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Marshaling of Assets:  Old Doctrine Learns New Tricks Image

Marshaling of Assets: Old Doctrine Learns New Tricks

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As the economy enters into a recession and debtors’ assets are losing value, dwindling or disappearing, the doctrine of marshaling assets is appearing in more and more collection actions and appellate decisions.  The increased use of marshaling assets is also the result of land prices remaining high while other property values, such as equipment and inventory, are decreasing substantially.  Creditors should know how to use the doctrine both offensively – if they choose to use it against another creditor – and defensively – if another creditor tries to use it against them.  Marshaling of assets is another tool in the kit available to creditors.  Being aware of this doctrine and how it can be applied helps prepare creditors when reviewing loan agreements, provides information about potential outcomes at trial, and protects a creditor’s ability to collect.

I. What is the marshaling of assets doctrine?

A creditor who invokes the marshaling doctrine (sometimes spelled “marshalling” and also known as the “two funds” doctrine) asks a court to force a superior creditor to satisfy their debt out of the security interest which the invoking creditor does not have a lien against.

The doctrine can be applied when:

  1. There are two creditors who have a common debtor;
  2. The common debtor has two funds or assets; and
  3. The first creditor has legal claims to both funds or assets while the second creditor has legal claim to only one.

The second creditor may ask the court to force the first creditor to access the non-common source of funds first to protect the common source and make it available to the second creditor.  Most frequently, the two funds are real estate and equipment/inventory.  For example, Creditor A has a lien against the debtor’s equipment and inventory while Creditor B has a lien against the debtor’s equipment and inventory and real estate.  Creditor A will ask the court to force Creditor B to liquidate the real estate for payment before liquidating the equipment or inventory.  If the court agrees, then the funds left from the liquidation of the equipment or inventory can be used to pay off Creditor A.  The purpose of the doctrine is to prevent a senior lienholder from arbitrarily destroying the rights of a junior lienholder.

II. Does the court have to marshal assets if a subsequent creditor asks them to?

The doctrine of marshaling assets is not an absolute right.  It is an equitable remedy, meaning the court controls it for the “promotion of justice” in a case-by-case basis.  Because it is equitable, the court takes into consideration all parties, including other non-invoking creditors and the debtor.  The doctrine cannot be invoked to create an unjust result or to substantially injure any party with an interest (including the debtor).  In other words, the court considers all evidence before it and makes its decision based on what it feels is “fair” to everyone.  It is up to the party requesting the marshaling to show it would not impose undue hardship on senior lienholders.

The courts often play a balancing game of fairness to all parties.  In a bankruptcy case applying Ohio law, the court found that even if the second creditor’s interests were unperfected, the unperfected interests would still be entitled to secured status under the facts of the case.  The first creditor had a large claim of roughly $31.7 million.  It was secured both by real property and collateral shared with the second creditor.  The court found the value of the real property to be $32.5 million.  As such, the court found it would be inequitable to allow the first creditor to pursue the shared collateral as its interests were wholly satisfied by the value in the real property.

A bankruptcy case applying Nebraska law came to the opposite conclusion when a junior creditor requested the marshaling of assets related to pharmaceutical goods.  Such marshaling would have delayed the sale of the assets substantially, resulting in a significantly lowered payment to the senior creditors.  The court refused to marshal assets, citing that the remedy of marshaling assets proposed by the junior creditor would be inequitable to the senior creditors whose debt would not be satisfied by sale of the pharmaceuticals alone regardless of price.

III. When does the doctrine of marshaling assets work and when does it not work?

Whether the request to marshal assets will or will not be successful depends on the specific facts of the claim and the court (and state) in which the claim is being brought.  Contributing factors include the size of the claims, a particular state’s laws regarding the marshaling of assets (such as that state’s homestead exemption rules), and that state’s court interpretations of marshaling assets doctrine.

For example, some courts do not allow a mortgagor to make an argument for marshaling of assets but instead reserved the right to marshal assets for secured creditors only.  In Minnesota, marshaling may not be applied to defeat statutory rights, such as properly perfected crop production input liens or other rights found under the U.C.C.  The United States Supreme Court has specifically recognized the inapplicability of the doctrine where certain funds at issue are exempted from collection under state law, such as when state statute exempts insurance benefits of a widow from claims of creditors of her husband’s estate.  Some courts of equity (i.e. bankruptcy court) have found that marshaling of assets can be invoked during trial, even if it was not raised in the pleadings.

While the elements of marshaling assets are consistent, the interpretations from court to court vary significantly.  For example, a bankruptcy court using Minnesota Law allowed the doctrine to be used on the homestead of a non-debtor spouse.  Debtor had transferred his interest in the homestead (as well as other real property) to non-debtor spouse and as a result, there was no common debtor for the two funds.  Despite the transfer to a non-debtor, the court ordered the marshaling of assets to protect the interests of creditors as their interests were created before the debtor had transferred the property to his wife.  The Eighth Circuit allowed this finding as it has an expansive view of marshaling assets, allowing the court to fashion broad equitable remedies.  Directly counter to the Eighth Circuit, the Tenth Circuit Court of Appeals using Colorado law did not allow the doctrine to be used against the non-debtor non-filing spouse.  In the Tenth Circuit Case, the debtor and spouse “sometimes owned and always controlled” a residence.  The debtor filed a Chapter 13 bankruptcy, which was converted to a Chapter 7.  At some point, the residence was sold, with half the proceeds going to pay off a home equity line of credit and half the proceeds going to the non-debtor spouse.  The court directly cited to the Minnesota case and stated it did not apply in Colorado.  The Colorado court did not allow the marshaling of assets because the elements of the doctrine were not strictly met.

Like other creditors, the doctrine of marshaling assets applies to the government.  Although not always in favor of the other creditors, taxing entities (including state taxing offices and the IRS) are subject to the marshaling of assets.  For example, a bankruptcy court applying Massachusetts law specifically found the United States (and its various governmental entities) is not wholly exempt from the doctrine.  In this specific case, the court found the IRS had properly been compelled by the lower court to marshal assets it had tax liens against to preserve funds for a bankruptcy estate and its unsecured creditors.  The IRS was required to look at the equity in the homestead or execute on nonexempt assets for payment.  However, in Kansas, when a Chapter 7 trustee requested the IRS refund be turned over to be included in the bankruptcy estate, the court found that the refund was used as a setoff and was never in the debtor’s control such that it was not subject to marshaling.

These cases – and many more uncited here – show the doctrine of marshaling assets is complex, can be unpredictable, and is evolving during this uncertain time.  Creditors should be aware of the doctrine and how it might apply in each of their cases.  Creditors may also want to keep the doctrine in mind when analyzing loans for renewal.  Proactive thinking will aid in protecting a creditor’s interests.

This information is general in nature and should not be construed as tax or legal advice.