By order of the Bankruptcy Appellate Panel, the precedential effect of this decision is limited to the
case and parties pursuant to 6th Cir. BAP LBR 8013-1(b). See also 6th Cir. BAP LBR 8010-1(c).

                                     File Name: 08b0014n.06
             BANKRUPTCY APPELLATE PANEL OF THE SIXTH CIRCUIT

In re: RONALD CHRISTOPHER KING
       and SHERIL LINN KING,

                               Debtors.


MICHAEL L. BAKER, Trustee in Bankruptcy,
           Plaintiff - Appellee,

       v.                                                     No. 07-8045

MORTGAGE ELECTRONIC
REGISTRATION SYSTEMS, INC.,
ENCORE CREDIT CORP., and
OPTION ONE MORTGAGE CORP.,
          Defendants - Appellants.


                         Appeal from the United States Bankruptcy Court
                        for the Eastern District of Kentucky, at Covington.
                            Case No. 05-24988; Adv. Pro No. 06-2093

                                      Argued: May 13, 2008

                               Decided and Filed: August 20, 2008

   Before: FULTON, PARSONS, and SHEA-STONUM, Bankruptcy Appellate Panel Judges.

                                     ____________________

                                            COUNSEL

ARGUED: Norman J. Frankowski II, FLAGEL & PAPAKIRK, Cincinnati, Ohio, for Appellants.
Debra S. Pleatman, ZIEGLER & SCHNEIDER, Covington, Kentucky, for Appellee. ON BRIEF:
Norman J. Frankowski II, FLAGEL & PAPAKIRK, Cincinnati, Ohio, for Appellants. Debra S.
Pleatman, Michael Burris Baker, ZIEGLER & SCHNEIDER, Covington, Kentucky, for Appellee.
                                      ____________________

                                            OPINION
                                      ____________________

        MARCIA PHILLIPS PARSONS, Chief Bankruptcy Appellate Panel Judge. In this appeal
we address an issue recently decided by the Sixth Circuit Court of Appeals in Chase Manhattan
Mortgage Corp v. Shapiro (In re Lee), 530 F.3d 458 (6th Cir. 2008): that a late-perfecting secured
creditor in the context of a refinanced mortgage is not protected from preference liability by either
the earmarking doctrine or the no-diminution-of-the-estate argument. Finding no determinative
factual distinction between Lee and the instant case, we AFFIRM the bankruptcy court’s order
granting judgment for the bankruptcy trustee in this preference action. In reaching this conclusion,
we reject the Appellants’ argument that the preferential transfer was excepted from avoidance by the
contemporaneous exchange defense of 11 U.S.C. § 547(c)(1). Although this issue was not raised
or addressed in Lee, our ruling is controlled by the Sixth Circuit’s earlier decision in Ray v. Security
Mutual Finance Corp. (In re Arnett), 731 F.2d 358, 360 (6th Cir. 1984).

                                     I. ISSUES ON APPEAL

        1. In a refinancing where one secured creditor is substituted for another such that there is
arguably no diminution of the estate, does the earmarking doctrine bar the avoidance of a mortgage
perfected outside of the 10-day grace period in 11 U.S.C. § 547(e)?

        2. Notwithstanding the failure to perfect within 10 days, is avoidance excepted by the
contemporaneous exchange defense of 11 U.S.C. § 547(c)(1)?

                    II. JURISDICTION AND STANDARD OF REVIEW

        The Bankruptcy Appellate Panel for the Sixth Circuit (the “Panel”) has jurisdiction to decide
this appeal. The United States District Court for the Eastern District of Kentucky has authorized
appeals to the Panel, and neither party elected to have this appeal heard by the district court. 28
U.S.C. § 158(b)(6), (c)(1). A bankruptcy court’s final order may be appealed as of right. 28 U.S.C.
§ 158(a)(1). An order is final if it “ends the litigation on the merits and leaves nothing for the court
to do but execute the judgment.” Midland Asphalt Corp. v. United States, 489 U.S. 794, 798, 109



                                                  -2-
S. Ct. 1494, 1497 (1989) (citations omitted). The bankruptcy court’s order granting the trustee’s
motion for summary judgment is a final order.

