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

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May 2000

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In Belisle v. Plunkett,<a href="#1" name="1a">1</a> the U.S. Court of Appeals for the Seventh Circuit held that the assertion of a
constructive trust is insufficient to defeat the employment of the trustee's strong-arm powers. There, the
debtor signed a contract, in his own name, to purchase a lease for $1.2 million. The debtor organized five
partnerships to obtain the funds to purchase the lease, then utilized the partnerships' funds to purchase the
lease. But the debtor closed the transaction in his own name, and he recorded the lease assignment in his
own name. Subsequently, the debtor and his wife filed for chapter 7, and the trustee asserted that the lease
was property of the estate. The partners filed an adversary proceeding seeking a declaratory judgment that
the lease was not property of the estate. The bankruptcy court granted the trustee summary judgment, and
the district court affirmed the granting of summary judgment.

In an opinion written by Circuit Judge Easterbrook, the Seventh Circuit held that under Bankruptcy
Code §544(a)(3), the trustee was able to avoid the partners' interest in the lease. The debtor defrauded the
partners, and the lease was subject to a constructive trust for the benefit of the partners. The imposition of
a constructive trust usually survives the commencement of a bankruptcy case. However, §544(a)(3) grants
a trustee the status of a bona fide purchaser. A bona fide purchaser, without knowledge of the earlier claim,
would take priority over an entity that had not recorded its interest, or otherwise taken steps to preclude
bona fide purchasers, such as recording a lis pendens against the property.

The partners contended that Bankruptcy Code §541(d) precluded the use of the strong-arm powers.
According to the partners, §§541(d) and 544(a)(3) allow a trustee to recover property transferred out of the
estate before the commencement of a bankruptcy case, but these provisions preclude a trustee from
recovering property that is subject to a constructive trust.

The Seventh Circuit rejected the partners' argument. One of the purposes of §544(a)(3) was intended
to deal with the problem of ostensible ownership. In addition, §544(a)(3) recognizes that a good-faith
purchaser is able obtain greater rights to property than the rightful owner if the rightful owner neglected to
record its interest. Section 544(a)(3) grants a trustee the status of a bona fide purchaser. Under applicable
non-bankruptcy law, a bona fide purchaser would have priority over the partners because the partners failed
to record their interests. Consequently, the trustee, as a bona fide purchaser, has priority over the partners.

The court also ruled that there was no conflict between §§541(d) and 544(a)(3). The Seventh Circuit
stated:

<blockquote>
Section 541(d) does not have anything to say about the effects of §544(a)(3). It forbids including
property in the debtor's estate "under subsection (a) of this section" and does not address whether
property may be included under some other part of the Code.<a href="#2" name="2a">2</a>

</blockquote>

The legislative history of §541(d) reflected that it was intended to deal with transactions in the secondary
mortgage market. Section 541(d) ensures that creditors of the service corporation stand behind the owners
of the income stream. Therefore, there was no indication that Congress intended that §541(d) was intended
to limit the application of §544(a).

Plunkett is a significant decision. Circuit Judge Easterbrook is one of the leading law and economics
scholars, and has an excellent understanding of commercial and corporate law. Plunkett is a correct
interpretation of bankruptcy law and policy. Ostensible ownership is an important policy permeating
secured lending. The recording statutes are designed to facilitate commercial lending. The purpose of
obtaining a security interest is to enable a lender to be repaid in the event of an insolvency proceeding. An
unrecorded or secret lien vitiates the reliability of the recording statutes because recognition of an
unrecorded or secret lien destroys the reliability of the recording system.

In a world without bankruptcy, a judgment creditor would have priority over a creditor with an
unperfected security interest.<a href="#3" name="3a">3</a> Section 544(a)(1) recognizes the priority provision contained in Article 9.
Section 544(a)(1) enables the trustee or debtor-in-possession to enforce this priority for the benefit of the
unsecured creditors. The trustee or debtor-in-possession is acting to collect assets for the benefit of all the
unsecured creditors. Under these circumstances, the trustee enforces the entitlements that the unsecured
creditors possessed against the debtor's property prior to the bankruptcy case because of §544(a)(1).
Therefore, a constructive trust should not be permitted to defeat the utilization of the trustee's strong-arm
powers.

This is also the correct result under Butner v. United States.<a href="#4" name="4a">4</a> There, the Supreme Court held that
non-bankruptcy law determines property interests in a bankruptcy case. The court stated:

<blockquote>
Property interests are created and defined by state law. Unless some federal interest requires a
different result, there is no reason why such interests should be analyzed differently simply because
an interested party is involved in a bankruptcy proceeding. Uniform treatment of property interests
by both state and federal courts within a state serves to reduce uncertainty, to discourage forum
shopping, and to prevent a party from receiving "a windfall merely by reason of the happenstance
of bankruptcy."<a href="#5" name="5a">5</a>
</blockquote>

The enforcement of the strong-arm provisions ensures that a creditor with an unperfected security interest
will not receive a windfall because of the happenstance of bankruptcy. If a creditor was unperfected prior
to the bankruptcy case, then the creditor's lack of perfection should be subject to attack under the
strong-arm clause.

The Seventh Circuit correctly interpreted the relationship between §§541(d) and 544(a). There is
nothing in the text or in the legislative history of §541(d) that §541(d) was intended to supercede §544(a).
In addition, the language and history of §544(a) reflects that this provision was intended to sanitize the
estate of any malfeasance committed by the debtor. Therefore, interpreting §541(d) as restricting the
utilization of §544(a) is an erroneous interpretation of the Bankruptcy Code.

<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=… F.2d 512 (7th Cir. 1989)</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=…; at 516</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=…. §9-301(1)(b)</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=… U.S. 48 (1979)</a>. <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=…; at 55</a>. <a href="#5a">Return to article</a>

Journal Authors

Carlos J. Cuevas

Journal Date

Monday, May 1, 2000 - 12:00