Wisconsin District Judge Throws Out Trustee Appeal, OK’s Earmarking Doctrine
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July 15, 2022, US District Court for Eastern Wisconsin – The District Court for Eastern Wisconsin dismissed Trustee Douglas F. Mann’s appeal against the Bankruptcy Court order granting summary judgment in favor of Defendant LSQ Funding Group L.C. (“LSQ”) in the bankruptcy case of Engstrom, Inc (“Debtor”). The District Court reasoned that the bankruptcy court correctly applied the earmarking and diminution of the estate doctrines to dismiss the Trustee’s adversary claims.
By background, Debtor was party to a factoring agreement with LSQ for several years until January 2020. Factoring, also known as accounts receivable or invoice financing, is an arrangement by which a business obtains credit based on funds the business expects to receive from its customers.
Under the Invoice Purchase Agreement (IPA), Debtor Engstrom would issue invoices to its customers for its services and then sell these invoices to LSQ. LSQ would advance Engstrom approximately 85% of the face amount of the purchased invoices. After LSQ had received payment from Engstrom’s customer, Engstrom would ask LSQ to forward the remainder of the face amount of the paid invoice, less the fees owed to LSQ under the IPA. To secure its obligations, Engstrom granted LSQ a first priority security interest in all of its personal property and fixtures, and the proceeds thereof, including all accounts.
On January 9, 2020, LSQ terminated the IPA and demanded payment of the $10,272,501.68 then due from Engstrom. Two weeks later, on January 23, 2020, Engstrom entered into a new factoring agreement with Canfield Funding LLC, d/b/a Millennium Funding (Millennium) with similar terms as it had with LSQ.
Millennium paid off Engstrom’s debt by making a wire transfer of $10,306,661.56 to LSQ. LSQ released all of its interests in Engstrom’s invoices and other assets and the same were now pledged to Millenium. As part of its deal with Millennium, Engstrom allegedly agreed that the funds being sent to LSQ could only be used to pay Engstrom’s debt to LSQ; Engstrom allegedly had no discretion to transfer those funds to any other person or entity.
Later, Millennium allegedly discovered that Engstrom was engaged in an alleged “fraudulent Ponzi scheme” through which it sold alleged “fake invoices” to Engstrom’s factor and allegedly obtained advances that were then used to pay off previously purchased invoices.
The Trustee filed a complaint seeking to avoid the payment made by Millenium to LSQ to pay off Debtor Engstrom’s debt as alleged “preference” and “fraudulent transfer”. In a detailed analysis, the bankruptcy court applied long-established Seventh Circuit law concerning the “earmarking” and “diminution of the estate” doctrines to conclude that Engstrom lacked an interest in the Millennium payment made to LSQ and that the payment had not diminished Engstrom’s bankruptcy estate.
The District Court agreed with Bankruptcy Court’s finding that the Trustee’s avoidance claims require proof of a “transfer of an interest of the debtor in property.” The Bankruptcy Court had explained on the basis of earmarking doctrine that the Debtor had no interest in the payment made by Millenium to LSQ.
The earmarking doctrine confirms that when a new lender makes a loan to a debtor for the specific purpose of paying off a former lender, the debtor has not made a transfer of its own property because the debtor still owes the same sum, only to a different creditor.
The District Court affirmed the Bankruptcy Court’s conclusion that the transfer of funds from Millenium to LSQ had no effect or “diminution” on Debtor’s bankruptcy estate and therefore could not be avoided by the Trustee. The Trustee’s contention that the earmarking doctrine does not apply in case of factoring arrangements also failed as the Courts agreed that the earmarking doctrine applies in case of unconventional loan transactions as well.
Mann v. LSQ Funding Grp., 2022 U.S. Dist. LEXIS 125414
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