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In re: SUPERIOR STAMP & COIN CO.,
INC.,
Debtor.
No. 99-55204
CAROLYN ADAMS, individually and
as the Personal Representative of                     D.C. No.
the Estate of Clarke E. Adams,                        CV-98-00409-CBM
Appellant,
OPINION
v.

PETER A. ANDERSON, Chapter II
Trustee,
Appellee.

Appeal from the United States District Court
for the Central District of California
Consuelo B. Marshall, District Judge, Presiding

Argued and Submitted
June 9, 2000--Pasadena, California

Filed September 6, 2000

Before: Stephen Reinhardt, Richard A. Paez, Circuit Judges,
and William L. Dwyer, District Judge.1

Opinion by Judge Reinhardt

SUMMARY 
 
The summary, which does not constitute a part of the opinion of the court, 
is copyrighted C 2000 by West Group. 
_________________________________________________________________

Bankruptcy/Preferential Transfers

The court of appeals reversed a judgment of the district
court. The court held that where a third party lends money to
a debtor on the condition that it be used to pay a specific debt,
the fact that the debtor requested the loan or that the funds
were advanced to the debtor rather than paid directly to the
recipient creditor does not render the transfer outside the
scope of the earmarking doctrine.

Debtor Superior Stamp and Coin Company agreed to auc-
tion appellant Carolyn Adams's coin collection and pay her
the net proceeds within 30 days after receiving the funds. The
net proceeds amounted to $374,000. Superior failed to pay
them. Superior negotiated a repayment schedule with Adams
that called for Superior to remit the proceeds to Adams in six
equal payments of $62,355.

The Bank of California, Superior's largest creditor, con-
cerned about Superior's financial situation, became actively
involved in Superior's day-to-day management. Because of
that involvement, Superior submitted to the bank a copy of
the letter to Adams confirming the repayment schedule. In an
effort to preserve Superior's business, the bank and Superior
entered into a written agreement, which required that Superior
submit monthly budgets to the bank for approval. In addition,
the agreement stated that Superior would not, without written
approval from the bank, pay any of its obligations other than
to the bank, which were due prior to January 1, 1994. The
debt to Adams was just such an obligation.

Under its agreement with the bank, Superior disbursed
checks to vendors and consignors according to budgets previ-
ously provided to the bank, and the bank reviewed the dis-
bursements before they were made. As for the payments to
Adams, Superior was to determine if it had a cash shortfall
and the bank would fund that shortfall up to $62,355 in order
to pay Adams.

Superior issued the first $62,355 check to Adams. The bank
reviewed it and approved the payment. The bank then
advanced to Superior's account the full amount of $62,355 to
clear the check and transferred the funds to Adams. Superior
issued a second $62,355 check to Adams. The bank again
approved the payment and advanced the funds necessary to
cover the check. This time, because Superior's account
already contained $42,439.10, the bank advanced only the
amount required to fund the shortfall. After these two pay-
ments, the bank did not pay Adams further or authorize Supe-
rior to make any more payments to her.

Superior filed for Chapter 11 bankruptcy. The trustee
attempted to recover the two payments made to Adams by
Superior, including both the amount for which the bank reim-
bursed Superior and the amount paid her out of the funds
Superior already had on deposit, on the ground that they were
voidable preference transfers. Adams argued that the bank-
ruptcy doctrine of earmarking immunized the transfers from
avoidance. The bankruptcy court ruled that the payments to
Adams were voidable transfers on the ground that the ear-
marking doctrine was inapplicable.

The district court affirmed the bankruptcy court. Adams
appealed, limiting her challenge to the amount covered by the
bank's advances, arguing that the payments by the bank of
Superior's checks to her were not transfers of an interest of
the debtor in property. Rather, she argued the bank was a third
party that transferred its own funds to Adams when it honored
the checks despite the shortfall in Superior's account.

