount equal to the lesser of: (A) the difference of (i) the sum of
(a} twenty-five percent (25%) of the first $1,400,000 of Realized Proceeds... (..
. hereinafter referred to as the “Carve Out’).

6. In anticipation of the receipt of Realized Proceeds, the Bank will immediately
make to or for the account of the Borrowers an advance pursuant to the Credit
Facilities up to the amount of $345,000 (the ‘“Advance”) so that the first seven items
on Schedule A may be paid immediately. The Bank shall be entitled to recover the
Advance from the Carve Out before any other funds from the Carve Out are paid to
or for the account of the Borrowers to pay Scheduled Liabilities.

7. The Bank shall pay the Advance and the Carve Out to or for the benefit of the
Borrowers by issuing a check or checks payable to the Borrowers... or to such
parties as the Borrowers may direct .. . all such directions to be in writing by the
Borrowers submitted to the Bank ....

aR RK

12. This Agreement is executed and delivered in the Commonwealth of
Massachusetts and it is the desire and intention of the parties that it be in all respects
interpreted according to the laws of the Commonwealth of Massachusetts.

(Letter Agreement).
I. DISCUSSION

The Debtor and Sovereign Bank assert three theories as to why the $309,226 deposited in the
Debtor’s account by Sovereign Bank should be payable directly to the Debtor’s employees instead
of becoming general funds of the Debtor’s bankruptcy estate. They argue that: (A) Sovereign Bank
advanced the money to the Debtor in trust for the benefit of the Debtor’s employees; (B) the funds
were “earmarked” for the payment of the Debtor’s employees and the Debtor was a mere conduit for
that payment; and (C) the money constitutes the collateral of Sovereign Bank, and it has the right to

dictate who gets paid when it chooses to “carve out” a portion of its security interest for the benefit

6

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 6 of 16

of a particular class of creditors.

The Trustee denies the existence of any trust relationship, or any other type of arrangement
that would prohibit his use of the funds to pay for the costs of administering the Debtor’s bankruptcy
estate.®
A. Property Held in Trust

The Debtor and Sovereign Bank contend that the Debtor was a mere conduit for the transfer
of funds from Sovereign Bank that were intended to enable the Debtor to meet its payroll
obligations. As the putative trustee of the funds intended for its employees, the Debtor asserts that
it only has bare legal title to the money with the equitable interest belonging to its employees. In the
Debtor’s view, all the bankruptcy estate obtained is its legal title, and, as the legal title holder, the
estate’s only duty is to give the funds to the Debtor’s employees.

As defined by statute, property ofa debtor’s bankruptcy estate includes “all legal or equitable
interests of the debtor in property as of the commencement of the case.” 11 U.S.C. § 541 (aj(1). In
general, to the extent that a limitation exists on a debtor’s right to hold and use property for its own
benefit, that limitation also exists when the property is transferred to a debtor’s bankruptcy estate.
This limitation is codified in the Bankruptcy Code:

(d) Property in which the debtor holds, as of the commencement of the case, only
legal title and not an equitable interest . . . becomes property of the estate under
subsection (a)(1) or (2) of this section only to the extent of the debtor's legal title to
such property, but not to the extent of any equitable interest in such property that the
debtor does not hold.

§ 541(d),
A Chapter 7 trustee cannot administer an equitable interest in property that the debtor does
notown. £.g., Inre Bardell, 361 B.R. 468, 472 (Bankr. N.D.W. Va.) (“[T]he only duty of a party

holding bare legal title without any equitable interest is to convey that legal title to the equitable

° The Trustee also asserts that te Debtor and Sovereign Bank lack standing to bring the
motion before the court. As the putative trustee of funds held for the benefit of its employees,
however, the court finds that the Debtor has standing to seek a declaration as to how the funds
should be disbursed. Likewise, Sovereign Bank has standing to the extent that it argues that it is
the putative settlor of the alleged trust, and to the extent that it asserts that the Trustee seeks to
commandeer the proceeds of its secured collateral.

7

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 7 of 16

interest holder.”); aff'd, 374 B.R. 588 (N.D.W. Va. 2007).