         On summary judgment, determinations of whether payments are preferential transfers under
11 U.S.C. § 547(b) are conclusions of law reviewed de novo. Spradlin v. Jarvis (In re Tri-City Turf
Club, Inc.) 323 F.3d 439, 442 (6th Cir. 2003). “De novo means the appellate court determines the
law independently of the trial court’s determination.” Treinish v. Norwest Bank Minn., N.A. (In re
Periandri), 266 B.R. 651, 653 (B.A.P. 6th Cir. 2001). “No deference is given to the trial court’s
conclusions of law.” Booher Enters. v. Eastown Auto Co. (In re Eastown Auto Co.), 215 B.R. 960,
964 (B.A.P. 6th Cir. 1998).

                                                  III.   FACTS

         In August 2004, Ronald and Sheril King (“Debtors”) purchased a home in Independence,
Kentucky. In order to finance the purchase, the Debtors borrowed from Homecomings Financial and
Wilshire Credit Corporation, granting mortgages in favor of both which were duly recorded on
September 30, 2004 (“Original Mortgages”).

         Less than a year later, the Debtors refinanced their Original Mortgages by obtaining a new
loan from Encore Credit Corp. (“Encore”) on July 22, 2005, in the amount of $138,600, a sum
sufficient to pay off the Original Mortgages and the closing costs on the new loan. That same day,
the Debtors executed a mortgage in favor of Mortgage Electronic Registration Systems, Inc.
(“MERS”), as nominee for Encore (“New Mortgage”).1 The funds to pay off the two Original
Mortgages were advanced on July 28, 2005, but MERS did not record the New Mortgage until
August 26, 2005.

         Less than 90 days later on October 16, 2005,2 the Debtors filed a voluntary petition for relief
under chapter 7. On November 9, 2006, the chapter 7 trustee, Michael Baker (“Trustee”),
commenced this adversary proceeding, asserting that the New Mortgage was avoidable as a


         1
             Encore assigned the servicing rights to Option One Mortgage Corp.
         2
           Because the Debtors’ bankruptcy case was filed before October 17, 2005, all references to the Bankruptcy
Code, 11 U.S.C. § 101-1330, herein “§ ___,” are to the pre-BAPCPA version. See Bankruptcy Abuse and Consumer
Protection Act of 2005, Pub. Law No. 109-8, § 1501(b)(1), 119 Stat. 23, 216 (stating that, unless otherwise provided,
the BAPCPA amendments do not apply to cases pending before the effective date of BAPCPA).

                                                         -3-
preferential transfer under § 547 because it had been recorded more than10 days after it was executed
by the Debtors and less than 90 days before the filing of the bankruptcy petition. Both parties moved
for summary judgment, agreeing that no facts were in dispute and that the only legal issues were
application of the earmarking doctrine and the contemporaneous exchange defense. Rejecting these
arguments, the bankruptcy court granted summary judgment for the Trustee, finding the New
Mortgage to be avoidable. The Appellants timely filed this appeal.

                                           IV.       DISCUSSION

A. 11 U.S.C. § 547(b)
          Under § 547 of the Bankruptcy Code, a trustee may avoid certain transfers made to creditors
within 90 days prior to the commencement of the bankruptcy case. The elements of a preferential
transfer are set forth in § 547(b), which states:
          Except as provided in subsections (c) and (i) of this section, the trustee may avoid
          any transfer of an interest of the debtor in property—
          (1) to or for the benefit of a creditor;
          (2) for or on account of an antecedent debt owed by the debtor before such transfer
          was made;
          (3) made while the debtor was insolvent;
          (4) made—
                  (A) on or within 90 days before the date of the filing of the petition; or
                  (B) between ninety days and one year before the date of the filing of the
                  petition, if such creditor at the time of such transfer was an insider; and
          (5) that enables such creditor to receive more than such creditor would receive if—
                  (A) the case were a case under chapter 7 of this title;
                  (B) the transfer had not been made; and
                  (C) such creditor received payment of such debt to the extent provided by the
                  provisions of this title.
“All five elements are prerequisites to the finding of a voidable preference.” In re Arnett, 731 F.2d
at 360.

