## Facts

- Scott and Darcy Heitkamp operated a homebuilding business and borrowed construction funds from Community First National Bank.
- The bank first loaned $50,000 to build a house, secured by a mortgage.
- When the debtors ran out of cash, the bank made a second $40,000 loan in November 1995.
- The bank did not disburse the second-loan proceeds to the debtors; it issued cashier’s checks payable directly to specified subcontractors who had provided goods or services for the house.
- At the bank’s direction, the debtors obtained mechanic’s lien waivers from the subcontractors in exchange for the checks.
- The debtors granted the bank a second mortgage as security for the second loan, but the bank did not record the second mortgage until March 1, 1996.
- Three days after the mortgage was recorded, the debtors filed a Chapter 7 petition; the house was later sold and competing claims were asserted to the sale proceeds.
- The Chapter 7 trustee filed an adversary proceeding to avoid the transfer of the second mortgage as a preference under 11 U.S.C. § 547(b); the bank asserted the earmarking doctrine.

## Issues

1. Whether the trustee could avoid the second mortgage as a preferential transfer under 11 U.S.C. § 547(b), or whether the earmarking doctrine meant there was no transfer of an interest of the debtor in property.
2. Whether the trustee carried the burden to show the earmarking doctrine did not apply where the bank’s loan proceeds were paid directly to subcontractors in exchange for lien waivers.

## Decision

- The Eighth Circuit reversed the district court’s affirmance of the bankruptcy court.
- The court held the earmarking doctrine applied because the second-loan funds were designated to pay specified subcontractors, the arrangement was carried out, and the transaction as a whole did not diminish the estate.
- The court concluded the trustee failed to prove an avoidable transfer of an interest of the debtor in property under § 547(b).
- The bank’s second mortgage was not avoided as a preference.

## Legal Principles

- A trustee may avoid a preference under 11 U.S.C. § 547(b) only if there is a transfer of an interest of the debtor in property.
- Under the Eighth Circuit’s earmarking doctrine framework, there is no avoidable transfer where: (1) a new lender and the debtor agree the new funds will pay a specified antecedent debt; (2) the agreement is performed; and (3) the transaction, viewed as a whole, does not diminish the debtor’s estate.
- When loan proceeds are disbursed directly to designated creditors and never come under the debtor’s dominion and control, the funds are not treated as property of the debtor’s estate for § 547(b) purposes.
- Substituting one secured position for another (e.g., replacing potential mechanics’ lienholders with a lender’s mortgage) does not constitute estate diminution when the net value available to other creditors is unchanged.
- The trustee bears the burden in a preference action to establish the elements of § 547(b), including showing that earmarking does not defeat the required “interest of the debtor in property.”

## Conclusion

The Eighth Circuit held that because the bank’s second-loan proceeds were earmarked and paid directly to subcontractors in exchange for lien waivers, the transaction did not transfer an interest of the debtors in property or diminish the estate; therefore, the trustee could not avoid the bank’s belatedly recorded second mortgage under § 547(b).


In re Heitkamp, 137 F.3d 1087 (8th Cir. 1998)