Pursuant to the Letter Agreement, the parties expressly contracted that it be interpreted
according to Massachusetts law. Accordingly, to the extent that the parties intended the Letter
Agreement to create a trust for the benefit of the Debtor’s employees, the court must look to the laws
of Massachusetts.

The term “trust” is defined as “a fiduciary relationship with respect to property, arising from
a manifestation of intention to create that relationship and subjecting the person who holds title to
the property to duties to deal with it for the benefit of .. . one or more persons, at least one of whom
is not the sole trustee.” Restatement (Third) Trusts § 2 (2003). Although the word “trust” is not
mentioned in the Letter Agreement, a trust ‘can be created without using the word ‘trust’ if the
language of the [document] indicates such an intention.” Smith v. Livermore, 10 N.E.2d 117, 124
(Mass. 1937). Under the view of the Second and Third Restatements, no requirement exists that a
beneficiary have notice of, or accept the trust. Restatement (Second) Trusts § 36 (1959), Restatement
(Third) Trusts § 14 (2003). In the case “ofa formal declaration of trust with its terms expressly set
out ina clear and unambiguous manner,” Massachusetts follows the Restatements and likewise does
not require notice or acceptance by the trust beneficiary. Mikshis v. Palionis, 187 N.E.2d 147, 148
(Mass. 1963). On the other hand, when the trust is an informal, voluntary trust, then Massachusetts
‘requires notice to the [beneficiary] or to some person in his behalf, and at least implied acceptance
by the [beneficiary], in order to perfect the creation of the trust.’ ” /d. (citation omitted). Notice to
the beneficiary is necessary because “the law is skeptical of the reality of a trust so declared” when
the owner of personal property puts the apparent title to that property in his or her own name as
trustee for another, when in fact the putative trustee is “without any intent to create a genuine present

interest in that other... .”? Regan v. Phillips, 187 N.E.2d 801, 802 (Mass. 1963).

’ Debtor’s counsel argues that West Virginia law — not Massachusetts law — should apply
to the transaction. Although West Virginia does not specifically require that the trustee or settlor
give notice to the beneficiary of a voluntary, informal trust, West Virginia does require that there
be a “‘manifestation of intention to create a trust’” in personal property. State ex rel. Ins.
Comm'r vy, Blue Cross & Blue Shield of W. Va., 638 S.E.2d 144, 152 (W. Va. 2006) (citation
omitted). Evidence of that manifestation “‘may be written or spoken or by conduct.’” Jd. Even if
West Virginia law did apply, the court’s conclusion that no trust relationship was created by the
Letter Agreement, or independently created by the Debtor, would remain unchanged.

8

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 8 of 16

In this case, the Letter Agreement is an attempt to allow Sovereign Bank to engage in the
liquidation of the Debtor’s assets — and the assets of related entities — to satisfy its secured claim.*
The opening paragraph of the Letter Agreement reflects that intention, and it also states that the
liquidation is for the benefit of the Debtor’s creditors, who are to be satisfied “in the order of priority
dictated by applicable law.” The second paragraph of the Letter Agreement notes that the Debtor
has ceased its business operations, terminated its employees, and that it has incurred numerous
unpaid habilities. Sovereign Bank then states is willingness “to make funds available to effectuate
the payment” of those unpaid liabilities, which are specifically listed on Schedule A. That list of
obligations includes the Debtor’s payroll obligations.

Thus, the Letter Agreement leaves little doubt that Sovereign Bank expressly made funds
available to the Debtor for the purpose of having the Debtor pay the existing wage claims of its
employees. The mere fact that the money was intended to be paid to the Debtor’s employees,
however, does not mean that the Letter Agreement establishes a trust that gives the Debtor’s
employees a present, equitable interest in the funds advanced to the Debtor. To create a trust, there
must either be “an express declaration of trust” or ““circumstances indicating an intention of the
depositor to piace the fund irrevocably beyond his control and to devote it to the indicated purpose.’”
Mid-Atlantic Supply, Inc. v. Three Rivers Aluminum Co., 790 F.2d 1121, 1126 (4™ Cir. 1988)
(citation omitted).