          1. The Lee Decision
          As noted, this preference statute, as well as the earmarking doctrine, was recently considered
by the Sixth Circuit Court of Appeals in Lee, a case with very similar facts to the instant case. In

                                                       -4-
Lee, the debtor purchased a residence in Michigan, with the purchase financed by a mortgage loan
and secured by a recorded mortgage on the realty. Chase Mortgage Company (“Chase”) eventually
became the holder of the loan note and the mortgage. Approximately six months before the debtor’s
bankruptcy filing, the debtor refinanced his residential mortgage loan with Chase. On October 6,
2003, Chase disbursed the new loan proceeds to pay off the earlier loan held by it, but the new
mortgage granted Chase was not recorded until December 17, 2003, 72 days later. The debtor filed
for bankruptcy relief under chapter 7 on March 4, 2004, 77 days after the recording of Chase’s new
mortgage. The chapter 7 trustee sought to avoid the new mortgage granted Chase as a preferential
transfer under § 547(b). The bankruptcy court granted summary judgment for the trustee, finding
that the trustee had met his burden on all elements under § 547(b) and that the earmarking doctrine
did not apply. Chase Manhattan Mortgage Corp v. Shapiro (In re Lee), 326 B.R. 704, 708 (Bankr.
E.D. Mich. 2005), rev’d 339 B.R. 165 (E.D. Mich. 2006). Although the district court reversed, the
court of appeals reinstated the bankruptcy court’s judgment in favor of the trustee. In re Lee, 530
F.3d 458.

       As in the instant case, the preference defendant in Lee, Chase, did not dispute that the trustee
had established the elements of an avoidable preference set forth in subsections (b)(1), (b)(3) and
(b)(4) of § 547. Id. at 467. The court of appeals explained that under subsection (b)(2), the trustee
must demonstrate that the transfer was made “for or on account of an antecedent debt owed by the
debtor before such transfer was made.” Id. at 464 (quoting § 547(b)(2)).
       A debt is antecedent if it is incurred before the transfer in question. In the context of
       a loan, the borrower incurs the debt at the time the lender disburses the loan
       proceeds. Therefore, lenders who advance loan proceeds prior to the recording of the
       mortgage are undertaking a transfer of an interest in the subject property for purposes
       of § 547. Such transfers are subject to preferential transfer liability.
Id. at 464-65 (internal citations and quotations omitted).

       The court of appeals noted that this potential problem for lenders is addressed by § 547(e)
of the Code by providing a grace period for perfecting a security interest.
       As long as the mortgage is recorded within the 10-day time period, the associated
       mortgage debt will not be deemed antecedent. On the other hand if perfection occurs




                                                  -5-
         more than ten days after the transfer takes effect, the transfer occurs at the time of the
         perfection, and the debt thus will be an antecedent one.”3
Id. at 465 (internal citations and footnote omitted).4 Under Michigan law, perfection occurs upon
recording.5 Because Chase’s new mortgage was recorded 72 days after the loan proceeds were
disbursed, well outside the 10-day grace period, the transfer was made on account of an antecedent
debt. Id. at 466.

         The Lee court explained that Chase’s arguments regarding earmarking and lack of diminution
of the estate come into play with respect to the two remaining elements of a preference. The first
is the requirement imposed by the prefatory language of § 547(b) that the transfer be property of the
debtor. Under the judicially-crafted earmarking doctrine, where a debtor uses borrowed funds
“specifically earmarked by the lender for payment to a designated creditor, there is held to be no
transfer of property of the debtor even if the funds pass through the debtor’s hands in getting to the
selected creditor.” Id. The second is the § 547(b)(5)’s improvement-in-position provision, which
is generally understood to require that the transfer impair or diminish the estate. Id. at 464.

