Hartley, In re

• Decision Date: 07 August 1987
• Docket Number: No. 86-3688,86-3688
• Citation: 825 F.2d 1067
• Parties: 17 Collier Bankr.Cas.2d 550, Bankr. L. Rep. P 71,951 In re James Ross HARTLEY & Sharon Lee Hartley, d/b/a Hartley Trucking, Debtors. Suzanne Cotner MANDROSS, Successor-Trustee, Plaintiff-Appellee, v. PEOPLES BANKING COMPANY, Defendant-Appellant.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1067

825 F.2d 1067

17 Collier Bankr.Cas.2d 550, Bankr. L. Rep. P 71,951

In re James Ross HARTLEY & Sharon Lee Hartley, d/b/a Hartley

Trucking, Debtors.

Suzanne Cotner MANDROSS, Successor-Trustee, Plaintiff-Appellee, v. PEOPLES BANKING COMPANY, Defendant-Appellant.

No. 86-3688.

United States Court of Appeals, Sixth Circuit.

Argued June 16, 1987.

Decided Aug. 7, 1987.

Thomas D. Drake, William E. Clark, Drake, Phillips, Kuenzli & Clark, Findlay, Ohio, John C. Elam, Patricia Scanlon, Robert J. Sidman, argued, Columbus, Ohio, for defendant-appellant.

H. Buswell Roberts, argued, Nathan & Roberts, Toledo, Ohio, for plaintiff-appellee.

Before KENNEDY and MILBURN, Circuit Judges; and CONTIE, Senior Circuit Judge.

CORNELIA G. KENNEDY, Circuit Judge.

This case presents the question of whether a payment by a third party to a creditor on behalf of a debtor is a voidable preferential transfer when the debtor grants security interests to the third party in exchange for the payment. The District Court held that defendant-appellant Peoples Banking Company ("Peoples") received from James Ross Hartley ("the debtor") a preferential transfer of $500,000, voidable under 11 U.S.C. Sec. 547(b) (1982), and granted plaintiff-appellee Suzanne Cotner Mandross, the trustee in bankruptcy ("Trustee"), partial summary judgment. The principal issue, in which others are subsumed, is whether the debtor owned the $500,000 paid to Peoples on June 10, 1981. We conclude that the debtor's interest in the $500,000 was only the value of the security interests he transferred to the third party in exchange for the third party's payment to Peoples. Accordingly, we reverse the holding of the District Court and remand for a determination of the value of the security interests.

The debtor owned and operated the Hartley Trucking Company, which engaged in interstate freight hauling. From November, 1979, through May, 1981, the debtor maintained accounts with Peoples. As the result of a series of transactions occurring prior to April 28, 1981, the debtor overdrew his checking account by approximately $1,206,800. The debtor twice tried to cover the overdraft, but the checks tendered were returned due to stop payments which had been placed on them.

On June 2, 1981, the debtor and representatives of Peoples and Midwest Emery Freight Systems, Inc. ("Midwest"), along with their respective counsel, met to determine how to pay the overdraft. The debtor had previously borrowed money from Midwest to cover overdrafts. At the meeting Midwest agreed to pay $500,000 directly to Peoples to cover the overdraft in return for security interests in the debtor's real and personal property. The debtor gave similar security interests to Peoples along with a $306,800 cognovit term note to cover the balance of the overdraft. ¹

On June 10, 1981, pursuant to the agreement of June 2, Midwest wire transferred $500,000 from its own bank account to Peoples' Bank account.

On September 8, 1981, the debtor filed a Chapter 7 petition in the U.S. Bankruptcy Court for the Northern District of Ohio, seeking relief under the provisions of Title 11 of the United States Code. Trustee brought an action to recover the $500,000 transferred from Midwest to Peoples, alleging that it was a voidable preference under 11 U.S.C. Sec. 547(b), and moved for partial summary judgment on that issue. The Bankruptcy Court submitted Proposed Findings of Fact, Proposed Conclusions of Law, and a Proposed Order to the U.S. District Court for the Northern District of Ohio on April 15, 1985. Derryberry v. Peoples Banking Co. (In re Hartley), 55 B.R. 770 (Bankr.N.D.Ohio 1985). These findings and conclusions stated that the $500,000 transfer to Peoples qualified as a voidable preference under section 547(b). The District Court adopted the Bankruptcy Court's Findings of Fact, Conclusions of Law, and Order as the Order of the District Court, and granted Trustee partial summary judgment in the amount of $500,000, plus interest. Peoples appealed.

Section 547(b) of the Bankruptcy Code, 11 U.S.C. Sec. 547(b), empowers a trustee to void a transfer as preferential if the trustee can show that the following six elements exist:

(1) a transfer of property of the debtor;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt owed by the debtor before the transfer was made;

(4) made while the debtor was insolvent;

(5) made on or within ninety days before the date of the filing of the petition, or between ninety days and one year before the date of the filing if the creditor is an insider; and

(6) the transfer enables the creditor to receive more than such creditor would receive if

(A) the case were a case under Chapter 7 of Title 11;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by Title 11.

