This is an appeal from a judgment of the District Court for the Western District of Kentucky affirming the bankruptcy court’s award of summary judgment in favor of plaintiff-appellee, Jerry Burns, Trustee, in a Chapter 7 proceeding. The Trustee had moved to avoid certain transactions as unauthorized post-petition transfers of property of the bankruptcy estate of debtor Frankie Dewayne Shelton. The summary judgment had the effect of avoiding the mortgage lien of defendant-appellant Peoples Bank and Trust Company. On appeal, Peoples Bank asserts two claims of error. For the reasons that follow, we vacate the judgment of the district court and remand with instructions.
I
Debtor Frankie Shelton filed a Chapter 11 bankruptcy petition on October 7, 1999.
On or about January 24, 2000, Firstar was granted relief from the automatic bankruptcy stay. The bankruptcy court authorized Firstar to enforce its mortgage liens, on which it had obtained a judgment in state court. Firstar thereupon gave notice of a public auction for the sale of real and personal property on April 8, 2000. Before the auction took place, however, Firstar reached an agreement with debtor Frankie Shelton and his father Virgil Shelton for a different disposition. Pursuant to this “Forbearance Agreement,” (1) Frankie conveyed his interest in the real property to his father Virgil by quitclaim deed; (2) Virgil mortgaged the property to Peoples Bank and Trust for a loan of $668,218; (3) Peoples Bank paid $650,000 to Firstar; and (4) Firstar released its liens. These transactions were completed by the end of March 2000.
It is undisputed that Virgil and Peoples Bank were aware of the pending bankruptcy proceedings. It is also undisputed that, although Firstar had obtained relief from the bankruptcy stay, neither the bankruptcy court nor the Trustee had specifically authorized or approved the above transactions. Hence, the Trustee moved pursuant to 11 U.S.C. § 549(a) to avoid Frankie’s conveyance to Virgil and Peoples Bank’s mortgage lien as unauthorized post-petition transfers. The bankruptcy court rejected the defense that the transactions were authorized, holding as a matter of law that the order authorizing Firstar to enforce its liens did not authorize Frankie to convey property to Virgil.
As a consequence, the bankruptcy court also avoided Peoples Bank’s mortgage lien pursuant to 11 U.S.C. § 549(a). The bankruptcy court ruled that the defenses of 11 U.S.C. § 550(b) and (e), in favor of a good faith transferee, were not available to Peoples Bank. The bankruptcy court also refused to apply the equitable “earmarking doctrine” to preserve these transactions. The bankruptcy court thus awarded summary judgment to the Trustee. In re Shelton,
II
Peoples Bank maintains on appeal that it is entitled to the defenses of 11 U.S.C. § 550(b) and (e). Under § 550(b), the
The bankruptcy court held that both defenses were unavailable to Peoples Bank for two reasons. First, because the Trustee had not sought recovery of any property from Peoples Bank under 11 U.S.C. § 550, the bankruptcy court held the § 550 defenses simply did not come into play. Second, even if the defenses were available, Peoples Bank was deemed not entitled to claim them because it was not a “good faith transferee.”
The bankruptcy court’s interpretation of the applicability of § 550, being an issue of law under the circumstances of this case, is subject to de novo review. See In re Dow Coming,
Peoples Bank has cited no contrary authority, preferring to argue that it is a “good faith transferee.” Yet, because Peoples Bank is not entitled to assert the § 550 defenses, we need not consider its “good faith transferee” status.
Ill
Peoples Bank also contends the lower courts erred by refusing to apply the earmarking doctrine. Inasmuch as the lower courts’ holdings in this regard were not fact-based determinations, but rather applications of law, this claim, too, presents an issue of law which we review de novo.
The earmarking doctrine is an equitable doctrine by which the use of borrowed funds to discharge a debt is deemed not to be a transfer of property of the debtor, and therefore not voidable. In re Montgomery,
(1) the existence of an agreement between the new lender and the debtor that the new funds will be used to pay a specified antecedent debt, (2) performance of that agreement according to its terms, and (3) the transaction viewed as a whole (including the transfer in of the new funds and the transfer out to the old creditor) does not result in any diminution of the estate.