[1] Under the Bankruptcy Code, a trustee may recover cer-
tain transfers made by the debtor within 90 days before the
bankruptcy petition was filed. A transfer by the debtor consti-
tutes an avoidable preference if six elements are shown: (1)
a transfer of an interest of the debtor in property; (2) to or for
the benefit of a creditor; (3) for or on account of an antecedent
debt; (4) made while the debtor was insolvent; (5) made on
or within 90 days before the date of the filing of the petition;
and (6) one that enables the creditor to receive more than such
creditor would receive in a Chapter 7 liquidation of the estate.

[2] To determine whether property that is transferred
belongs to the debtor, the diminution of estate doctrine is
applied. Under this doctrine, a transfer of an interest of the
debtor in property occurs where the transfer diminishes
directly or indirectly the fund to which creditors of the same
class can legally resort for the payment of their debts, to such
an extent that it is impossible for other creditors of the same
class to obtain as great a percentage as the favored one. Gen-
erally, transfers by a debtor of borrowed funds constitute
transfers of the debtor's property because the borrowed funds,
had they not been transferred, would have been available in
bankruptcy to satisfy the claims of other creditors.

[3] The earmarking doctrine is an exception to this general
rule. [4] The earmarking doctrine applies when a third party
lends money to a debtor for the specific purpose of paying a
selected creditor. That the bank did not pay Adams directly,
and Superior requested the loan in order to pay Adams did not
render the earmarking doctrine inapplicable.

[5] That Superior may have had the power to divert the
loan after it was deposited into Superior's account did not
amount to control of the funds by Superior. [6] The proper
inquiry was not whether the funds entered the debtor's
account, but whether the debtor had the right to disburse the
funds to whomever it wished, or whether their disbursement
was limited to a particular old creditor or creditors under the
agreement with the new creditor. Where a transfer is made
pursuant to an antecedent agreement between the new lender
and the debtor that the new funds will be used only to pay a
specified creditor, the lender rather than the debtor controls
the funds.

[7] Because the bank disbursed the funds pursuant to such
an antecedent agreement, Superior did not exercise control
over the money even though Superior requested the loan to
pay Adams and the funds were placed in Superior's account
rather than being paid directly to Adams by the bank. [8] The
payments made by the bank to fund the checks to Adams fell
within the earmarking doctrine.

_________________________________________________________________

COUNSEL

Stacey M. Garrett, Keesel, Young & Logan, Long Beach, Cal-
ifornia, for the appellant.

Gregory S. Abrams and Judith Seeds Miller, A.S.K. Finan-
cial, Tarzana, California, for the appellee.

_________________________________________________________________

OPINION

REINHARDT, Circuit Judge:

This case involves a dispute over the interpretation of the
"earmarking" doctrine -- a rule that is applied in bankruptcy
cases. The question before us is whether the bankruptcy court
erred in determining that certain payments were avoidable
under 11 U.S.C. S 547 as preferential transfers. We hold that
where a third party lends money to a debtor on the condition
that it be used to pay a specific debt, the fact that the debtor
requested the loan or that the funds were advanced to the
debtor rather than paid directly to the recipient creditor does
not render the transfer outside the scope of the earmarking
doctrine. The decisions of the bankruptcy court and the dis-
trict court are reversed.

I. BACKGROUND

Superior Stamp & Coin ("Superior") operated as a full ser-
vice auction house specializing in the auction of coins, sports
and Hollywood memorabilia, and related goods, until the
company filed for bankruptcy in 1994. Appellee Anderson
was appointed trustee in 1996.

In 1992, appellant Carolyn Adams and Superior entered
into an auction consignment agreement. Under the agreement,
Superior agreed to auction Adams's coin collection and pay
Adams the net proceeds within 30 days after receiving the
funds. The net proceeds amounted to $374,125.57. Superior
failed to pay them. In April, 1994, after Adams inquired about
whether Superior had remitted the auction funds, the copresi-
dent of Superior, Ira Goldberg, negotiated a repayment sched-
ule with her that called for Superior to remit the proceeds to
Adams in six equal payments, each totaling $62,355.00.

In early 1994, Superior was under severe financial strain.
The Bank of California ("bank"), Superior's largest creditor,
had become concerned about Superior's financial situation,
and was actively involved in Superior's day-to-day manage-
ment. Because of that involvement, Goldberg submitted to the
bank a copy of his letter to Adams confirming the repayment
schedule.

