Constructive Trust on Real Estate Hits Paydirt in the Sixth Circuit

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Nov 2001

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The constructive trust is a fiction: an equitable remedy imposed against one who
commits fraud (or some other bad act) in order to prevent unjust enrichment.
Although the idea of imposing a constructive trust might sound good to the unsecured
creditor, constructive trusts are inimical to the Bankruptcy Code's priority scheme
because they result in some creditors receiving special treatment as they effectively move
from "last in line" to "first in line." The impact of a constructive trust on any
bankruptcy case is governed by <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §541(d)</a>, which has the effect of
excluding from a bankruptcy estate assets held in constructive trust by the debtor in
favor of another, because under §541(d), property is part of the debtor's estate
only to the extent of the legal title, but not to the extent of the equitable
interest that the debtor does not own. The efforts of unsecured creditors to squeeze
themselves into the parameters of <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §541(d)</a> are legendary:

<blockquote>
...each of those unsecured creditors would rush into the bankruptcy court to
argue that debtor's dealings with it were more egregious than his dealings with
the others and the debtor's bad conduct justified special treatment, i.e., the
imposition of a constructive trust by the bankruptcy court...
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Boyd, 233 F. 3d. 922, 936 (6th Cir. 2000)</a>.

In its 1994 decision in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Omegas Group, 16 F. 3d 1443,
1448-1453 (6th Cir. 1994)</a>, the Sixth Circuit held that <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§541(d)</a> will not operate to exclude from the bankruptcy estate property that is
subject to a constructive trust unless the constructive trust is declared by a court
in a pre-petition court proceeding. Omegas is often cited as the cornerstone of the
Sixth Circuit's concerted effort to quash unsecured creditors' attempts to convince a
bankruptcy judge that he or she should impose a constructive trust that enables them
to effectively make an end run around bankruptcy's priority scheme. In cases since

Omegas, the Sixth Circuit has clarified its position to allow a constructive trust
under certain rather limited circumstances. For example, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re McCafferty, 96
F. 3d 192 (6th Cir. 1996)</a>, the court recognized that the imposition of
a constructive trust in favor of the debtor's ex-wife was appropriate because, in that
case, the property subject to the constructive trust was exempt from distribution to
creditors.

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Morris, 260 F.3d 654 (6th Cir., Aug. 13, 2001)</a>, is
a real estate dispute in which the Sixth Circuit appears to have relaxed its "ban"
on constructive trusts once again in order to reach the right result. The opinion of
the court—written by Judge Batchelder, who authored the court's opinion in
Omegas—demonstrates that the court was willing to overcome procedural and substantive
obstacles in order to impose a constructive trust on the disputed parcel of real
estate.

The facts of the case are somewhat complicated. Apparently, Marilyn Morris and John
Poss started out as friends. Morris was in the tool manufacturing business and wanted
to buy a parcel of land so that she could relocate her business. Unable to get a
conventional mortgage, she persuaded Poss to lend her $17,500 to buy the
17.5-acre parcel. Morris took the title to the land and did not grant Poss a
mortgage but, instead, she signed a cognovit note payable over 15 years. Next,
Morris convinced Poss to lend her $149,750 to enable her to build a new
building (consisting of a plant on the first floor and her apartment on the second
floor) on the 17.5 acres of land. Once again, Poss did not take a mortgage in
exchange for the financing he provided, but instead, Morris and Poss entered into an
odd transaction: Morris entered into a 15-year lease with Poss for the 2.5 acres
of land on which the building was situated, and in exchange, Poss built Morris's
building on the land and then leased the building to Morris for 15 years with a
payment structure that would amortize the repayment of Poss's $149,750 loan, plus
interest. The net result was that Morris owned the land on which the building was
located and leased it to Poss for 15 years, and Poss owned the building and leased
it to Morris for 15 years. Neither Morris nor Poss made regular payments to one
another as set forth in their respective leases.

Without telling Poss, and before Morris and Poss signed the documentation for their
odd reciprocal lease arrangement, Morris obtained a $40,000 loan from Huntington
Bank and gave the bank a security interest in her business assets, plus a mortgage
on the entire 17.5 acre parcel. When Morris fell behind in her payments to Poss
on the $17,500 note, Poss did not initially seek to collect but, instead,
offered to postpone payments under the note for one year. However, once Poss learned
of the Huntington Bank mortgage, his friendship with Morris evaporated and he sued
her on the cognovit note: That case was assigned to Ohio state court Judge Yost.
Ultimately, Poss got a judgment for approximately $17,000, which Morris did not
pay, so Poss started a foreclosure action to collect his judgment on the note.

Morris also fell behind on her lease payments for the building, so in 1989,
Poss sued her for rent. This rent lawsuit was consolidated with Poss's foreclosure
action, and ultimately Poss got a $152,000 judgment against Morris. Once again,
Poss found it difficult to enforce his judgment against Morris, so the parties tried
to negotiate a settlement. In 1993, however, settlement negotiations deteriorated,
so Poss filed a third lawsuit against Morris—a forcible entry and detainer lawsuit
alleging that her continued possession of the building was unlawful.