         In order for the earmarking doctrine to apply, three conditions must be met: (a) an agreement
between a new creditor and the debtor for the payment of a specific antecedent debt; (b) performance
of the agreement according to its terms; and (c) the transaction does not result in a diminution of the
debtor’s estate. Id. at 466 (citing McCuskey v. Nat’l Bank of Waterloo (In re Bohlen Enters., Ltd.),
859 F. 2d 561, 566 (8th Cir. 1988)). The Lee court concluded that none of these conditions were
satisfied in the facts before it. The court of appeals observed that the transfer that the trustee was
seeking to avoid was the grant of the new mortgage rather than the payment of the new loan proceeds


         3
           In pertinent part, § 547(e)(2) provides:
         For the purposes of this section, . . . , a transfer is made—
         (A) at the time such transfer takes effect between the transferor and the transferee, if such transfer is
         perfected at, or within 10 days after, such time, . . . ; [or]
         (B) at the time such transfer is perfected, if such transfer is perfected after such 10 days.
         4
           The court observed that BAPCPA increased the grace period from 10 days to 30 days, but noted that in the
case before it, Chase’s new mortgage was recorded well outside even the new 30-day grace period, such that the result
would be the same under either version of the law. In re Lee, 530 F.3d at 465 n.2.
         5
           Under § 547(e)(1)(A), “a transfer of real property . . . is perfected when a bona fide purchaser of such property
from the debtor against whom applicable law permits such transfer to be perfected cannot acquire an interest that is
superior to the interest of the transferee[.]” “Applicable law” in Lee was Michigan law since the debtor’s residence was
located there. In re Lee, 530 F.3d at 466.

                                                            -6-
to discharge the original loan and thus did not involve a transfer of “earmarked” funds. The court
refused to conflate the two transfers and treat them as one for purposes of applying the earmarking
defense, observing that to do so would ignore what actually occurred in the transaction and disregard
the Bankruptcy Code’s plain meaning. Id. at 471. As to the third component of the earmarking
doctrine that necessitates a showing that the transaction did not result in a diminution of the estate,
the court of appeals again refused to look at the transaction as a whole, rejecting Chase’s argument
that because the loan in question was simply a refinancing the debtor’s estate had not been impaired
or diminished. The court noted that from the point the old loan was paid off until such time as the
new mortgage was recorded, Chase did not hold a perfected lien interest, even though Chase’s old
mortgage was still of record and was not discharged until January 16, 2004, a date after the new
mortgage was recorded on December 17, 2003, such that there was never a time that Chase did not
have a recorded mortgage. Id. at 472. As explained by the court of appeals:
        The fact that the discharge was not recorded until after the recording of the new
        Mortgage is of no moment. There was no debt to be secured under the Original
        Mortgage once the Original Loan was paid. Even if the Discharge was not timely
        recorded by the Register of Deeds (and it was not), there was no debt and a bona-fide
        purchaser could have relied on the fact that the Original Mortgage had been released
        when the Original Loan was paid.
Id. at 467. Due to Chase’s lack of a perfected lien interest, “Chase’s subsequent perfection of the
New Mortgage diminished Lee’s estate because the non-exempt equity in the Property that otherwise
would have been available for distribution to Lee’s unsecured creditors became encumbered, and
unavailable to unsecured creditors, by the New Mortgage that Chase received.” Id. at 472.6 For this
same reason, the court also concluded that the § 547(b)(5) element of a preference had been
established. Id.

