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Home New Cases BAP Reverses! No Earmarking Defense When Debt Character Changes

BAP Reverses! No Earmarking Defense When Debt Character Changes


May 27, 2022, Bankruptcy Appellate Panel for the Tenth Circuit – Philip J. Montoya, the chapter 7 trustee (“Trustee”) of Chuza Oil Company (“Debtor”) appeals the Bankruptcy Court ruling which disallowed the Trustee to clawback alleged preferential and fraudulent transfers made to Paula Goldstein (“Paula”) under a subordinated promissory note.

The Debtor filed a Chapter 11 case in 2014 in the New Mexico Bankruptcy Court and the plan was confirmed in 2016. The plan made the claims of the insider unsecured creditors subordinated to that of the non-insider unsecured creditors. In 2012, the Debtor had borrowed $500,000 from Leon Goldstein, father of Bobby Goldstein (CEO and director of the Debtor company) under a promissory note. Since Leon Goldstein was an “insider”, the Chapter 11 plan had made this loan subordinated to the claims of non-insider unsecured creditors.

Paula (wife of Leon Goldstein) and Bobby Goldstein (collectively “Defendants”) made loans to the Debtor post-confirmation to keep it a going concern. Despite the distribution scheme under the confirmed plan, the Debtor made payments on the note, from September 2016 through December 2017, even though not all non-insider claimants had been paid by then. The Debtor allegedly used the loans made by Defendants to make payments to the Defendants under the note.

The Bankruptcy Court rejected Trustee’s attempts to clawback the transfers made to the Defendants. While relying on the earmarking doctrine, it held that these transfers did not constitute a transfer of an interest of the Debtor in property. It also allowed Defendant’s defense of contemporaneous-exchange-for-new-value.

The Bankruptcy Appellate Panel (“BAP”) applied dominion/control test and diminution-of-the-estate test to find that the Debtor did not have control over the conditionally lent funds. However,  BAP ruled that notwithstanding the Debtor’s lack of control over the conditionally lent funds, the Debtor’s estate was diminished by the transfers because of the resulting replacement of subordinated debt with unsubordinated, unsecured debt. 

The BAP concluded that the transfers under the note were preferential and constructively fraudulent transfers of interest of the Debtor in property under section 547 and 548 (a)(1)(B) of the Bankruptcy Code. 

Montoya v. Goldstein (In re Chuza Oil Co.), 2022 Bankr. LEXIS 1510


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