Constructive Trusts the UCC and Bankruptcy Code 544(a)(1) Part One

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Apr 2000

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Article 9 of the Uniform Commercial Code (UCC) governs security interests in personal property.<a href="#1" name="1a">1</a> One
of the goals of Article 9 is to make commercial lending more efficient, and this goal has been effectuated
through the implementation of a central filing system. The most common manner of perfecting a security
interest in personal property is through the filing of a financing statement with a filing officer. This enables
a prospective lender to conduct a quick and inexpensive search through the public records to determine
whether another entity has a perfected interest in the particular article of personal property that will serve
as collateral for the transaction. If an entity fails to record its interest, then that entity's interest is
subordinate to a creditor with a perfected security interest.<a href="#2" name="2a">2</a> Such subordination is appropriate because
Article 9 abhors secret liens. Secret liens threaten the ability of prospective lenders to rely on the integrity
of the filing system.

Bankruptcy Code §544(a)(1) grants a trustee the status of a hypothetical lien creditor.<a href="#3" name="3a">3</a> Section
544(a)(1) states:

<blockquote>
(a) The trustee shall have, as of the commencement of the case and without regard to any knowledge
of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the
debtor or any obligation incurred by the debtor that is voidable by
<blockquote>
(1) a creditor that extends credit to the debtor at the time of the commencement of the case,
and that obtains, at such time and with respect to such credit, a judicial lien on all property on
which a creditor on a simple contract could have obtained such a judicial lien, whether or not such
a creditor exists.<a href="#4" name="4a">4</a>
</blockquote>
</blockquote>

The policies underlying §544(a)(1) have been described by one court as follows:

<blockquote>
The strong-arm clause may be read as relying on the principle of ostensible ownership—the principle
that, other things being equal, what the creditor sees ought to be what the creditor gets. There seems to
be at least two important reasons why the idea of ostensible ownership bulks so large in bankruptcy law.
First, it helps to police against fraud on the part of debtors—fraud that may occur with or without the
collusion of creditors. Secondly, quite apart from any imputation of fraud, it helps to permit the kind
of reliance said to be essential to a dynamic commercial economy.<a href="#5" name="5a">5</a> (Citations omitted.)

</blockquote>

<blockquote><blockquote>
<hr>
<big><center>
...the concept of a constructive trust is repugnant to §544(a)(1).
</center></big>
<hr>
</blockquote></blockquote>

Consequently, §544(a)(1) seeks to enforce the policies underlying Article 9.

Federal courts are divided on whether property subject to a constructive trust is subject to the trustee's
strong-arm powers.<a href="#6" name="6a">6</a> One case that held that the trustee's strong-arm powers could not be employed against
property subject to a constructive trust is Sanyo Electric Inc. v. Howard's Appliance Corp.<a href="#7" name="7a">7</a> In this case,
the debtor was a retailer of home appliances, operating exclusively in New York state. The debtor granted
Sanyo a security interest in all Sanyo goods.

Sanyo perfected its security interest in New York. In March 1986, the debtor began warehousing its
inventory in New Jersey. Thereafter, the debtor filed chapter 11 and attempted to avoid Sanyo's interest
in the New Jersey goods (the "Goods") through the application of §544(a)(1). The bankruptcy court held
that the debtor was equitably estopped from challenging the validity of Sanyo's security interest in the
Goods. The district court reversed, holding that the debtor had a superior interest in the Goods because
Sanyo failed to perfect its security interest in the Goods.

The Second Circuit Court of Appeals held that Sanyo's interest in the Goods was superior to the
debtor's interest in the Goods. The court began its analysis by examining what constituted property
of the estate, and stated:

<blockquote>
Property in which the debtor holds only legal title and not an equitable interest, however, becomes
property of the estate "only to the extent of a debtor's legal title to such property, but not to the extent
of any equitable interest in such property that the debtor does not hold." That is, the bankruptcy estate
does not include "property of others in which the debtor ha[s] some minor interest such as a lien or
bare legal title."<a href="#8" name="8a">8</a> (Citations omitted.)
</blockquote>

When a debtor has engaged in malfeasance and it holds property in a constructive trust, then that property
is beyond the purview of the debtor's estate.<a href="#9" name="9a">9</a> Under New Jersey law, a constructive trust is imposed when
there was malfeasance that resulted in a transfer of property. The court ruled that a constructive trust should
be imposed on the Goods in favor of Sanyo. The Second Circuit stated:

<blockquote>
It is noteworthy that until approximately six months prior to the filing of its chapter 11 petition, Howard
had always stored its inventory at its Nassau County location, as required by the security agreement,
and its Suffolk County stores. While Howard's contentions that the decision to warehouse in New
Jersey was "borne of necessity" and "not out of sinister motives" do not fall upon deaf ears, we agree
with the bankruptcy court that Howard, in light of its conduct, "acted with the expectation that Sanyo
would not perfect its security interest in this inventory by filing a financing statement in New Jersey."
Howard must have known that, under the terms of the security agreement, it was obligated to keep its
Sanyo merchandise at its Nassau County location, and that by storing its inventory in New Jersey, it
would frustrate Sanyo's interest in those goods.<a href="#10" name="10a">10</a>

</blockquote>

In Howard's Appliance, the Second Circuit imposed a constructive trust because it thought that the
debtor prevented Sanyo from perfecting its security interest in the Goods. Significantly, the Second
Circuit's decision is bereft of any mention of the policies underlying §544(a)(1) or Article 9, and the court
ignores the importance of the policy of ostensible ownership. Equally significant, there is no discussion
concerning the language of §544(a)(1), which grants to the debtor-in-possession the status of a hypothetical
lien creditor so that none of its knowledge or malfeasance will be imputed to the unsecured creditors. The
court apparently viewed the pre-petition entity and the debtor-in-possession as one and the same. However,
the debtor-in-possession is a fiduciary for the unsecured creditors, and its actions are intended to benefit
the unsecured creditor body. Thus, the concept of a constructive trust is repugnant to §544(a)(1).

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… §9-102(1)(a)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… §9-301(1)(a)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §544(a)(1)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Great Plains Western Ranch Co. Inc. (In re Great Plains Western Ranch Co. Inc.), 38 B.R. 899, 904
(Bankr. C.D. Cal. 1984)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, Inc. v. Wilson (In re Omegas Group Inc.), 16 F.3d 1443 (6th Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Oil Co.
Inc. v. Swineheart (In re Haber Oil Co. Inc.), 12 F.3d 426 (5th Cir. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Plunkett, 877
F.2d 512 (7th Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Tleel (In re Tleel), Sanyo Electric Inc. v. Howard's Appliance Corp. (In
re Howard's Appliance Corp.), 874 F.2d 88 (2nd Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… National Bank of Miami v. General Coffee Corp.
(In re General Coffee Corp.), 828 F.2d 699 (11th Cir. 1987)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Quality Holstein Leasing, 752 F.2d
1009 (5th Cir. 1985)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Electric Inc. v. Howard's Appliance Corp. (In re Howard's Appliance Corp.), 874 F.2d 88 (2nd Cir.
1989)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 93</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 94</a>. <a href="#10a">Return to article</a>

Journal Authors

Carlos J. Cuevas

Journal Date

Saturday, April 1, 2000 - 12:00