        The court of appeals rejected Chase’s policy argument that imposing preference liability
would be unfair because the refinancing transaction involved a mere substitution of its new mortgage
for its original mortgage and ultimately benefitted the debtor’s other creditors rather than Chase by
lowering the debtor’s monthly mortgage payments. Id. at 473. Observing that a bankruptcy court’s
equitable powers must be exercised within the confines of the Bankruptcy Code, the court noted that


        6
          The record in the instant case does not establish when the Original M ortgages were released, although
Appellants state in their brief that “[t]here is no evidence in the record that the Property was ever unencumbered.”
(Appellants’ Br. at 4.) Lee informs us that this fact is irrelevant to our holding.

                                                        -7-
“[t]o insulate Chase from preference liability would essentially write § 547(e) out of the Bankruptcy
Code and, in the process, defeat the sound policy the statute was intended to promote—the
discouragement of secret liens.” Id. at 472. The court explained that Chase’s suggested equitable
approach to determining the appropriate timing for perfection would not only lead to
unpredictability, but would also substitute a court’s judgment for that of Congress, who “by enacting
§ 547(e)(2), has already determined the appropriate length of time between a creditor’s transfer of
value and perfection.” Id. at 473. Lastly, the court suggested that the equities did not lie in Chase’s
favor since as a sophisticated lender it could have prevented the problem by timely perfecting its
security interest within the Bankruptcy Code’s long-established 10-day grace period. “We simply
are not at liberty to rewrite the Code’s preference provision under the rubric of doing equity to
protect late-perfecting secured creditors.” Id. at 474.

       2. The Case Sub Judice
       Applying Lee to the instant case results in the inescapable conclusion that the New Mortgage
granted to MERS by the Debtors is avoidable as a preferential transfer under § 547(b). The only
factual distinction between Lee and this case is that Lee involved a refinancing by the same creditor,
while in this case the refinancing by a new creditor. This difference is irrelevant and has no bearing
on the outcome of the Trustee’s preference action. With regard to the specific elements of an
avoidable preference, the Appellants herein, as in Lee, did not dispute that the Trustee had
established subsections (b)(1), (b)(3) and (b)(4) of § 547. As to subsection (b)(2) that the transfer
be on account of an antecedent debt, it must be noted that, under the law of the state of Kentucky
where the Debtors’ residence is located, perfection of a mortgage occurs upon recording. See Ky.
Rev. Stat. Ann.§ 382.270. Because the New Mortgage granted to MERS was recorded on August
26, 2005, more than 10 days after the new loan proceeds were disbursed on July 28, 2005, the
transfer was “for or on account of an antecedent debt owed by the debtor before such transfer was
made.” § 547(b)(2). For the reasons set forth in Lee, the transfer was an interest of property of the
Debtors, the earmarking doctrine is inapplicable, and § 547(b)(5)’s diminution of the estate element
is established. Accordingly, the Debtors’ transfer of the New Mortgage to MERS satisfies all five
required elements of § 547(b), and is avoidable as a preference unless the contemporaneous
exchange exception of § 547(c)(1) applies.



                                                  -8-
B. 11 U.S.C. § 547(c)(1)

        Under § 547(c)(1) of the Bankruptcy Code:
        The trustee may not avoid under this section a transfer—
        (1) to the extent that such transfer was—
                (A) intended by the debtor and the creditor to or for whose benefit such
                transfer was made to be a contemporaneous exchange for new value given to
                the debtor; and
                (B) in fact a substantially contemporaneous exchange[.]

        In Arnett, the Sixth Circuit Court of Appeals addressed this statute in the context of facts
similar to the instant case, although the case involved the refinancing of an automobile rather than
real property. In re Arnett, 731 F.2d at 359. As in the present case, the refinancing creditor failed
to timely perfect its security interest within § 547(e)(2)’s 10-day grace period; perfection did not take
place until 33 days after the creation of the security interest. Despite the untimely perfection, the
bankruptcy court ruled in the trustee’s preference action that the new creditor’s perfection was
“substantially contemporaneous” with the loan transaction and, therefore, the transaction fell with
the exception to the trustee’s avoidance powers found in § 547(c)(1). Ray v. Sec. Mut. Fin. Corp.
(In re Arnett), 13 B.R. 267 (Bankr. E.D. Tenn. 1981), aff’d 17 B.R. 912 (E.D. Tenn. 1982). Although
the district court affirmed, the court of appeals reversed.

