Split Noted: Who Bears The Burden On Earmarking for 11 U.S.C. 547(b)

Per In re ESA Environmental Specialists, Inc. (4th Cir. Mar. 1, 2013)

Under 11 U.S.C. 547(b), "[a] trustee in bankruptcy may avoid any transfer of an interest of the debtor in property" to a creditor for an antecedent debt made within 90 days of the petition, while the debtor was insolvent, that enables the creditor to recover more than it would in bankruptcy.

Courts have created an earmarking "affirmative defense" to such avoidance actions.  The earmarking defense applies when new creditor makes a loan to the debtor specifically for (or earmarked for) the payment of a designated old creditor.  In brief, the defense recognizes that the new loan never becomes part of the debtor's estate.  Moreover, the position of other creditors are not hurt by such an earmarked loan--the new creditor is simply substituted for the old creditor, and will receive the same pro-rata share of the bankruptcy proceeds as all other creditors.

In this opinion, the CA4 notes a circuit split on who bears the burden of proving the earmarking "affirmative defense."  (p. 8-9, n.6.)  It is unquestioned that the trustee bears the general burden of proving the avoidability of a transfer.  But a majority of circuits (the CAs 3, 6, and 9) hold that, if the trustee proves the general avoidability of a transfer, the burden shifts to the defendant to prove that the funds were earmarked.  In contrast, the CA8 holds that the trustee has the burden of proving that the earmarking defense does not apply.

I agree with the CA8.  To be sure, the majority school is consistent with the general rule that the burden of proving affirmative defenses is on the defendant.  But I do not believe that the earmarking defense is actually an affirmative defense (the CAs 3 and 9 hold as much).  Rather, it is a negative defense--if proven, it shows that the transfer was not "of an interest of the debtor."  The debtor never acquired full--i.e., equitable and legal--title to the transferred funds.  Instead, to the extent the debtor receives earmarked funds, it acts more in the capacity of a trustee, receiving legal but not equitable title to the funds, with no independent control but instead subject to an obligation to transfer the funds to the old debtor.  Thus, the burden of disproving this negative defense rests with the party bearing the burden of proof--the trustee.