Adbox Redux: Who Must Prove and Disprove Earmarking

In the previous post, I commented on In re Adbox, Inc., 2007 WL 1584582 (9th Cir. June 4, 2007), a case which explains the maybe not so obvious – why can’t creditors counterclaim in an avoidance action and offset their claims against their disgorgement liability?

I omitted to mention in that post, which was already long enough, that Adbox also contains a good, practical groundrule on who has the burden of proof to establish the “earmarking” defense to a preference claim. To quote the Court, “the ‘earmarking doctrine’ is a court-made exception [to preference liability] that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor.” This would be the case, for example, when a bank makes a loan subject to covenants that the loan proceeds will be used to make particular payments.

Does the trustee have the burden to disprove earmarking, because an element of preference liability is a transfer of property of the debtor (and not property in effect held in trust for another)? Or is earmarking an affirmative defense which must be proved by the creditor? The Ninth Circuit adopted the holding of an earlier BAP decision, In re Sierra Steel, Inc., 96 B.R. 271, 274 (Bankr. App. 9th Cir. 1989), holding that the Trustee must make a preliminary showing that the payment “was from one of the debtor's accounts over which the debtor ordinarily exercised total control.” Once that showing is made, “the burden then shifts to the defendant in the preference action to show that the funds were earmarked.”

Copyright Dean T. Kirby 2007. All rights reserved.