        The Sixth Circuit explained that § 547(c)(1) has two crucial elements: “(1) The parties must
intend the exchange to be substantially contemporaneous and (2) the exchange must in fact be
substantially contemporaneous.” In re Arnett, 731 F.2d at 362. As to the second element, the court
held that in order to be substantially contemporaneous in fact, perfection must take place within the
time period set forth in § 547(e)(2), i.e., 10 days under pre-BAPCPA.
        Section 547(e)(2)(B) explicitly provides that a security interest perfected more than
        10 days after its creation does not relate back and is deemed to have occurred on the
        date of perfection. The applicability of section 547(c)(1) to delayed perfection of
        security interests is thus limited to 10 days.
Id. at 364. As explained by the court of appeals:
        The particular problems posed by the delay between creation and perfection of
        security interest were well recognized by Congress. One of the principal purposes
        of the Bankruptcy Reform Act is to discourage the creation of “secret liens” by
        invalidating all transfers occurring within 90 days prior to the filing of the petitions.
        Thus, creditors are discouraged from waiting until the debtor’s financial troubles

                                                   -9-
        become all-too-manifest before recording security interests. Section 547(e)(2)(A)
        and (B) reflect this concern by providing that a transfer of a security interest relates
        back to the date of the underlying transaction if perfection occurs no more than 10
        days afterwards; if perfection occurs more than 10 days later, the transfer is deemed
        to occur at the date of perfection.
                The lower courts’ broad reading of section 547(c)(1) effectively negates
        section 547(e)(2). . . . [T]he evidentiary problems inherent in an expansive reading
        of section 547(c)(1) embody a Pandora's box of evils, even if no risk of fraud or
        misrepresentation was present in this case.
                 ....

                If the sole test is the intention of the parties as required in 11 U.S.C.
        § 547(c)(1)(A), then it would be necessary for the Court to conduct extensive factual
        inquiries into situations which would lend themselves to collusion and the fabrication
        of evidence, and perhaps render the preference section inoperable against all but the
        most flagrant violations. The purpose of adding the requirement of 11 U.S.C.
        § 547(c)(1)(B) is to avoid the inherent evidentiary difficulties of 11 U.S.C.
        § 547(c)(1)(A) by requiring that the parties’ conduct bears out their intentions.
        [citation omitted].
                In light of the explicit grace periods provided for perfection of security
        interest in sections 547(e)(2) and 547(c)(3), Congress has clearly struck the balance
        in favor of repose in this area of the law. Case-by-case development of the
        contemporaneous exchange exception would quickly result in uncertainty and
        protracted litigation, delaying, not expediting, the satisfaction of creditors’ claims and
        the debtor’s return to financial health. The policies of discouraging creditors “from
        racing to the Courthouse to dismember the debtor during his slide into bankruptcy”
        and facilitating equality of distribution would be severely eroded under the lower
        courts’ construction of the statute . . . .
Id. at 363-64.

        Based on the unequivocal holding of the Sixth Circuit in Arnett, the assertion that the
preferential transfer to MERS is protected from avoidance by the contemporaneous exchange
exception of § 547(c)(1) must be rejected.

                                         V. CONCLUSION

        The order of the bankruptcy court granting summary judgment in favor of the Trustee is
AFFIRMED in all respects. The Trustee established all of the elements of a preferential transfer
under § 547(b) of the Bankruptcy Code, and the transfer does not fall within the contemporaneous
exchange exception to avoidance under § 547(c)(1). Neither the earmarking doctrine nor the
assertion of no diminution of the estate protects a creditor that fails to timely perfect within the grace
period provided by § 547(e)(2), even though the transaction arises in the context of a refinancing.

                                                   -10-