In an effort to preserve Superior's business, the bank and
Superior entered into a written agreement on May 13, 1994,
regarding the consequences of Superior's default on its credit
agreement with the bank. The agreement required, among
other things, that Superior submit monthly budgets to the
bank for approval. In addition, the agreement stated that the
"[b]orrower will not, under any circumstances, without writ-
ten approval from bank, pay any obligations of borrower other
than to bank, which were due prior to January 1, 1994." The
debt to Adams was just such an obligation.

Superior subsequently submitted a budget to the bank that
included, among the items to be paid, the installment to
Adams. On May 25, 1994, Superior and the bank met to dis-
cuss, among other things, the procedures established by the
bank for advancing funds to Superior. The memorandum pre-
pared to confirm the outcome of the meeting noted that Supe-
rior would disburse checks to vendors and consignors
according to budgets previously provided to the bank, and that
the bank would review the disbursements before they were
made. The memorandum further stated: "Regarding the
Adams payment, the company will determine if it has a cash
shortfall on Friday after the Crain payment and payroll. The
bank will fund that shortfall up to $62,355 in order to pay
Adams. If no check to Adams is sent, then the bank will not
fund the $62,355."

In accordance with the agreement, Superior issued a
$62,355 check to Adams on May 27, 1994. When the check
was presented to the bank, it was subjected to a "special
review" process and then approved by the bank. The bank
then advanced to Superior's account the funds necessary to
clear the check -- in this case, the full amount of the $62, 355
payment -- and simultaneously electronically transferred the
funds to Adams. Superior issued a second $62,355 check to
Adams on July 7, 1994, again in accordance with a budget
approved by the bank. The bank again approved the payment
and advanced the funds necessary to cover the check. This
time, because Superior's General Account already contained
$42,439.10, the bank advanced only $19,915.90 -- the
amount required to fund the shortfall. Counsel for Adams
conceded at oral argument that the $42,439.10 paid to Adams
out of Superior's existing funds was not subject to the ear-
marking exception and was therefore voidable as a preference
transfer. Remaining at issue in this case, therefore, are the two
payments, totaling $82,270.90, advanced by the bank. After
these two payments, the bank decided that it would not pay
Adams further or authorize Superior to make any more pay-
ments to her.

In spite of the efforts to save Superior, the company failed.
On August 26, 1994, Superior filed an involuntary petition for
Chapter 11 bankruptcy. Some time later, an adversary pro-
ceeding was filed against Adams by the trustee in an attempt
to recover the two payments made to her by Superior, includ-
ing both the amount for which the bank reimbursed Superior
and the amount paid her out of the funds Superior already had
on deposit. The trustee sought to recover the payments on the
ground that they were voidable preference transfers. In oppo-
sition, Adams argued that the bankruptcy doctrine of earmark-
ing immunized the transfers from avoidance. After a trial, the
bankruptcy court ruled that the payments to Adams were
voidable transfers on the ground that the earmarking doctrine
was inapplicable. Adams appealed to the district court, which
affirmed the bankruptcy court. Adams then appealed to this
court, subsequently limiting her challenge to the amount cov-
ered by the bank's advances.

II. DISCUSSION

We review the district court's decision on appeal from the
bankruptcy court de novo. See Preblich v. Battley, 181 F.3d
1048, 1051 (9th Cir. 1999). Thus, we apply a clearly errone-
ous standard to the bankruptcy court's findings of fact and
review its conclusions of law de novo. See id. The issues we
decide here are all matters of law.2