The Letter Agreement does not contain any express declaration of trust. Also, no indication
exists in the Letter Agreement that the Debtor was to hold the money advanced by Sovereign Bank
in a fiduciary capacity. The context of the Letter Agreement is not Sovereign Bank’s desire to
benefit the Debtor’s employees; rather, the stated context of the Letter Agreement was that the
Debtor had defaulted on its obligations to Sovereign Bank, and the Letter Agreement’s purpose was
to effect a winding down of the Debtor’s business so that its assets could be liquidated. All creditors
~ not just the Debtor’s employees — were intended to benefit from the liquidation of the Debtor’s
assets, and were to be paid “in the order of priority dictated by applicable law.” If applicable law

is the Bankruptcy Code (and bankruptcy was expressly contemplated as an eventuality in the Letter

* Accompanying the Letter Agreement was another document “Consent to and Waiver of
Notice of Secured Party Private Sales.”

9

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 9 of 16

Agreement), the administrative fees are to be paid before wage claims. The Letter Agreement also
expressly states that the money transferred to the Debtor to enable it to meet its payroll obligations
was made “for the benefit of the [Debtor]” — not for the benefit of the Debtor’s employees. The
court simply cannot find any viable manifestation of intent on behalf of Sovereign Bank to create
a fiduciary relationship between the Debtor and its employees based on the language of the Letter
Agreement.

Although the Debtor now declares that the funds were held in trust for its employees, no
written or spoken manifestation of that intent previously existed, nor is there any assertion by the
Debtor that it gave notice to its employees of the alleged, informal, voluntary declaration of trust.
Although the Debtor was subject to lawsuits by its employees at the time the Letter Agreement was
executed, and although the Debtor did write the checks to its employees, the circumstances existing
at the time of the execution of the Letter agreement, and the Debtor’s subsequent conduct, only
demonstrates the intended use to which the Debtor was going to put the money. While it is plain that
the Debtor intended its employees to benefit from their Letter Agreement, the circumstances of this
case are insufficient to establish that the Debtor created a trust relationship, with accompanying
fiduciary duties, between the advanced money and its employees.

Moreover, as detailed by the Trustee, a portion of the $309,226 deposited in the Debtor's
account by Sovereign Bank was used by the Debtor for purposes other than paying its employees.
On April 24, 2008 — apparently out of concern that there was not enough money in the account to
honor all of its payroll checks — an additional $2,500 was deposited into the Debtor’s account,
meaning that all deposits totaled $311,726, When the funds in the Debtor’s bank account were
turned over to the Trustee pending resolution of this matter, however, he only received $303,153.
No accounting is before the court explaining the use to which the Debtor put the missing $8,573.

Insum, the Letter Agreement fails to create an express trust, and fails to manifest an intention
by Sovereign Bank to create a fiduciary relationship between the Debtor and its employees with
respect to the $309,226. Regarding the Debtor, it never executed a separate, written declaration of
trust with respect to the funds in its account, and the circumstances of this case, viewed in light of
the Debtor’s actions with respect to the $309,226, fail to create an informal, voluntary trust. While

the Letter Agreement is most likely a contract to transfer property for the benefit of the Debtor’s

10

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 10 of 16

employees as third parties to the contract, such a contract does not create a trust-type relationship.
E.g., Restatement (Third) Trust § 5 (2003) (“The following are not trusts: .. . (1) contracts to convey
or certain contracts for the benefit of third parties... .”).
B. Earmarking

The Debtor argues that the Trustee cannot use the $309,226 sent by Sovereign Bank to the
Debtor’s bank account on the grounds that the money was “earmarked” for the payment of the
Debtor’s payroll obligation.

To adequately explain why the earmarking doctrine is not applicable to this case, a brief
explanation of the development of this judge-made doctrine is necessary.

A trustee in bankruptcy has certain powers to recapture payments made by a debtor to the
debtor’s creditors within the 90-day period preceding the date of the debtor’s bankruptcy petition.