In the present record, there appears to be no dispute that the first two of these requirements are satisfied by the instant transactions, whereby Peoples Bank loaned new funds for the explicit and exclusive purpose of discharging Frankie’s debt to Firstar. It is further undisputed that neither the bankruptcy court nor the district court made any finding as to the
The bankruptcy court found it unnecessary to reach the third requirement because it held the earmarking doctrine otherwise inapplicable for three reasons. First, it correctly recognized that the earmarking doctrine is traditionally applied as a defense to a preference claim and has not been applied in the Sixth Circuit to a post-petition transfer. Second, the bankruptcy court correctly noted that the instant transactions, including conveyance of property from the debtor to his father as a precondition to the substitution of creditors, are different from the classic earmarking arrangement. Third, recognizing that the earmarking doctrine is equitable in nature, the bankruptcy court held that Peoples Bank had failed to carry its burden of showing entitlement to such relief. That is, the bankruptcy court, despite finding no evidence of wrongful purpose, was not persuaded that Peoples Bank proceeded with a “white heart.” The bankruptcy court recognized that avoidance of Peoples Bank’s mortgage lien produced an “extreme result,” but faulted Peoples Bank for entering into the transactions with less than reasonable due diligence.
We agree with the conclusion that Peoples Bank is not blameless and has contributed to this “extreme result.” Peoples Bank offers no satisfactory explanation for its failure to seek Trustee or bankruptcy court approval of the proposed transaction before consummating it. Yet, we remain unpersuaded that the extreme result of voiding Peoples Bank’s mortgage lien is unavoidable.
Although the earmarking doctrine has not been applied to post-petition transfers in the Sixth Circuit, other courts have so expanded its application. See In re Westchester Tank Fabricators,
We also recognize that the subject transactions are somewhat unique, involving more than a mere substitution of creditors pursuant to an agreement that permitted the debtor no control over the disposition of the new funds. Yet, where the bankruptcy court had authorized Firs-tar to sell the debtor’s property at a public sale, and Firstar instead agreed to an intra-family transfer of the property as a means of obtaining satisfactory enforcement of its mortgage hens through the interposition of a new creditor, we fail to apprehend the significance of this difference in determining the applicability of the earmarking doctrine. Again, we conclude this difference, too, does not necessarily preclude equitable relief under the earmarking doctrine.
Also questionable is the bankruptcy court’s holding that Peoples Bank failed, for lack of a “white heart,” to carry its burden of proving entitlement to equitable relief. Ordinarily, where the earmarking doctrine is invoked as a defense to avoidance of a transfer, it is the trustee who bears the burden of proving the non-applicability of the doctrine. See In re Heitkamp,
Insofar as the subject transactions included an unauthorized post-petition transfer of property from Frankie to Virgil, the bankruptcy court correctly concluded that the transfer was voidable — not “void,’’but “voidable.” See 11 U.S.C. § 549(a) (“the trustee may avoid”); In re Bean,
Asked how these transactions resulted in a diminution of or injury to the estate, the Trustee contends simply that the lack of prior notice deprived him of the opportunity to evaluate their impact on the estate. The Trustee does not even allege that the transactions diminished the property of the estate. He simply does not know. Ultimately, the Trustee’s avoidance of the transfers appears to have been motivated not by a desire to serve the best interests of the estate, but a desire to vindicate his own authority. Yet, “the Trustee’s duty to act in the best interest of the bankruptcy estate does not include an obligation to punish debtors, let alone others, for punishment’s sake.” Id. at 203. Where, as here, there is no evidence of abusive or fraudulent conduct, the Trustee is not to be concerned with abstract concepts of justice, but should act to protect the bankruptcy estate and its creditors. Id. Based on the present record, it is far from clear that the Trustee so acted in this case. The Trustee may ultimately be vindicated, but justice requires that he be put to the test.
This Court is asked to pass on the availability of equitable relief pursuant to the earmarking doctrine — to expand the doctrine so as to prevent an unfair result. Because of the incompleteness of the requisite factual record, as outlined above, we are unable to do so. Accordingly, the matter will be remanded for further fact-finding consistent generally with the above analysis and directed particularly to the question whether the subject transactions resulted in a diminution of the bankruptcy estate. The answer to this question, though not necessarily dispositive, must
IV
For the foregoing reasons, the judgment of the district court is VACATED. The lower courts’ refusal to apply the earmarking doctrine was based on an incomplete factual record and a misapprehension concerning the burden of proof. The action is therefore REMANDED to the district court with instructions (1) to afford the parties a reasonable opportunity to present evidence on the question whether the subject transactions resulted in a diminution of the bankruptcy estate; (2) to make findings of fact on this issue; and (3) to reconsider the applicability of the earmarking doctrine in light of such findings.
KAREN NELSON MOORE, Circuit Judge, concurring in part and dissenting in part.
While I concur in that part of the majority opinion that concludes that Peoples Bank is not entitled to the defenses of 11 U.S.C. § 550(b) and (e), based on our decision in Suhar v. Burns (In re Bums),
Notes
. The order granting relief from the bankruptcy stay has not been made a part of the record. The precise scope of relief granted is therefore indeterminate on the present record. Yet, Peoples Bank has not directly challenged the bankruptcy court’s ruling in this regard on appeal, and the scope of relief granted is given no further scrutiny.