[1] Under S 547(b) of the Bankruptcy Code, a trustee may
recover certain transfers made by the debtor within 90 days
before the bankruptcy petition was filed. A transfer by the
debtor constitutes an avoidable preference if six elements are
shown: (1) a transfer of an interest of the debtor in property;
(2) to or for the benefit of a creditor; (3) for or on account of
an antecedent debt; (4) made while the debtor was insolvent;
(5) made on or within 90 days before the date of the filing of
the petition; and (6) one that enables the creditor to receive
more than such creditor would receive in a Chapter 7 liquida-
tion of the estate. See 11 U.S.C. S 547(b); Hansen v. MacDon-
ald Meat Co. (In re Kemp Pacific Fisheries Inc.), 16 F.3d
313, 316 n.6 (9th Cir. 1994); In re Smith, 966 F.2d 1527, 1529
n.1 (7th Cir. 1992). Adams concedes that five of those ele-
ments exist and disputes only the bankruptcy court's conclu-
sion as to the first element. That is, Adams argues that the
payments by the bank of Superior's checks to Adams were
not "transfer[s] of an interest of the debtor in property." 11
U.S.C. S 547(b). In Adams's view, the bank is a third party
that transferred its own funds to Adams when it honored the
checks despite the shortfall in Superior's account.

[2] In order to determine whether property that is trans-
ferred belongs to the debtor for purposes of S 547, we apply
the "diminution of estate" doctrine. In re Kemp, 16 F.3d at
316 (9th Cir. 1994). Under this doctrine, a transfer of an inter-
est of the debtor in property occurs where the transfer "dimin-
ish[es] directly or indirectly the fund to which creditors of the
same class can legally resort for the payment of their debts,
to such an extent that it is impossible for other creditors of the
same class to obtain as great a percentage as the favored one."
Id. (quoting 4 Collier on Bankruptcy P 547.03, at 547-26
(15th ed. 1993)); see also id. ("property belongs to the debtor
for purposes of S 547 if its transfer will deprive the bank-
ruptcy estate of something which would otherwise be used to
satisfy the claims of creditors.")(citation omitted). Adams
concedes that, generally, transfers by a debtor of borrowed
funds constitute transfers of the debtor's property because the
borrowed funds, had they not been transferred, would have
been available in bankruptcy to satisfy the claims of other
creditors. In re Kemp, 16 F.3d at 316.

[3] There is an exception (or perhaps a corollary) to this
general rule, however, known as the earmarking doctrine.
Adams contends that the portion of the two transfers made to
her that was covered by the funds advanced by the bank falls
within this exception. The issue before us is whether the ear-
marking doctrine applies where a debtor requests a loan to
pay a particular creditor, and the lender does not pay the cred-
itor directly but advances to the debtor the funds to pay the
selected creditor.

To determine the proper scope of the earmarking exception,
it is appropriate to consider briefly the origins and rationale
of the doctrine and its various applications. The earmarking
doctrine arose in cases in which a debtor owed money to a
creditor (the "old creditor") under circumstances in which
another party was a guarantor of the debtor's obligation. See
in re Kemp, 16 F.3d at 316 n.2; McCuskey v. National Bank
of Waterlook (In re Bohlen Enterprises, Ltd.), 859 F.2d 561,
565 (8th Cir. 1988). Where the guarantor paid to the old cred-
itor the money owed by the debtor (thereby becoming a "new
creditor" of the debtor), the courts rejected the claim that such
a payment was a voidable preference. Two principal ratio-
nales were used to justify the conclusion that no preference
transfer had occurred: courts stated (1) that the transfer was
of the new creditor's, not the debtor's, property; and (2) that
there was no diminution in the debtor's estate because the
transaction merely substitutes one creditor for another. See id.
at 565.

"Where the guarantor, instead of paying the old creditor
directly, entrusted the new funds to the debtor with instruc-
tions to use them to pay the debtor's obligation to the old
creditor, the courts quite logically reached the same result."
Id. at 565. Because the substance of this second type of trans-
action appeared to be identical to the first, courts overlooked
the formal distinction that the funds were placed in the debt-
or's possession before payment to the old creditor. See, e.g.,
Brown v. First National Bank of Little Rock, 748 F.2d 490,
492 n.6 (8th Cir. 1984). In order to preserve the original ratio-
nale for the doctrine, courts stated that, although the debtor
has possession of the new funds for some period, the funds
never become the debtor's property because they are not
within the debtor's "control." See In re Bohlen, 859 F.2d at
565. Courts then extended the doctrine "beyond the guarantor
situations and . . . applied it to situations where the new credi-
tor is not a guarantor but merely loans funds to the debtor for
the purpose of enabling the debtor to pay the old creditor." Id.
at 566; see also In re Kemp, 16 F.3d at 316 n.2.

