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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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Fifth Circuit Rules for PACA Claimants, and Weakens PACA, All in One Curious Ruling

Set of colored vegetables for kids

Most restructuring practitioners are aware, either vaguely or through punishing experience, of the power of PACA creditors.  PACA (or the Perishable Agricultural Commodities Act, 7 U.S.C. § 499a et seq. for those who hate brevity) requires that buyers of produce hold such produce – and their proceeds – in trust for the benefit of produce sellers.  General creditors of the produce buyer receive nothing, even if they hold a lien on the buyer’s assets, until produce sellers are paid in full on any valid PACA claims (including their interest and attorneys’ fees in most instances).

But sometimes, or many times, the PACA trust assets needed to pay produce sellers are not present.  Accounts must be collected, by use of employees, lawyers, collection agents, or other parties.  Inventory must be preserved and then sold, incurring further costs.  In short, assets to pay PACA claims don’t magically appear, and if no one is paid to pound the pavement to sell that inventory and collect those funds, nothing will be collected, and nobody gets paid.

The Bankruptcy Code deals with the problem very simply.  If assets are being collected for the benefit of unsecured or priority creditors, the post-petition costs and expenses incurred to liquidate such assets are granted first priority of payment.  11 U.S.C. § 503(b)(1)(A).  Alternatively, if assets are being collected (or costs incurred) for the benefit of a secured creditor, the secured creditor’s collateral can (and should) be surcharged.  11 U.S.C. § 506(c).  If the secured creditor complains or balks, the trustee or DIP can (and should) abandon the collateral and force the secured creditor to pay its own costs to liquidate the collateral.

However, a recent Fifth Circuit opinion rejects this common sense approach when PACA is involved.  In Kingdom Fresh Produce, Inc. v. Stokes Law Office (In re Delta Produce), the Fifth Circuit held that the trust structure of PACA mandates that produce sellers be paid in full even prior to the costs of counsel which collected every single dollar needed to pay those very produce sellers’ claims.

The case has limited reasoning.  It borrows from cases holding that PACA creditors are ahead of secured creditors or other creditors, and expands that principal to cover everything.  A utility keeps the power on at the food warehouse so the inventory can be preserved and sold?  That is a foolish utility, unless it knows to a certainty the proceeds can pay PACA sellers in full, leaving funds left over to pay the utility bills.  Employees show up to make collection calls, or process payments?  Good luck getting paid for such efforts, if despite their work funds are insufficient to pay PACA claims in full.  In short, Kingdom Fresh turns a food business in wind-down into a charity for the benefit of PACA claimants, with everyone providing pro bono service to enhance the PACA trust.

Kingdom Fresh recognizes this “free rider problem“: why would anyone work even one iota for an insolvent produce buyer, if payment for their efforts comes behind all the PACA claimants?  But while the Kingdom Fresh Court notes this problem, its proposed solutions are, frankly, illusory.  The Court notes (remarkably, in the view of The Bankruptcy Cave) many professionals will be willing to work to collect assets for PACA creditors, and bear the risk of their fees being behind millions of dollars of such PACA creditors.[1]  Wow.  Second, the Fifth Circuit states that a court-appointed Special Master could do the collections work.  Yet this is not at all what Special Masters do under Federal Rule 53.  Third, the Kingdom Fresh Court notes that PACA allows recovery of attorneys’ fees – and so presumably attorneys working for the estate to collect A/R can get paid from the account debtors?  We guess so, but this is also speculative.  And who is to say the unpaid produce sellers cannot glom onto an attorneys’ fee award the same way they have a senior interest in an underlying claim or judgment owed by a third party to a debtor?  The opinion is silent.

Kingdom Fresh can be viewed as a victory for produce sellers and other beneficiaries of PACA – once again, such creditors are declared to be first among all other creditors.  But its slavish devotion to PACA renders every insolvency case involving the sale of produce much harder – things will grind to a halt until professionals employed to collect and liquidate assets negotiate with PACA creditors to be paid.  By depriving courts of the power to surcharge PACA trust assets, collection of those assets will be delayed or just won’t happen at all.  No one benefits, not even those which PACA is supposed to help.  Kingdom Fresh is, in fact, one of the most anti-PACA cases we at The Bankruptcy Cave have seen, despite its protestations to the contrary.

[1] This is an astounding and unsupported assumption. People taking on greater risk need greater compensation.  No one will take on risk of non-payment for free.

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