In July 1993, Morris and Poss entered into a settlement agreement in the
forcible-entry and detainer lawsuit. Pursuant to the settlement, Morris was relieved
from the judgment against her in exchange for which she was to convey a particular
seven-acre parcel of land to Poss within 60 days and vacate the building by Jan.
1, 1994. In September 1993, Judge Yost entered a judgment that adopted the
settlement agreement and incorporated it by reference in his order.

On the very same day, as Judge Yost entered his order incorporating the settlement,
the settlement unraveled. Morris moved for relief from the court's order, and Poss
moved for its enforcement. Judge Yost denied Morris's motion, and in April 1994,
required Morris to immediately comply with her obligations under the settlement, failing
which Poss could resort to all of his remedies at law or in equity. Morris appealed,
but the Ohio Court of Appeals affirmed Judge Yost. When Poss learned of this in
July 1995, he obtained an ex parte order directing the county recorder to convey
the seven-acre parcel described in the settlement agreement to himself. As soon as
Morris learned about this ex parte order, she appealed it. Poss, however, returned
to Judge Yost, claiming that Morris failed to comply with the settlement, and after
an evidentiary hearing, Judge Yost agreed with Poss and ordered the sheriff to seize
the building. Morris appealed once again, then filed chapter 13 on Sept. 8,
1995—less than 90 days after Poss obtained the ex parte order directing the county
recorder to convey the parcel to him.

Morris's chapter 13 bankruptcy petition listed Poss as a secured creditor in the
amount of $150,000. Her chapter 13 plan indicated that she lived in the
apartment above the plant in the building.

Amazingly, after all this litigation, Poss failed to file a proof of claim in
Morris's chapter 13 case. As soon as the claims bar date expired, Morris amended
her chapter 13 plan to provide that distributions under the plan would only be made
to creditors who had timely filed a proof of claim. Poss objected to this plan, but
the court overruled his objection because he had not filed a proof of claim. The
court also held that Poss's objections to the amended plan did not give him an
"informal proof of claim." Poss appealed the bankruptcy court's decision to the
Bankruptcy Appellate Panel for the Sixth Circuit, which dismissed it as premature.

Meanwhile, before Poss's objection to Morris's chapter 13 plan had been overruled,
Morris filed a two-count adversary proceeding against Poss. Count One sought to avoid
the July 1995 ex parte order that effectively transferred the seven-acre parcel to
Poss. Count Two claimed that Poss's alleged lien impaired her $5,000 homestead
exemption under state and federal law.

Amidst these machinations in the bankruptcy court, the appeals were being decided
in the Ohio state court because the bankruptcy court granted relief from the automatic
stay for their pursuit. Indeed, immediately after Poss's objections to Morris's chapter
13 plan were overruled, the Ohio Court of Appeals held that Poss was never
entitled to the ex parte order that effectively conveyed the seven-acre parcel to
himself; that matter was remanded to Judge Yost for further proceedings. In its
ruling, the Ohio Court of Appeals held that Judge Yost had the power to evict
Morris and her business from the building based on her breach of her own promise in
the settlement agreement to vacate the building, but that the nature of a forcible
entry and detainer action prohibited Judge Yost from determining who held legal title
to the seven-acre parcel. Thus, upon the remand of the case to Judge Yost, Poss
obtained relief from the automatic stay in order to have Judge Yost determine his
ownership interest in the seven-acre parcel of real estate.

In April 1997, Judge Yost issued his decision on the title to the disputed
seven-acre parcel. He found that the settlement agreement created an enforceable contract
for the conveyance of the property from Morris to Poss, but then ruled that Poss had
failed to complete either an execution on his judgment lien against the parcel, or a
conveyance of the parcel to him, before Morris filed for bankruptcy. Consequently,
Judge Yost concluded that legal title to the seven-acre parcel remained with Morris when
she filed her chapter 13 petition. However, based on Morris's failure to abide by
the terms of her own promises in the settlement agreement, Judge Yost held that Poss
was entitled to pursue appropriate enforcement proceedings in Ohio state court, including
an application for an order transferring legal title from Morris to himself. Until the
entry of such an order, however, Morris had legal title and ownership of the
seven-acre parcel.

After Judge Yost found that she retained legal title to the seven-acre parcel,
Morris moved for a summary judgment in her adversary proceeding against Poss.
Incredibly, Poss failed to timely respond to Morris's summary judgment motion—even
after receiving an extension of time to do so. Based on the record before it—which
apparently included Judge Yost's April 1997 ruling—the bankruptcy court granted
summary judgment in favor of Morris and held that (1) she had legal title to the
seven-acre parcel and (2) the alleged conveyance to Poss pursuant to the wrongfully
obtained ex parte order was simply a nullity. The bankruptcy court also held that
even if Poss had properly attempted to enforce the conveyance, the conveyance itself
would have occurred within the 90-day preference period and therefore would have
been avoidable pursuant to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §547</a>.

