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What’s Yours is Mine and What’s Mine is For the Benefit of My Creditors: Bankruptcy Courts Remain Reluctant to Impose Constructive Trusts on Debtor Property

There is an inherent tension between the goals of bankruptcy law and the state law doctrine of constructive trust.  A central tenet of bankruptcy policy is that similarly situated creditors should be treated equally: because an insolvent business or individual will not be able to pay all creditors in full, a proper bankruptcy system must provide as equitable a distribution to each of them as possible.  Constructive trust law, on the other hand, works to the advantage of a single creditor – which always means the detriment of the others when everyone is competing for limited funds.

Constructive trusts are imposed when “property has been acquired in such circumstances that the holder of the legal title may not in good conscience retain the beneficial interest.”  Beatty v Guggenheim_Exploration_Co, 225 N.Y. 380, 386 (1919) (Cardozo, J.).  When a creditor in a bankruptcy case alleges that the debtor is holding certain property in constructive trust, it is saying that the debtor does not really own the property; the debtor is simply holding on to it for the creditor.  Because only the debtor’s property can be used to pay its creditors, any property held in constructive trust for one creditor is removed from the asset pool for all other creditors, who can only fight over whatever is left.

Bankruptcy courts are wary of constructive trusts.  However, the constructive trust doctrine is governed by state law, which is not preempted by the Bankruptcy Code.  In New York for example, the elements of a constructive trust claim are: (1) a confidential relationship; (2) a promise; (3) reliance; and (4) unjust enrichment.  Sharp v. Kosmalski, 40 N.Y.2d 119, 121 (1976).  Under New York law, the unjust enrichment requirement, “does not require the performance of any wrongful act by the one enriched.”  Simonds v. Sismonds, 45 N.Y.2d 233, 242 (1978).  Constructive trust law notwithstanding, bankruptcy courts in the Second Circuit have demonstrated a marked reluctance to apply the doctrine when it can be avoided; the latest case in that trend is Fetman, No. 1-15-43716-nhl, 2017 WL 598476 (Bankr. E.D.N.Y. Feb. 14, 2017).

In Fetman, a pair of secured creditors attempted to prevent a § 363 sale by claiming that, for the past thirty years, they were the “true owners” of the properties to be sold.  Those creditors were Mr. and Mrs. Fetman, who also happened to be the debtor’s parents.  The debtor owned two parcels of real property, located at 4301 and 4305 Tenth Avenue in Brooklyn, which the chapter 7 trustee intended to sell to satisfy claims against the debtor.  The properties were subject to a $2.3 million judgment lien in favor of the debtor’s parents, and an additional $21.4 million judgment lien in favor of another creditor.  Both liens were to attach to the proceeds of the sale, but the Fetmans objected on the grounds that the properties were actually owned by them, not the debtor.

The Fetmans explained that they first purchased the 4305 property in the name of a corporation that Mr. Fetman owned when they first immigrated to the United States in the 80’s.  In 1992, the Fetmans purchased the 4301 property in their son’s name because they were not yet American citizens.  They later transferred the 4305 property from their corporation to their son so he could finance loans that the parents could then use to purchase other properties.  With respect to both properties, the Fetmans provided the purchase money, received all of the income generated, and paid all associated expenses.  For his part, the debtor joined in his parents’ objection to the § 363 sale.  He also acknowledged that he had promised to convey the properties to his parents at their request.

Taking the Fetman’s claims at face value, they appear to have easily satisfied the first three requirements for a constructive trust under New York law.  Family members are often deemed to entrust their confidence in one another; the debtor promised that he would own the property in name only, and formally convey it to his parents at their request; the Fetmans purchased the 4301 property, and conveyed the 4305 property to their son, in reliance on that understanding.  It was the fourth requirement – unjust enrichment – on which the Fetmans were ultimately tripped up.  Acknowledging the tension between constructive trust and bankruptcy law, the court pointed out that, in the Second Circuit, “a constructive trust has been imposed against a bankruptcy estate only where a court has found some pre-petition unjust conduct by the debtor relating to the subject property.”  The court rejected the Fetmans’ constructive trust claim, finding not only that they failed to demonstrate sufficient misconduct by the debtor to justify imposing a constructive trust, but they actually benefitted from the arrangement (at least until the trustee proposed selling it for the benefit of creditors who had nothing to do with the Fetmans).  Accordingly, the court granted the trustee’s motion to sell the properties.  To the extent the Fetmans believed themselves to be the owners of the properties, that order must have doubly stung because not only were they about to lose their property, but they were the ones who set the ball in motion by filing an involuntary bankruptcy petition against their son in the first place.

In refusing to impose a constructive trust, the court may have given somewhat short shrift to constructive trust law.  It is far from clear that “misconduct” is a requirement under New York law, particularly in light of the Court of Appeals’ Sismond decision, which suggests that a “wrongful act” is not necessary.  The Fetman court relied heavily on Second Circuit precedent involving bankruptcy proceedings, rather than state law decisions.  In fact, the only New York case that the court directly cites in support of a “misconduct” requirement ultimately refused to impose a constructive trust, not because there was no misconduct, but because there was no evidence of a promise to surrender the property.  See Plotnikoff v. Finkelstein, 105 A.D.2d 10, 14 (1st Dept. 1984).  It seems plausible to say that, outside of bankruptcy, the debtor in Fetman would have been “unjustly enriched” had he simply decided to sell his parents’ properties and use the proceeds to buy $21.4 million worth of Lay’s potato chips.  It is not entirely clear why the result should be different if he (or the chapter 7 trustee) used the proceeds to pay his creditors instead.  That is not to say that the Fetman court incorrectly applied New York law.  The constructive trust doctrine certainly has room for interpretation, and the issues are highly dependent on the equities of a given case.  However, the court was clearly concerned with balancing the goals of bankruptcy law against those of constructive trust law.  Its willingness to read a misconduct requirement into the elements of a constructive trust claim – with little to no discussion of the underlying state law basis – is indicative of the continuing trend in bankruptcy proceedings to tip the balance of those interests toward an equitable distribution to all creditors – and not allow the imposition of a constructive trust.