11 U.S.C. § 547. The purpose of recapturing these payments is to avoid preferential treatment by

the debtor among the debtor’s pre-petition creditors. Union Bank v. Wolas, 502 U.S. 151, 160-61
(1991). To be successful on a § 547 preference action, the trustee must demonstrate, among other
things, that the property transferred belonged to the debtor in the first instance. 11 U.S.C § 547(b).

The “earmarking” doctrine is a creditor's defense to a trustee’s preference action and “is
entirely a court-made interpretation of the statutory requirement that a voidable preference must
involve a ‘transfer of an interest of the debtor in property.’” Jz re Bohlen Enterprises, Ltd., 859 F.2d
561, 565 (8" Cir. 1988). In essence, the earmarking doctrine involves three parties: “[w]hen new
funds are provided by the new creditor for the benefit of the debtor for the purpose of paying the
obligation owed to the old creditor, the funds are said to be ‘earmarked’... .” Jd The “inequities”
sought to be remedied by the earmarking doctrine are two fold. The doctrine prevents a guarantor
of the debtor from having to pay an obligation twice, and it prevents the debtor’s bankruptcy estate
from receiving a windfall:

The earliest enunciation of the doctrine occurred in cases where the new creditor
providing new funds to pay off the old creditor, was himself also obligated to pay that
prior debt.... Where such a guarantor paid the debtor's obligation directly to the old
creditor, the courts rejected the claim that such payment was a voidable preference.
The holding rested on a finding that the new creditor's payment to the old creditor did
not constitute a transfer of the debtor's property. The courts buttressed this conclusion
with the rationale that no diminution of the debtor's estate had occurred since the new
funds and new debt were equal to the preexisting debt and the amount available for

il

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 11 of 16

general creditors thus remained the same as it was before the payment was made. A
possible additional rationale may have been the view that such a result was needed
to avoid unfairness and inequity to the new creditor. If his direct payment to the old
creditor was voided, and the money was ordered placed in the bankruptcy estate, the
new creditor, as guarantor, would have to pay a second time.

Where the guarantor, instead of paying the old creditor directly, entrusted the new
funds to the debtor with instructions to use them to pay the debtor's obligation to the
old creditor, the courts quite logically reached the same result.

> 2K He a

The courts have extended the doctrine beyond the guarantor situations and have
applied it to situations where the new creditor is not a guarantor but merely loans
funds to the debtor for the purpose of enabling the debtor to pay the old creditor. The
same rationales have been used to justify the results where the doctrine has been so
extended, 1.e., that the debtor held the new money "in trust", that the debtor did not
have "control" of the new money and that the transaction did not diminish the
debtor's estate. Earmarking has been held to exist where the new lender himself
directly pays the old creditor, and even in cases where the new lender entrusts the
funds to the debtor with instructions to use them to pay the old creditor.

Bohlen Enterprises, Ltd, 859 F.2d at 565-66.

Three generally accepted requirements must exist before the earmarking defense to a
preference action may be successful: “(1} the existence of an agreement between the new lender and
the debtor that the new funds will be used to pay a specified antecedent debt; (2) performance of that
agreement according to its terms; (3) the transaction viewed as a whole . . . does not result in any
diminution of the estate.” Jd at 566; see also Sheehan y. Valley Nat'l Bank (in re Shreves), 272
B.R. 614, 624 (Bankr. N.D.W. Va. 2001) (adopting the Bohlen Enterprises requirements); Hovis v.
Powers Constr. Co. (In re Hoffman Assocs.), 194 B.R. 943, 958-59 (Bankr. D.S.C. 1995) (same);
Wasserman v. Village Assocs., 153 B.R. 972, 982 (Bankr. D. Md. 1993) (same).