On appeal, the district court permitted Poss to raise new issues so long as they
were issues of law and required no factual development. After considering Poss's
appeal on its merits, the district court affirmed the bankruptcy court.

In its opinion (dated Aug. 13, 2001), the Sixth Circuit Court of
Appeals reversed and held that the bankruptcy court erred in failing to recognize
that, at the moment Morris signed the settlement agreement that contained her promise
to convey the seven-acre parcel to Poss, Morris undertook an equitable duty to
convey that parcel to him. Consequently, as a matter of Ohio law, the disputed
seven-acre parcel became impressed with a constructive trust automatically and without
the need for any court order or decree. The Sixth Circuit court also held that
the constructive trust did not constitute an avoidable preference because the
constructive trust arose when Morris signed the settlement agreement years before filing
her chapter 13 petition—and hence beyond the preference period. Thus, the Sixth
Circuit Court of Appeals reversed both the bankruptcy court and the district court
and remanded the matter to the bankruptcy court for proceedings consistent with the
appellate opinion.

Morris is somewhat surprising for several reasons. First, the reversal was a
procedural long shot in light of Poss's failure to respond to the summary judgment
motion filed against him in the adversary proceeding. Nevertheless, the court held
that Poss's failure to respond was not a jurisdictional bar to its adjudication of
issues raised for the first time on appeal. Instead, the court found that its
consideration of Poss's appeal was simply a departure from the general rule that
appellate courts will not consider issues raised for the first time on appeal. The
court noted that deviations from this general rule are permitted where, as in this
case, the issue is presented with sufficient clarity and completeness that its
resolution will not require further factual development, and adjudication of the appeal
will promote the finality of litigation.<a href="#1" name="1a">1</a>

Substantively, Morris is an important departure from the court's clear attempt to
discourage unsecured creditors from claiming that the debtor's bad acts require the
bankruptcy court to impose a constructive trust. Morris is consistent with <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…,
supra,</a> to the extent that both cases hold that a constructive trust imposed
pre-petition will operate to exclude the property from the debtor's estate pursuant
to <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §541(d)</a>. Morris is also somewhat inconsistent with Omegas

because Omegas required that the pre-petition constructive trust be declared by a court
in a pre-petition proceeding, while Morris (like <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, supra</a>) did not
require a formal pre-petition judicial decision declaring the existence of the
constructive trust. Instead, in Morris, the Sixth Circuit honored a constructive
trust, which it determined that Ohio law automatically impressed upon the seven-acre
parcel when Morris signed the settlement agreement years before the debtor filed her
bankruptcy petition. Morris also answers, in the affirmative, the question of whether
a bankruptcy court may give effect to a state court judgment obtained post-petition
in an action commenced pre-petition, but notes that state law governs the effective
date of such a judgment.

The fact that the court overlooked the procedural obstacles inherent in ruling
for Poss evidences its willingness to relax its aversion to constructive trusts where
necessary to achieve justice, especially if the constructive trust is to be imposed
upon real property because disputes regarding real property trigger equitable remedies
in many states due to the uniqueness of the land and the inherent inadequacy of any
legal remedy. Undoubtedly, however, zealous unsecured creditors are likely to view
Morris as a "carte blanche" to argue that the "debtor's bad acts" and the equities
of their particular situations warrant imposition of a constructive trust in their
favor. The unfortunate language in the conclusion of the court's opinion, to the
effect that a constructive trust cannot be avoided as a preference, will likely spur
on these zealous unsecured creditors even though the opinion itself clarifies that the
court's holding on the preference issue was due to its ruling that the constructive
trust arose years before Morris's bankruptcy, and therefore beyond the preference
period.

In the final analysis, Morris represents the court's sincere and diligent attempt
to reach the right result. After all, Morris broke her own promise to convey the
seven-acre parcel pursuant to a settlement agreement, which became a court order.
She then engaged in "hard-ball" tactics in her bankruptcy case. In its zeal to
do the right thing, the Sixth Circuit was willing to overlook procedural obstacles,
and even relax its aversion to the imposition of constructive trusts based on the
debtor's "bad acts." Although Morris might have been Poss's friend before the case
began, the Sixth Circuit Court of Appeals was his best friend when it ended.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The court was so concerned that its ruling would be construed as excusing the failure of counsel to respond to summary judgment motions
that its opinion includes a reminder that the lower courts could impose appropriate sanctions on Poss's attorney for failing to respond to Morris's
summary judgment motion in the adversary proceeding. <a href="#1a">Return to article</a>

Journal Authors

Lisa Sommers Gretchko

Journal Date

Thursday, November 1, 2001 - 12:00

Bankruptcy Rule

2001