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A Lender’s Federal Post-Judgment Interest Quandary

Post-judgment interest is not something most lenders consider when making a loan. In fact, it is not ordinarily the subject of significant analysis even when litigation becomes necessary.  Where the United States District Court is the preferred venue, however, parties easily can fall into the quandary of being stuck with the federal statutory post-judgment interest rate, which is currently less than 1% per annum.

Pre-judgment, a lender often has solid rights to contract interest and potentially very high default interest rates, which often approach double-digits, added to a recovery when a solvent obligor is on the other side. But a final judgment may be a game-changer on the rate of interest a lender is able to receive.  Recent circuit court decisions are developing the law on post-judgment interest in a way contrary to the economic recovery of contracting parties, and lenders in particular.  It may be possible, however, to draft around this problem.

Current State of the Law

In cases pending before the United States District Court, “post-judgment interest is governed by federal law,” even where jurisdiction is based upon diversity, because post-judgment interest is viewed as a procedural issue. Citicorp Real Estate Inc. v. Smith, 155 F.3d 1097, 1107 (9th Cir. 1998). Federal post-judgment interest is governed by 28 U.S.C. § 1961(a), which provides for “a rate equal to the weekly average 1-year constant maturity Treasury yield” (currently 0.79% and 0.46% a year ago, see here under 1-year Treasury bills).

While federal case law uniformly holds that an “exception to § 1961 exists when the parties contractually agree to waive its application,” there has been significant recent litigation concerning how explicit contracts must be to constitute a waiver. See Fidelity Federal Bank, FSB v. Durga MA Corp., 387 F.3d 1021, 1023 (9th Cir. 2004).  Importantly, a typical contract imposing interest at a specific rate upon a default “until paid” is insufficient under the case law in the Second, Fifth, and Tenth Circuits. FCS Advisors, Inc. v. Fair Finance Co., Inc., 605 F.3d 144 (2d Cir. 2010); Tricon Energy Ltd. v. Vinmar Int’l, Ltd., 718 F.3d 448 (5th Cir. 2013); In re Riebesell, 586 F.3d 782 (10th Cir. 2009). The Fifth Circuit has gone so far as to hold that the term “post-judgment” should be used in order to evidence a clear intent by the parties to waive 28 U.S.C. § 1961 and impose the default contract interest rate post-judgment. Tricon Energy Limited, 718 F.3d at 459.

The Ninth Circuit is the only jurisdiction with an arguable basis in which to assert that a contractual default rate should apply to post-judgment interest. In Citicorp Real Estate, Inc. v. Smith, the court affirmed a judgment awarding post-judgment interest greater than that provided in 28 U.S.C. § 1961 because: 1) the promissory note at issue included an agreed-upon interest rate upon a default; and 2) the parties had previously stipulated to an arbitration award establishing liability that included an interest rate at the rate specified in the note “after judgment until collected.”  155 F.3d at 1108.  It is not clear from the Citicorp holding whether the outcome would have been the same if the parties had not stipulated to an arbitration award with a post-judgment interest rate.  Some trial courts within the Ninth Circuit, however, interpreted Citicorp to allow the application of a contractual default rate of interest to post-judgment interest based solely on a default interest clause. See Mission Produce, Inc. v. Organic Alliance Inc., 2016 WL 1161988 *11 (N.D. Cal. Mar. 24, 2016); Abbate Family Farms Ltd. Part. v. GD Fresh Dist., Inc., 2012 WL 2160959 *6 (E.D. Cal. Jun. 13, 2012); Best Western Intern., Inc. v. Richland Hotel Corp. GP, LLC, 2012 WL 608016 *11-12 (D. Ariz. Jan. 18, 2012); Beaulieu Group LLC v. Inman, 2011 WL 4971701 *5 (D. Ariz. Oct. 19, 2011).

Even Ninth Circuit courts now may require more explicit language before finding a waiver of the federal statutory post-judgment interest rate. While not binding precedent, the Ninth Circuit’s March 16, 2016 holding in the unpublished opinion OREO Corp. v. Winnerman, 642 Fed. Appx. 1951 (9th Cir. 2016), seems to signal that a typical default interest rate in a contract is insufficient to waive § 1961.  In OREO, the court reversed a trial court’s award of post-judgment interest at a promissory note’s default rate.  In doing so, the Ninth Circuit took a very narrow view of Citicorp and reasoned that post-judgment interest at the default rate was allowed in Citicorp  only because the parties had stipulated to an arbitration award with a higher rate of interest.

Implications

Plaintiffs should carefully consider the likely application of the federal statutory post-judgment interest rate when analyzing the benefits of filing in federal court. Unless the contract at issue includes a provision expressly applying the default interest rate post judgment, there is a strong probability the court will impose post-judgment interest at only the federal statutory rate, which is presently less than 1%.

Lenders and other contracting parties currently crafting documents would be wise to include language making clear that the parties intend for the default interest rate to apply not just upon an event of default, but also to post-judgment interest to the extent a lawsuit is necessary.

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