In Milavetz, the Supreme Court held that bankruptcy attorneys are prohibited from advising clients to incur debt in contemplation of filing for bankruptcy. Justice Sotomayor’s vague attempt to limit the reach of this prohibition is less than helpful. “Advice to incur more debt because of bankruptcy, as prohibited by §526(a)(4), will generally consist of advice to ‘load up’ on debt with the expectation of obtaining its discharge—i.e., conduct that is abusive per se.” She goes on in an attempt to clarify the Court’s elusive position: “our construction of §526(a)(4) to prevent only advice principally motivated by the prospect of bankruptcy further ensures that professionals cannot unknowingly run afoul of its proscription.  Because the scope of the prohibition is adequately defined, both on its own terms and by reference to the Code’s other provisions, we reject Milavetz’s vagueness claim.”

The opinion has drawn heavy fire from the consumer bankruptcy bar as many fear it will significantly restrict the range of topics practicioners can discuss with clients. As Justice Roberts pointed out at oral argument, under certain circumstances, incurring debt in contemplation of bankruptcy might be perfectly appropriate. Indeed, through the earmarking doctrine, Courts have long recognized an expection to the trustee’s avoidance powers as they relate to pre-bankruptcy payments to creditors. Problem: alerting consumer clients to the existence of the earmarking doctrine is akin to recommending that they incur new debt.

In order for pre-bankruptcy payments to creditors to trigger the avoidance powers of the trustee, preference laws require property be transferred in satisfaction of an antecedent or past debt. The preference laws do not apply if property is transferred in exchange for a new debt. Under the earmarking doctrine, newly borrowed money simply passing through the debtor’s hands and designated solely to satisfy an existing debt is not an avoidable preference. In order for the rule to appply, the debtor must have no control over the property; it must be “earmarked” for payment to the existing creditor on account of the existing debt. By incurring new debt earmarked specifically for an existing creditor, the debtor does not diminish the bankruptcy estate and the preference laws are not triggered. Property of the debtor is not going to pay down debt, instead funds from a non-debtor source indepenedent of the estate are merely passing through the debtors hands. This is certainly an academic distinction but a substantive one nonetheless.

What remains to be seen is whether the prohibitions contained in Milavetz prevent advising clients of this loop hole in the preference laws.  After all, for the earmarking doctrine to apply, new debt must be incurred. Further, in the case of the consumer seeking to sheild a family member from an adversary case, it can be argued that the new debt will usually be principally motivated by the impending bankruptcy filing as it is the creation of the estate that triggers the trustee’s avoidance powers. Proper use of the earmarking doctrine should be an example of an appropriate circumstance in which a bankruptcy attorney can properly advise a client to incur new debt before filing bankruptcy. However, in light of the sweeping prohibitions contained in Milavetz, is the bankruptcy bar now prohibited from providing clients valuable information regarding the pitfalls inherent in pre-bankruptcy transfers and the trustee’s avoidance powers? Is incurring new debt pursuant to the earmarking doctrine principally motivated by the prospect of bankruptcy?

Certainly nothing in the Milavetz decision changes the analysis under the Bankruptcy Code. The earmarking doctrine will continue to exist in theory, only time will tell whether bankruptcy attorneys will be permitted to discuss its implications with their clients.