[4] Thus, we have held that the earmarking doctrine applies
"when a third party lends money to a debtor for the specific
purpose of paying a selected creditor." In re Kemp, 16 F.3d
at 316 (quoting In re Smith, 966 F.2d at 1533); see also In re
Bohlen, 859 F.2d at 566 (holding that the earmarking doctrine
requires: "(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 agree-
ment according to its terms; (3) the transaction viewed as a
whole . . . does not result in any diminution of the estate.3")
"A key inquiry" in the analysis of whether a third party trans-
fer is voidable is the source of control over the new funds:

       If the debtor controls the disposition of the funds and
       designates the creditor to whom the monies will be
       paid independent of a third party whose funds are
       being used in . . . payment of the debt, then the pay-
       ments made by the debtor to the creditor constitute
       a preferential transfer.

In re Kemp, 16 F.3d at 316 (emphasis added)(citation omit-
ted). Here, the bankruptcy court held that the transfer was
voidable on the ground that Superior, rather than the bank,
"controlled" the borrowed funds. The court reached this con-
clusion because (1) the bank did not pay Adams directly, and
(2) Superior requested the loan in order to pay Adams. These
facts do not, however, serve to render the earmarking doctrine
inapplicable.

[5] The bankruptcy court held that "a debtor has and main-
tains a property interest in funds advanced to it by its lender,
even if the loan advance was intended and/or conditioned on
the funds being used to pay . . . a specific creditor." The court
suggested that Superior "controlled" the borrowed funds
because the advances from the bank were deposited in Superi-
or's account rather than paid directly to Adams by the bank.
This gave Superior "control," the court stated, because pos-
session of the funds gave it the power (though not the right)
to divert the loan to another use. The bankruptcy court's con-
clusion contravenes our rule applying the earmarking doctrine
to cases in which "a third party lends money to a debtor for
the specific purpose of paying a selected creditor. " In re
Kemp, 16 F.3d at 316; see also 4 Collier on Bankruptcy,
P 547.25 at 547 ("The rule is the same regardless of whether
the proceeds of the loan are transferred directly by the lender
to the creditor or are paid to the debtor with the understanding
that they will be paid to the creditor in satisfaction of his
claim, so long as such proceeds are clearly `earmarked.' ").
The fact that Superior may have had the power  to divert the
loan after it was deposited into Superior's account does not
amount to "control" of the funds by Superior. If it did, the ear-
marking doctrine would have been limited to situations in
which the guarantor or other new creditor paid the old creditor
directly. For when the funds are first handed-over to the
debtor, the debtor will, by virtue of possession, almost always
have the power to break the agreement to transfer the funds
to the old creditor.

[6] Accordingly, the proper inquiry is not whether the funds
entered the debtor's account, but whether the debtor had the
right to disburse the funds to whomever it wished, or whether
their disbursement was limited to a particular old creditor or
creditors under the agreement with the new creditor. For
example, in In re Kemp, the trustee sought to avoid a transfer
made by a bank when it honored the debtor's check despite
a negative account balance. We found that the earmarking
doctrine did not apply:

       [The bank] did not exercise the requisite control over
       the funds or place any limits whatsoever on the par-
       ties to whom Kemp Pacific Fisheries could present
       checks. There is no indication in the record that[the
       bank] [loaned money to Kemp] because the pre-
       senter of the check was MacDonald, or in any way
       communicated to the debtor that the check would
       only be honored on the condition that the presenter
       was MacDonald.

In re Kemp, 16 F.3d at 316-17; see also In re Smith, 966 F.2d
1527, 1531 (7th Cir. 1992) (finding that where a bank extends
provisional credit to a debtor the debtor has an interest in
property because the debtor had the right to disburse the funds
without limitation). Where a transfer is made pursuant to an
antecedent agreement between the new lender and the debtor
that the new funds will be used only to pay a specified credi-
tor, by contrast, the lender rather then the debtor "controls"
the funds. See In re Bohlen, 859 F.2d at 566-67.

