4th Cir.: In Re Star Development- Account is Property of the Estate Despite Assertion of Earmarking and Trust.

Summary:

Mukesh Majmudar and Hopkins Hospitality Investors, LLC (HHI) sought to recover $1 million deposited into an account titled in the name of Star Development Group, LLC—the Chapter 7 debtor entity that Majmudar also managed. The funds were originally posted as collateral for a letter of credit related to a mechanic’s lien on a hotel construction project. After Star filed bankruptcy, the Trustee included the account as property of the estate. Majmudar and HHI filed an adversary proceeding, asserting that the funds were not estate property under three theories: (1) the "earmarking" doctrine; (2) a resulting trust for the benefit of the bank; and (3) 11 U.S.C. § 541(b)(1)’s exclusion for powers exercisable solely for the benefit of others.

The bankruptcy court (Judge Guttman), affirmed by the district court (Judge Bennett), rejected all three theories on summary judgment. The Fourth Circuit affirmed in a per curiam unpublished opinion by Judge Wynn, joined by Judges Wilkinson and Niemeyer.

The Court found that:

• Earmarking failed because there was no written agreement that the Debtor could only use the funds to pay a specific creditor, nor were the funds actually disbursed to satisfy any antecedent debt.

• Resulting trust was unsupported because neither the account documents nor Debtor’s sworn filings established any trust relationship, and all records indicated the Debtor was treated as owner.

• Section 541(b)(1) did not apply, as this was not a “power exercisable solely for the benefit of another,” nor did the circumstances resemble those in T & B Scottdale Contractors, where clear contractual obligations and third-party beneficiaries existed.

Commentary:

While this case serves as a sharp reminder that even creatively repurposed doctrines like earmarking and implied trusts will not rescue insiders who have blurred entity boundaries and failed to memorialize restrictions on asset control.

But that caution may also provide a roadmap  for debtors in bankruptcy to protect funds provided by third-parties  from  unnecessarily being applied towards general unsecured creditors  rather than secured or priority claims.  Earmarking  in bankruptcy would require establishing the following elements:

1. A  third party advances funds to the debtor
   The funds must come from a third party, not from the debtor’s own resources.

2. The new funds are specifically designated to pay a particular, pre-existing debt
   There must be an agreement—explicit or implied—among the debtor, the third-party, and perhaps the original creditor that the new funds will be used to pay that specific antecedent debt.

3. The funds are actually used to pay that designated creditor
   The payment must go  to the old creditor, or at least be used by the debtor for that exact purpose.

4. The debtor does not have control or discretion over the use of the funds
   If the debtor could use the funds for any purpose (i.e., they are not “earmarked”), then the defense fails. Courts look closely at whether the debtor had authority to disburse the funds to anyone other than the specified creditor.

Commentary:

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