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Cases of Interest

Are Balance Transfers Avoidable?

Crystal Jones, Associate Attorney

Pre-petition, the Debtor transferred $10,000 from one credit card account to another through the use of convenience checks. The Trustee sought to force the receiving creditor (Creditor B) to pay the $10,000 over to the bankruptcy estate pursuant to 11 U.S.C.§ 547(b), which allows a bankruptcy trustee to recover preferential payments made pre-petition for the benefit of all creditors. The Bankruptcy Court ruled in the Trustee's favor. Creditor B appealed, arguing that the payment, made directly from one creditor to another by use of convenience checks, was not a transfer of "property of the debtor," one of the required elements of a preference.

The preference laws were designed, as the Bankruptcy Court notes in this case, to remove the incentive of creditors of an insolvent debtor from "competitive last-minute grabbing" of a debtor's assets. Importantly, a transfer is only preferential if the property transferred belongs to the debtor. The Bankruptcy Court held that a transfer directly from one creditor to another, made by use of convenience checks was in fact, a transfer of property of the debtor.

On appeal, Creditor B made several arguments. It contended that the Debtor had no "property interest" in the money that was transferred. Further, Creditor B argued that the "earmarking doctrine" applied to the transfer. The earmarking doctrine applies when borrowed funds are specifically earmarked by the lender to pay a particular creditor. If the earmarking doctrine applied to the transfer, argued Creditor B, the funds would never really be the Debtor's property. For the preference law to apply, the property sought to be returned must have been the debtor's property to begin with. Finally, Creditor B argued that, because the transfer did not cause a diminution of the estate, it wasn't a preferential transfer. The Appeals Court disagreed with Creditor B and reaffirmed the Bankruptcy Court's holding.

The Appeals Court explained that the Debtor exercised significant control over the money by choosing to pay a single creditor, rather than paying all creditors pro rata or, alternatively, keeping the money and using it to purchase property. The Appeals Court stated that if the Debtor had chosen to keep the convenience check funds or purchased property with them, the assets of the estate at the time of bankruptcy would have been greater. This could have allowed equal distribution of such assets to creditors pro rata. Instead, the Debtor chose to disburse the proceeds of these checks to a single creditor. As such, the estate was essentially "diminished" of the assets that could have otherwise been acquired.

Creditor B, in a related argument, contended that because the Debtor deposited the convenience checks in her bank account, the transactions involved a "transfer of debt" which would merely result in a substitution of creditors, not a depletion of the Debtor's estate. The Appeals Court rejected this argument pointing to the "economic reality' of the transaction. The Court explained that a balance transfer is in the nature of a a loan from the bank. When the Debtor obtained the loan, she also obtained control of the loan proceeds, making it irrelevant that the Debtor never had cash in hand.

The Appeals Court also rejected Creditor B's argument that earmarking doctrine applied to the transfer. In this case, it is undisputed that Creditor A, in issuing the convenience checks, did not specifically restrict the funds for payment of the Debtor's debt to Creditor B. The Court held that it was the Debtor, not the lender, who exercised control of the funds and designated such payment to the creditor of his choosing. The Appeals Court acknowledged that other bankruptcy courts have viewed similar transfers differently. In In re Parks, which is currently on appeal from a Kansas bankruptcy court, the court held that a transfer of credit card balances was "a mere substitution of creditors which had no impact on either the property of the estate or the value of the claims asserted against the estate." Additionally, in a decision from Utah, the court stated that the "availability of credit" constituted only a potential wealth because creditors could not force debtors to use such credit to create liquidity for distribution.

The Appeals Court stated that these opinions disregard the fact that, had the Debtor retained the proceeds of these convenience checks, they would have been available to all creditors equally. As such, the Appeals Court reaffirmed the Bankruptcy Court's granting of the Trustee's Motion for Summary Judgment on her preference claim, and ordered Creditor B to return the $10,000 to the estate. Meoli v. MBNA Am. Bank, N.A. (In re Wells) 382 B.R. 355, (B.A.P. 6th Cir. 2008)

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