In this case, the Trustee is not seeking to recover a preference payment; rather, the Trustee
is asserting his right to use funds that were in the Debtor’s bank account when the involuntary
petition against it was filed. Thus, the Debtor is asking the court to apply a judge-made doctrine
intended to avoid perceived inequities in preference litigation to a different context — the Debtor

seeks to use the earmarking doctrine in an effort to determine what constitutes property of the

12

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 12 of 16

bankruptcy estate under 11 U.S.C. § 541(a). The court, however, declines to extend the application
of the earmarking doctrine to § 541(a) because § 541(a) already clearly defines what is, and what is
not, property of a debtor’s bankruptcy estate. In short, “{i]f a debtor receives funds from a new
creditor to pay its existing debt, the debtor’s interest in the funds must be analyzed under § 541,
including any limitations thereunder, as for example, those set forth in § 541(b) and (d), and the
limitation on § 541(a)(1) related to traceable property that the debtor holds in trust for another.”
Manchester v. First Bank & Trust Co. (In re Moses), 256 B.R. 641, 648 (B.A.P. 10" Cir. 2000); see
also Parks v. Georges Motor Co. (in re Johnson), No. 04-5239, 2006 Bankr. LEXIS 690 at *13
(Bankr. D. Kan. April 24, 2006) (refusing to apply the earmarking doctrine outside of its intended
purpose as a preference defense).

Accordingly, the court will not apply the “earmarking” doctrine outside of its intended
application as a preference defense, and will analyze whether the $309,226 at issue in this case is
property of the estate within the confines of 11 U.S.C. § 541(a).

C. Carve Out Agreement

The Debtor and Sovereign Bank assert that the $309,226 deposited in the Debtor’s bank
account constitutes part of Sovereign Bank’s secured collateral. Thus, they argue, because the
money belongs to Sovereign Bank, it can use the money to pay whomever it wishes.

Several courts, including this one, have approved carve out agreements that allow secured
creditors to pay over a portton of their collateral to such other entities as the secured party directs.
E.g., Motorola, Inc. v. Official Comm. of Unsecured Creditors (In re Iridium Operating, LLC), 478
F.3d 452 (2d Cir. 2007); Jn re SPM Mfg. Corp., 984 F.2d 1305 (1* Cir. 1993); In re Tackley Mill,
LLC, 386 B.R. 611 (Bankr. N.D.W. Va. 2008). A review of those cases, however, reveals important
distinctions between the types of carve out agreements approved in those cases and the “Carve Out”
that is defined by the Letter Agreement.

In the case of In re SPM Mfs. Corp., 984 F.2d at 1307, a case involving conversion from a
Chapter 11 proceeding to a Chapter 7 proceeding, the secured lender had a $9 million lien on all the
assets of the debtor. Under a post-petition agreement with the debtor’s unsecured creditor’s
committee, the secured lender agreed to share a portion of the proceeds of any liquidated collateral

with the unsecured creditors in return for gaining their cooperation in the bankruptcy proceeding.

13

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 13 of 16

id, at 1308. The eventual liquidation of the debtor’s estate only realized $5 million in proceeds. and,
honoring its agreement, the secured lender paid a portion of that amount to the unsecured creditor’s
committee. /d. at 1312. The effect of the agreement was to upset the priority distribution scheme
of the Bankruptcy Code by paying unsecured creditors ahead of priority unsecured creditors. /d. at
1312-13. The court held, however, that no party other than the secured lender had any claim to the
$5 million in liquidation proceeds. fad at 1312. Moreover, the Bankruptcy Code only governed
distributions from the estate -- “creditors are generally free to do whatever they wish with the
bankruptcy dividends they receive, including share them with other creditors.” /d at 1313. Thus,
the court approved the transaction and thereby held that the funds distributed by the secured lender
were never property of the debtor’s bankruptcy estate.

