ESA Environmental Specialists, Inc. (ESA) was an engineering firm that had various constructions projects under contract with the federal government. As such, ESA was required to obtain surety bonds to secured completion of the contracts and pay vendors and subcontractors. ESA originally obtained eight surety bonds from Hanover in 2006. In April 2007, ESA borrowed $12.2 million from Prospect Capital to fund operations. Shortly, thereafter, ESA sought seven additional surety bonds from Hanover. Hanover, however, required that ESA to obtain a Letter of Credit for $1.375 million from Sun Trust, which was accomplished on May 17, 2007, through depositing such amount in a CD with Sun Trust. Those funds were also obtained from Prospect Capital, under agreement that the amount of the loan from Prospect Capital was increased by $1.575 million. ESA’s financial situation deteriorated and it filed Chapter 11 on August 1, 2007, at which time Hanover withdrew the $1.375 million from Sun Trust. During the initial Chapter 11 proceeding, nearly all of ESA’s assets were sold to Prospect Capital, including the rights under the government contacts, the right to return of collateral following completion of those contracts, and litigation rights of ESA, including preference actions. Prospect Capital (through its affiliates) failed to commence work on the government contracts, with Hanover ultimately completing them. In February 2008, the Chapter 11 case was converted to Chapter 7, with the Trustee seeking (with the agreement of Prospect Capital) to avoid the $1.375 million received by Hanover, alleging that Hanover was an indirect beneficiary of a preferential transfer by ESA into the Sun Trust CD. Hanover contested this, arguing that the funds were not a preferential transfer as they had been specifically earmarked for payment to Hanover and because ESA received new value in exchange for the loan from Prospect Capital which funded the Sun Trust CD. The bankruptcy court, affirmed by the district court, agreed, additionally holding that “[i]t would be inequitable to require Hanover to return the portion of the Prospect [Loan] used to cover the costs to complete the [Government Contracts] when Hanover did the work, and paid the obligations.”
The Court of Appeals described the “earmarking” defense to a preference action was “[w]hen a third person makes a loan to a debtor specifically to enable that debtor to satisfy the claim of a designated creditor.” 5 Collier on Bankruptcy ¶ 547.03[a] (16th ed. 2011); see Va. Nat’l Bank v. Woodson (In re Decker), 329 F.2d 836, 839 (4th Cir. 1964). Where normally an unconditioned loan to a bankrupt debtor becomes part of the assets of the estate, a loan that is specifically intended for payment of a specific debt is not preferential, as it does not otherwise diminish the bankruptcy estate, since the lender would not have made the loan for the general benefit of creditors. Earmarking, however, only applies when a loan is used to extinguish a specific, designated, existing debt. Here the funds were used to incur a new debt.
In regard to the New Value defense, as provided by 11 U.S.C. § 547 (c)(1), the Court of Appeals began by restating that it would only over turn the bankruptcy court’s finding of fact, which formed the basis for allowed the “new value” defense, upon clear error. Because the bankruptcy court had found that Hanover had offered uncontradicted evidence of new value in excess of $1.375 million, it was not required to show the exact amount of the new value. The dissent, however, would have found that 11 U.S.C. § 547(a)(2) defines “new value,” as as “money or money’s worth in goods, services, or new credit, or release by a transferee of property previously transferred to such transferee.” Here instead, ESA only received a conditional promise for payment at some indefinite point in the future, which should not constitute receipt of “new value” in the amount of the promised payment. Hanover instead obtained $1.375 million without replacing that with anything of value.
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