According to the legislative history, the purposes of section 547(b) are to facilitate equality of distribution among creditors of the debtor and to deter the "race of diligence" of creditors to dismember the debtor before bankruptcy. H.R.Rep. No. 595, 94th Cong., 1st Sess. 177-78 (1977), reprinted in 1978 U.S. Code Cong. & Admin. News 5787, 6138.

We are concerned here with the first element, whether there has been a transfer of the debtor's property. Peoples does not dispute that there was a transfer, but argues that the $500,000 that Midwest transferred to Peoples belonged to Midwest, not to the debtor. Peoples contends that property transferred by a third person to a creditor on behalf of a debtor does not become property of the debtor. This is sometimes called the "earmark" rule--funds loaned to a debtor that are "earmarked" for a particular creditor do not belong to the debtor because he does not control them. Grubb v. General Contract Purchase Corp., 94 F.2d 70 (2d Cir.1938). Peoples further argues that the transferred funds could not have belonged to the debtor because the transfer did not diminish the debtor's estate. Before the transaction, the debtor owed $806,800 to Peoples. ² After the transaction the debtor owed $500,000 to Midwest and $306,800 to Peoples. Any diminution of the debtor's estate, asserts Peoples, resulted from the debtor's transfer of security interests to Midwest. Peoples argues that where a debtor surrenders property in order to obtain a loan from a third party to pay a creditor, the amount of the preference, if any, is determined by the value of the assets surrendered or encumbered. Steel Structures, Inc. v. Star Mfg. Co., 466 F.2d 207 (6th Cir.1972).

Trustee argues that this Court should not follow the "earmark" rule established in Grubb, claiming that the rule is particularly inappropriate when a secured creditor, such as Midwest, is substituted for an unsecured creditor, such as Peoples. Trustee contends that the entire $500,000 became the debtor's property when Midwest loaned it to him, despite the fact that it was paid directly to Peoples. Voiding the entire transfer, asserts Trustee, would further the policies of section 547(b). Finally, Trustee criticizes Peoples' argument that the transfer did not diminish the debtor's estate, arguing that diminution of the estate is not an element of section 547(b), and furthermore that the transaction did in fact deplete the estate by $500,000.

In the context of transfers by third parties, the diminution of estate doctrine asks whether the debtor controlled the property to the extent that he owned it and thus the transfer diminished his estate. "Where there is a question as to the debtor's ownership of the money, 'the court must determine whether the debtor had such an interest in the funds such that a transfer thereof would result in a diminution of the estate.' " Commodity Exch. Servs. Co. v. The Cotton Bd. (In re Commodity Exch. Servs. Co.), 67 B.R. 313, 316 (N.D.Tex.1986) (quoting Hargadon v. Cove State Bank (In re Jaggers), 48 B.R. 33, 36 (Bankr.W.D.Tex.1985)). If the transfer diminishes the estate, the other creditors are injured because less remains for them to share. Although the doctrine developed under section 60 of the former Bankruptcy Act, the predecessor to section 547(b), courts have used the doctrine in cases arising under section 547(b) to determine whether the debtor owned the property in question. ³ See, e.g., Genova v. Rivera Funeral Home (In re Castillo), 39 B.R. 45, 46 (Bankr.D.Colo.1984).

When a third person loans money to a debtor specifically to enable him to satisfy the claim of a designated creditor, the general rule is that the proceeds are not the property of the debtor, and therefore the transfer of the proceeds to the creditor is not preferential. 4 Collier on Bankruptcy p 547.03, at 547-25 (15th ed. 1987). This rule arose from Grubb v. General Contract Purchase Corp. In that case, the debtor owed the defendant $25,000. The debtor borrowed the money to pay the defendant from a third party, who made a check out to the defendant, paying him directly. After the debtor went bankrupt, the trustee challenged the payment as a preferential transfer, voidable under section 60 of the former Bankruptcy Act. The court, in a decision written by Judge Learned Hand, held that the payment was not preferential because the funds did not belong to the debtor: the debtor never controlled the money, and the money never became a part of the debtor's assets. 94 F.2d at 72. The transaction merely substituted one creditor for another without loss to the estate. Cases under section 547(b) have followed Grubb. ⁴ See, e.g., In re Castillo; Sun Railings, Inc. v. Silverman (In re Sun Railings, Inc.), 5 B.R. 538 (Bankr.S.D.Fla.1980).

Even where the debtor transfers a security interest in return for the loan, the payment is only a voidable preference to the extent the transaction depleted the debtor's estate. In Steel Structures, Inc. v. Star Manufacturing Co., the debtor contracted with a third party to build a building. The defendant-creditor, Star...