Earmarking, Conduit and Agency Bankruptcy Preference Defenses

Three lesser known defenses to bankruptcy preference claims are: the earmarking defense, the conduit defense and the agency defense. The defenses have different and distinct elements. Recognizing the potential availability of one of these defenses requires a clear understanding of these elements and the situations these elements might exist.

The Confusion in Understanding and Applying the Defenses

These 3 defenses are often confused.  This confusion is primarily caused by the common terminology the defenses share. For example, some courts have described the earmarking defense in terms of the “debtor merely acting as a conduit”.

Confusion also arises because  two of the defenses, the conduit and the agency defenses, inevitably are the basis of adding new defendants.  If the originally named defendant is able to defend using either of these defenses, then the plaintiff is likely to amend the complaint to substitute one or more new defendants for the originally named defendant.  The success of a conduit and agency defense requires that the defendant give the plaintiff the names of the companies or individuals who were the ultimate recipients of the preferential transfers.   Needless to say, not a good way to keep customers or clients.

Even worse, under a “relation back” theory, the substitution of parties might be deemed effective as of the date of the filing of the complaint.  Because this substitution can occur months after the expiration of the statute of limitations, for the “newly named”, substitute defendants, the conduit and agency defenses do not seem like defenses at all.   Rather the “defenses” seem more like procedural weapons for the plaintiff that allow for the extension of the statute of limitations.

The Earmarking Defense – A True Defense that is Likely to be Overlooked

The earmarking defense is a true defense – if it applies the bankruptcy preference claim is dead and the transfers at issue are not recoverable from anyone.   The earmarking defense is also one of the few defenses where a defendant may have no indication of the facts that give rise to the defense.  Simply, the earmarking defense arises because of actions taken between the debtor and a third party.   The creditor who is paid may be oblivious that the reason he got paid was because of this third party arrangement.

For example, a subcontractor on a construction project may have a lien on a building for payment of the work he did.  The subcontractor gets paid and releases the lien.  The subcontractor is unaware that the money he received came from a bank who has a mortgage on the building.  In fact, the bank released funds to the debtor in order for the subcontractor to be paid and his lien released.  One secured creditor (the bank) was substituted for another secured creditor (the subcontractor who had a lien).  By virtue of the earmarking defense there is no preferential payment.

Of all of the defenses, the earmarking defense likely is the most often overlooked defense.  Since the plaintiff controls the facts on which an earmarking defense is based, it is critical for a defendant to explore even a remote possibility of the defense through independent investigation and formal discovery.

The Elements and Differences between the Bankruptcy Preference Defenses

The following table breaks down the key distinctions between and the elements of the earmarking, conduit and agency defenses.

 
 
Conduit Defense
Earmarking Defense
Agency Defense
 
 
Funds/Property Flow:
Debtor ---> Defendant ---> Third party
Third Party ---> Debtor ---> Defendant
Debtor ---> Defendant ---> Third party
 
 
Defendant's Argues "Transfer" actually was:
Debtor ---> Third party
Third Party ---> Defendant
Debtor ---> Third party
 
 
Underlying Concept:
Defendant was not an initial transferee or an immediate or mediate transferee of the initial transferee.
Transfer was not of property in which debtor had an interest.
Debtor did not transfer any interest in property when giving possession to defendant.
 
 
Basic Inquiry:
Was defendant merely acting as a non-stakeholder intermediary in the transfer of property from the debtor to a third party?
Did payment/transfer of property result merely in substitution of a new creditor for an old creditor and, accordingly, did not increase debtor's liabilities or reduce the debtor's assets?
Did the Defendant receive, hold and transfer the payment/other property as the agent of the Debtor?
 
 
Elements:
Either (1) the defendant did not have the ability to redirect the transfered funds; or (2) the defendant had a duty or obligation to a third party that prohibited defendant's use of the funds on his own account prior to transfer.
The 4 elements are (1) the existence of agreement between new creditor and debtor conditioning new funds on use to pay antecedent creditor, (2) new creditor advances funds, (3) new credit is at same or lesser priority as antecedent debt of creditor being paid (e.g. unsecured loan replaces unsecured or secured trade debt but not when secured loan replaces unsecured debt), and (4) in some jurisdictions, a requirement that the payments the defendant received be traceable back to the payments made by the new creditor.
The 3 elements are (1) debtor and defendant agreed for defendant to act as debtor's agent; (2) defendant received and held the funds pursuant to the agency agreement; and (3) defendant transfered the funds in compliance with the agency agreement.
 
 
Key Document
Agreement of defendant with third party
Agreement of third party with debtor
Agreement of the debtor with the defendant
 
 
Who is "Initial Transferee"
Third party for whom defendant acted as agent
There is no "Initial Transferee" since no "Transfer" by debtor occurred
Third party to whom defendant transferred property at direction of debtor
 
 
Applicable Bankruptcy Code Section(s)
550
547(b)
547(b)(1); 101(54)(D)
 
 
Affirmative Defense
No - Disproves element of plaintiff's case.
No - Disproves element of plaintiff's case.
No - Disproves element of plaintiff's case.
 
 
Who has Knowledge of Facts Forming Basis of the Defense
The defendant necessarily has the information forming basis for the conduit defense. Plaintiff may not be aware of the existence of or terms of the agency relationship between the defendant and the actual initial transferee.
Debtor will have knowledge of the factual basis for the earmarking defense. Debtor must have made agreement with third party providing debtor funds/property to satisfy obligation to defendant. In fact, the defendant may have no knowledge whatsoever of the agreement between the debtor and the ultimate source of the funds used to pay the defendant.
The debtor must have appointed defendant as debtor's agent but may not know if transfers by defendant were made per debtor's instructions or the names of the persons to whom defendant made the transfers. So as to the agency defense, portions of the relevant information may be in each of the debtor's and the defendant's knowledge.