[7] Here, the bank advanced the funds for the specific pur-
pose of paying a specific creditor, namely Adams. The bank
agreed to fund the payments to the extent necessary but only
on the express condition that the amounts involved be paid to
Adams. Superior was required to obtain written approval
before making each payment to Adams by specifically listing
the payments on a budget submitted to the bank. Superior's
actions were not "independent of" the bank. The bankruptcy
court suggests that Superior controlled the funds because it
requested the loan, thereby "designating" Adams as the recip-
ient of the payment. However, it is irrelevant whether the
debtor or the lender initiates discussions concerning a loan or
proposes a particular creditor as the recipient of the funds, so
long as the funds are advanced on the condition that they be
used to pay that specific creditor. Where there is an agreement
between a new lender and the debtor that the funds will be
used to pay a specified antecedent debt, a debtor has not exer-
cised control over the funds by "designat[ing ] the creditor to
whom the monies will be paid independent of a third party
whose funds are being used in . . . in payment of the debt."
In re Kemp, 16 F.3d at 316 (citation omitted). Because the
bank disbursed the funds pursuant to such an antecedent
agreement, Superior did not exercise "control " over the
money even though Superior requested the loan to pay Adams
and the funds were placed in Superior's account rather than
being paid directly to Adams by the bank.

[8] In sum, the $82,270.90 in payments made by the bank
to fund the checks to Adams falls within the earmarking doc-
trine. Accordingly, that portion of Superior's payments to
Adams did not constitute the "transfer of an interest of the
debtor in property" under S 547(b) of the Bankruptcy Code.
We hold that the trustee may not avoid the transfers of that
amount.

III. CONCLUSION

The judgment of the district court is hereby REVERSED.
The case is REMANDED to the district court with instruc-
tions to remand to the bankruptcy court to enter judgment
consistent with this opinion.

_______________________________________________________________

FOOTNOTES

1 Honorable William L. Dwyer, Senior U.S. District Judge for the West-
ern District of Washington, sitting by designation.
2 The district court made a factual finding that "Superior had the power
(although not the right) to disburse [the] advanced funds as it saw
fit."Although we question whether Superior actually had such power, in
view of the instantaneous nature of the transfers, it is not necessary to
determine whether the district court's finding was in error, given the basis
on which we decide this case.
3 This third requirement of the earmarking exception is not met where
the amount of the estate available for creditors is diminished even though
the funds transferred to the old creditor were not the debtor's property
because they were never in the debtor's "control. " Typically, this occurs
where the debtor transfers a security interest in property to the new credi-
tor by offering collateral for the loan. In such situations, an unsecured
creditor is replaced with a secured creditor, thus diminishing the amount
available in bankruptcy for creditors of the same class. See International
Ventures, Inc. v. Block Properties VII (In re Int'l Ventures, Inc.), 214 B.R.
590, 595-96 (Bankr. E.D. Ark. 1997). Where a debtor transfers a security
interest to the new creditor in return for the loan, the payment is voidable
to the extent of the value of the collateral transferred by the debtor. See
Glinka v. Bank of Vermont (In re Kelton Motors, Inc.), 97 F.3d 22, 28 (2d
Cir. 1996); Mandross v. Peoples Banking Co. (In re Hartley), 825 F.2d
1067, 1071 (6th Cir. 1987); Virginia Nat'l Bank v. Woodson (In re
Decker), 329 F.2d 836, 839-40 (4th Cir. 1964). The bankruptcy court
found that the bank was at all relevant times an undersecured creditor of
Superior. Counsel for Anderson conceded at oral argument that no collat-eral was advanced by Superior in return for these particular loans, and that
with respect to these particular payments the bank had an unsecured claim
in bankruptcy and was thus in the same position as other general creditors.
Accordingly, Superior did not transfer a property interest to the bank. The
question at issue is whether Superior exercised sufficient control of the
funds to render the transaction a transfer of its interest in property to
Adams.