The U.S. District Court for the District Court recently issued two opinions addressing lower court appeals which turned on the statutory defenses provided for in 11 U.S.C. §§ 547(c)(2) and (4), in addition to the availability of the “earmarking doctrine”. The opinions, both penned by Chief Judge Leonard P. Stark, make clear that the arrangement of a “payment plan” between the debtors and defendant may not necessarily render transactions made pursuant thereto “ordinary” for purposes of § 547(c)(2); furthermore, they confirm that the “earmarking doctrine” will be strictly construed. In both cases, the District Court held for the appellee/plaintiff on the substantive issues of the appeals.
“Earmarking” Strictly Construed
The earlier of the two opinions, Masiz v. Burtch (In re Vaso Active Pharmaceuticals, Inc.), 537 B.R. 182 (D. Del. 2015), involved an adversary proceeding brought by a plan-appointed trustee to recover $776,363 from the defendant, John Masiz (“Masiz”). Masiz founded the Debtor approximately nine years prior. Following a 2004 lawsuit by the Securities and Exchange Commission in connection with an initial public offering of the Debtor’s equity, Masiz agreed to resign as CEO and board member of the Debtor, but remained as a “strategic consultant”. In 2006, the Debtor, as represented by Kelley Drye & Warren, LLP (“KDW”) filed a malpractice lawsuit against Robinson & Cole, LLP (“R&C”), the firm that had provided legal representation in connection with the IPO. Concurrently, the Debtor arranged for Masiz to begin working on an unpaid basis, but if the Debtor succeeded in its malpractice suit, Masiz would be paid retroactively. For these purposes, the Debtor agreed to compensate Masiz at $175,000 per annum.
R&C settled the malpractice suit for $2.5 million, although not before firing KDW. Following disbursement of the settlement funds, KDW asserted an attorney’s lien in the same, which further prompted the Debtor to enter into a separate settlement with KDW, whereby KDW agreed to accept $595,000 in satisfaction of its fees. The KDW settlement “acknowledged” that the Debtor intended to release $598,000 of the R&C settlement to Masiz in satisfaction of his accrued unpaid wages. Subsequent to that transfer, but before the bankruptcy, the Debtor made an additional $178,363 payment to Masiz on account of his continued employment.
The Trustee alleged in his complaint that the two payments to Masiz were either preferential payments under 11 U.S.C. § 547 or fraudulent transfers under 11 U.S.C. § 548. Ultimately, the Bankruptcy Court (Judge Sontchi) issued two opinions granting summary judgment in the Trustee’s favor with respect to the §§ 547 and 548 claims. Masiz appealed both to the District Court, arguing the Trustee lacked standing; that the “earmarking doctrine” excluded the transfers from avoidance; that several issues of disputable fact were impermissibly decided at the summary judgment stage (including whether § 547(b)(5) had been established); and that while the Bankruptcy Court was correct in finding Masiz had established a new value defense, it erred in the calculating the amount of that new value.
The District Court quickly dismissed the contention that the Trustee had not yet acquired standing to bring the instant action, pointing to specific language in the confirmation order. Moving on to Masiz’s “earmarking” argument and pertinent to this post, Chief Judge Stark noted that the doctrine targets one of the fundamental elements of a preference action under 547(b) – e.g., that a voidable preference first requires some interest of the debtor in property. He cited the “earmarking” standard elucidated in past Third Circuit and Delaware Bankruptcy Court Opinions as follows: “[w]hen … funds are provided by [a] new creditor to or for the benefit of the debtor for the purpose of paying the obligation owed to [an existing] creditor, the funds are said to be ‘earmarked’ and the payment is held not to be a voidable preference.” In re Winstar Commc’ns, Inc., 554 F.3d 382, 400 (3d Cir. 2009). The District Court went to say that in “order to invoke this doctrine, a party must demonstrate ‘(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, and (3) the transaction viewed as a whole … does not result in any diminution of the [debtor’s] estate.’” Id. “The central inquiry is ‘whether the debtor had the right to disburse the funds to whomever it wished, or whether the disbursement was limited to a particular old creditor or creditors under the agreement with the new creditor.’” In re AmeriServe Food Distribution, Inc., 315 B.R. 24, 30 (Bankr.D.Del.2004) (quoting In re Superior Stamp and Coin Co., Inc., 223 F.3d 1004, 1009 (9th Cir.2000)).
The Bankruptcy Court found that the R&C settlement did not direct any funds to Masiz, nor did it mention the KDW settlement. The District Court agreed, and rejected the contention that the KDW settlement should be the operative document for “earmarking” purposes. Chief Judge Stark found that KDW did not have control over or disburse any funds, and pursuant to the AmeriServe decision, a party must both disburse funds and direct those funds for the “earmarking doctrine” to apply. Thus, the District Court rejected Masiz’s argument.
The District Court subsequently dismissed Masiz’s argument that summary judgment was inappropriate since the Trustee had not established § 547(b)(5). This element requires that the transfer in question: “enables such creditor to receive more than such creditor would receive if— (A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and (C) such creditor received payment of such debt to the extent provided by the provisions of this title.” Chief Judge Stark found that § 547(b)(5), as measured from the time of the bankruptcy filing, simply requires that the creditor in question would have received less than a 100% payout of its claim in a Chapter 7 liquidation. Given the substance of the plan and disclosure statement, the District Court found that circumstance was met.
Lastly, the District Court found that the Bankruptcy Court did not err in the calculation of Masiz’s “new value” defense. This defense, as codified in § 547(c)(4), provides that a trustee may not avoid any transfer: “to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor—(A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor.” Chief Judge Stark found that Masiz’s new value contribution was properly valued at 72 days of service, which translated to $34,520.55 when converted to a percentage of the annual $175,000 salary he agreed to. The District Court found that Masiz pointed to no other method of calculation and that his claiming the new value amount to be disputed does not render it so for summary judgment purposes.
Note that on October 2, 2015, Masiz appealed Chief Judge Stark’s order and opinion to the Third Circuit Court of Appeals. The appeal remains pending as of this writing.
Part II of this post will be up tomorrow.