In the case of /ridium Operating, LLC, 478 F.3d at 456, a Chapter 11 case, the debtor’s
unsecured creditor’s committee decided to compromise their causes of action against the debtor’s
secured lender, and use funds realized from that compromise to pursue a cause of action against the
debtor’s parent company. An administrative claim holder (who also happened to be the debtor's
parent company} objected to the settlement on several grounds, including that the settlement paid
money to the general unsecured creditors without paying priority creditors in full. /@ The
settlement, however, was presented to the court under Fed. R. Bankr. P. 9019. /d at 464. In
evaluating a Rule 9019 settlement agreement, the bankruptcy court must, among other things,
evaluate whether the settlement is fair, reasonable, and in the best interest of the bankruptcy estate.
fd. at465. When making this determination, a bankruptcy court can “endorse a settlement that does
not comply in some minor respects with the priority rule if the parties to the settlement justify, and
the reviewing court clearly articulates the reasons for approving, a settlement that deviates from the
priority rule.” Jd. at 464-65. Much like /ridium Operating, LLC, this court in the case of Tackley
Mills, LLC, 386 B.R. 611, while it was still a Chapter 11 proceeding, approved a settlement under
Rule 9019 that allocated a portion of the secured creditor’s collateral to the unsecured creditors’
committee as the quid pro quo for terminating litigation. At the time the settlement agreement was
presented to the court for approval, no party was contending that it violated the Bankruptcy Code’s
priority treatment rules.

In the view of Sovereign Bank and the Debtor, the Letter Agreement creates a similar type

14

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 14 o0f16

scenario to that detailed in SPM Mfg. Corp., Iridium Operating LLC, and/or Tackley Mills, LLC.
The court disagrees. fridium Operating LLC, and Tackley Mills LLC, are plainly distinguishable
from this case inasmuch both concerned court scrutiny and approval of settlement agreements
presented under Rule 9019, In this case, there is no indication that the Letter Agreement constituted
a settlement agreement, and even if it did, the agreement was never presented to the court for
approval. The standards of Rule 9019 are simply not applicable here.

More importantly, however, the $309,226 deposited in the Debtor's bank account was not
a distribution by Sovereign Bank of its secured collateral to the employees of the Debtor, and,
therefore, it is unlike SPM Mf. Corp. No indication exists that Sovereign Bank was contractually
obligated to make the payment to the employees, or that it was making a gift ofits secured collateral.
Paying the employees was an obligation of the Debtor — not of Sovereign Bank.

In fact, the money intended to pay the wages of employees was an “advance” for the benefit
of the Debtor, and the funds were payable to the Debtor and not its employees. The “advance” was
made pursuant to the parties’ pre-existing Credit Facilities; thus, it appears that the $309,226 was
a loan to the Debtor that had to be repaid. In fact, Sovereign Bank preserved for itself the right to
recover the “advance” from the “carve out” before any other funds from the “carve out” could be
disbursed to pay the Debtor’s Scheduled Liabilities. (Letter Agreement J 6). Its claim that the
$309,226 constitutes a carve out of the type recognized in bankruptcy is both contrary to the terms
of the Letter Agreement and common usage.

TH. CONCLUSION

The abrupt cessation of Debtor’s business has caused a hardship for its creditors, including
its former employees, and generated turmoil in the communities in which it operated. Unfortunately,
this is not an uncommon occurrence, Business distress and failure, as well as business success and
longevity, are dual features of our economic experience. They have been a part of our country’s
historical landscape since the beginning of the Republic. In instances of failure, as in this case,
bankruptcy — as imperfect as it might be ~ is the legal field upon which creditors clash for primacy
over the assets of a liquidating debtor. It is the process whereby order is brought to what would
otherwise be an unruly and haphazard dissolution. Unfortunately, a bankruptcy case is not without

its economic casualties. Moreover, the resolution of disputes during the administration of a case can

15

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 15 of 16

appear at times to be both perplexing and frustrating. While the court can do little to alleviate the
harsh effects of a business bankruptcy, it can seek to ifluminate its decisions with clarity and
empathy. This opinion embodies that effort. In that regard, if the court were free to simply fashion
whatever remedy it so desired, the wages would be paid. But for the reasons the court has outlined,
that is not the case. Instead, the court is honor bound to apply the law as best as it can. In this
instance, the facts and the pertinent law show that the Trustee’s argument has greater merit. Thus,
for the reasons set forth herein, the court will sustain his objection to the Debtor’s motion.

The court will enter a separate order pursuant to Fed. R. Bankr. P. 9021 that denies the

Debtor’s motion to authorize payment of pre-petition wages and related taxes.

16

Case 3:08-bk-00482 Doc 215 Filed 07/02/08 Entered 07/02/08 11:10:51 Desc Main
Document Page 16 of 16