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.