Absent justifiable equitable grounds, a distribution to a non-bankrupt co-owner is calculated based on the non-bankrupt co-owner’s interest at the time of sale as determined under state law, not at the time of bankruptcy, according to the Fifth Circuit.
The complex facts boil down to this: The manager of a residential apartment complex was a minority owner in the project where the ownership interests were held as tenants-in-common. Disputes broke out between the manager and 19 tenants-in-common. To prevent the manager from selling the complex at a price they believed inadequate, the 19 filed chapter 11 cases that were jointly administered. The manager-minority owner did not file.
The 19 debtors eventually persuaded the bankruptcy court to approve a sale of the project for a price considerably higher than the price at which the manager would have sold the property before bankruptcy. In his March 27 opinion for the Fifth Circuit, Circuit Judge Edward C. Prado said that the bankruptcy court properly ordered the sale of the non-bankrupt co-owner’s interest under Section 363(h).
The non-bankrupt manager-minority owner had a 3% interest in the property on the filing date. By operation of the agreements among the owners, the non-debtor manager’s ownership interest grew to 22% immediately before the sale. In distributing the net proceeds of sale, the bankruptcy court gave 3% to the manager, not 22%. The district court upheld the bankruptcy court.
On appeal in the circuit, the 19 debtors argued that the manager’s 3% interest was fixed as of the filing date. Naturally, the manager disagreed and demanded 22% of the net proceeds.
Judge Prado said that the question implicated Section 363(j), which provides for the distribution of proceeds “according to the interests of such . . . co-owners, and of the estate,” when property is sold under Section 363(h).
Judge Prado said that Section 363(j) “is silent as to how the trustee or the court is to ascertain the interests of co-owners and of the estate.” Second, he said, “no court has specifically addressed whether Section 363(j) requires distribution of proceeds in accordance with the interest share at the time of distribution or the interest share at the time of commencement of the case.”
While he found “no case law” supporting the notion that ownership interests are fixed as of the filing date, Judge Prado said that “general principles of bankruptcy law support giving effect to otherwise valid, legally binding transfers of ownership . . . under Texas law,” citing cases like Butner v. U.S., 440 U.S. 48 (1979).
“[I]t naturally follows,” Judge Prado said, “that state law should similarly determine the interest shares for the purposes of a Section 363(j) distribution following a sale pursuant to Section 363(h).” Because it was “uncontested” that the manager owned 22% at the time of sale, he held that the manager was entitled to 22% of the net sale proceeds.
“However,” Judge Prado said, the “inquiry . . . does not end there,” because the debtors contended that the bankruptcy court was justified in lowering the distribution “on equitable grounds” based on Texas law of constructive trust.
Judge Prado cited In re Haber Oil Co., 12 F.3d 426 (5th Cir. 1994), for the proposition that because “the constructive trust doctrine can wreak such havoc with the priority system ordained by the Bankruptcy Code, bankruptcy courts are generally reluctant ‘to impose constructive trusts without a substantial reason to do so.’” Id. at 436.
Judge Prado refused to invoke a constructive trust because there were “serious procedural deficiencies” in the bankruptcy court that didn’t give the manager notice that constructive trust theories were threatening to reduce the manager’s ownership from 22% to 3%.