Federal common law, if applicable, allows a court to impose a constructive trust even when a constructive trust is not available under state law, according to Bankruptcy Judge Kevin Gross of Delaware.
The creditor was a subcontractor under a contract between the debtor and the U.S. Department of Energy. Although the DOE had paid the debtor for its work and the work performed by the creditor, the debtor had not paid the creditor about $360,000.
The creditor objected when the debtor sought court approval of a settlement that would have paid about $2.6 million to someone else. The creditor contended that $360,000 was subject to a constructive trust in its favor and should be withheld from the settlement.
In his March 16 opinion, Judge Gross rejected several of the creditor’s theories. Earmarking was inapplicable, Judge Gross said, because the contract between the debtor and the creditor did not require setting money aside for the creditor.
A pass-through theory likewise failed, because the contract did not say that money from the DOE merely passed through the debtor.
Georgia law governed the contract, but a state law constructive trust theory did not work because Georgia requires fraud or inequitable conduct. Since the debtor “did not engage in dishonest conduct,” Judge Gross said that the creditor was not entitled to a constructive trust under Georgia law.
Judge Gross found the creditor’s salvation under In re Columbia Gas Systems Inc., 997 F. 2d 1039 (3d Cir. 1993), where the Third Circuit applied federal common law of constructive trust “because of the involvement of the Federal Energy Regulatory Commission and the application of the Natural Gas Act.” The Third Circuit relied on Section 541(d) for the proposition that money is held in a constructive trust “when a debtor collects money on behalf of another.”
Judge Gross said he “reads Columbia Gas as allowing a bankruptcy court to impose a constructive trust when one would not be imposed under applicable non-bankruptcy law.” He applied federal common law in the case at bar because “it is the Department of Energy and a federal research project that are involved.”
Although the debtor did not act with malice, Judge Gross imposed a constructive trust because he found “that the money was never included in the debtor’s estate and [the creditor] is entitled to payment for work it performed.”
Nonetheless, Judge Gross said that the creditor had another obstacle to surmount: tracing.
The debtor argued that the creditor could not trace the $360,000 even under the lowest intermediate balance test because the payments from the DOE were comingled with other funds in a general account that had a zero balance several times.
Judge Gross did not accept the debtor’s representations as gospel. Instead, he granted the creditor leave to take discovery on the question of whether other accounts belonging to the debtor could be included in calculating the lowest intermediate balance test. In the meantime, Judge Gross directed the debtor to set $360,000 aside.