Constructive Trusts in Bankruptcy

Since few debtors in bankruptcy have sufficient assets to pay their debts in full, times are generally tough for unsecured creditors and their lawyers. The word “haircut” crops up frequently in discussions with the debtor. For unsecured creditors, the haircut is often as close as a Sweeney Todd shave. A creative creditor’s lawyer will labor mightily to find something special about his client’s situation to elevate his or her claims above those of the sure-to-be-disappointed masses. One common tactic is to identify a particular asset or asset pool that is closely related to a particular claim, as in, “we were to be paid out of that fund,” or, “that’s the property I was swindled out of.” On the basis of such a relationship, the creditor may ask the court to impose a constructive trust over that asset for the creditor’s benefit, so that the asset becomes, in effect, collateral for the otherwise unsecured claim, or, better still, is awarded to the creditor as his or her own property. Hopeful creditors should be wary, however, for the remedy of constructive trust, in practice, is far more difficult to obtain in bankruptcy than outside it, and for good reason. [1]

A constructive trust is a court-imposed trust relationship, created ex post facto, to return property to its rightful owner. Generally, a constructive trust may be imposed when one party has acquired legal title to property under circumstances that such party could not, in good conscience, retain the beneficial interest thereto. 76 Am. Jur. 2d Trusts §168. In order to prevail in an action to impose a constructive trust, a claimant must demonstrate that another party (1) holds an identifiable res [2] and (2) is subject to an equitable duty to convey or return such res to the claimant. See Yohe v. Yohe, 466 Pa. 405, 411 (Pa. 1976). This “equitable duty” may arise out of a number of circumstances, including fraud, bad faith, duress, coercion or undue influence. See 76 Am. Jur. 2d Trusts §169.

Constructive trusts may also be imposed to remedy a breach of fiduciary duty that has led to unjust enrichment. For example, in Griffin v. Armana, 687 So. 2d 1188 (Miss. 1996), the court imposed a constructive trust on real property that the defendant had wrongfully obtained from her elderly uncle. The uncle had told his niece he would grant her certain real property upon his death. He had even drafted and executed a deed, which he had then placed in a safety deposit box. At some point, the niece secretly removed the deed from the deposit box and recorded it. The court found that the confidential nature of the relationship between the uncle and his niece, combined with the niece’s abuse thereof, warranted the imposition of a constructive trust on the real property. Id. at 1195.[3] Thus, at common law, the constructive trust provides a simple and appropriate remedy to a party that has been defrauded by a person with whom it shared a “confidential relationship,” such as a family member, agent or financial advisor.      

Limitations in a Bankruptcy Case

The inherent flexibility of the constructive trust remedy lends itself well to a one-on-one court proceeding. However, that remedy appears less equitable in the multi-party landscape of bankruptcy. One primary purpose of the Bankruptcy Code is to distribute debtor funds equally among the debtor’s creditors. The imposition of a constructive trust disrupts this process, allowing one creditor to receive more than its share of the debtor’s assets at the expense of all other creditors. See In re First Cent. Fin. Corp. 377 F.3d 209, 217-18 (2d Cir. 2004) (“The constructive trust doctrine can wreak … havoc with the priority system ordained by the Bankruptcy Code.”)(citation omitted). This does not play well in a bankruptcy, where all creditors have been equally “wronged” by the debtor’s inability to repay its debts.

Not surprisingly, constructive trusts are more difficult to obtain in a bankruptcy case. A recent opinion from the Second Circuit, In re Flanagan, 2007 U.S. App. LEXIS 23622 (2nd Cir. 2007), illustrates this point. In Flanagan, the plaintiff obtained a money judgment against the debtor prior to the debtor’s bankruptcy filing. At the time of the judgment, the debtor held certain stock that could have been sold to satisfy the plaintiff’s judgment; nonetheless, before filing its bankruptcy case, the debtor continuously refused to disclose or turn over his interest in the stock. Eventually, the debtor was facing prison for contempt. At this time, the debtor’s father made a loan to his son, which was used by the debtor to satisfy the plaintiff’s judgment. The debtor then filed a chapter 11 bankruptcy and subsequently attempted to avoid the payment to the plaintiff as a preference under §547(b) of the Bankruptcy Code. To avoid preference liability, the plaintiff filed a counterclaim seeking to impose a constructive trust on the debtor’s interest in the stock. The plaintiff claimed its constructive lien on the stock made it, in effect, a secured creditor of the debtor who could satisfy its claim out of the stock proceeds. If the plaintiff were granted the constructive trust remedy, the debtor would be unable to show the plaintiff had received more than it would have in a hypothetical liquidation under §547(b)(6) of the Bankruptcy Code, and the preference action would fail.

The Flanagan court rejected the constructive trust argument for two reasons. First, the court held that since the plaintiff was never legally entitled to ownership of the stock, the elements of a constructive trust might not have been satisfied under state law. Second, the court found that even if state law would permit the imposition of a constructive trust based on a theory of unjust enrichment, the court simply was not persuaded that the remedy was appropriate in bankruptcy:

[T]he effect of a constructive trust in bankruptcy is to take the property out of the debtor’s estate and to place the constructive trust claimant ahead of other creditors with respect to the trust res …. It is therefore not the debtor who generally bears the burden of a constructive trust in bankruptcy, but the debtor’s general creditors. This type of privileging of one unsecured claim over another clearly thwarts the principle of ratable distribution underlying the Bankruptcy Code. As a consequence bankruptcy courts have been reluctant, absent a compelling reason, to impose a constructive trust on the property in the estate.

Id. at 22.[4] The Flanagan court found no such “compelling reason,” and therefore, the plaintiff’s claim was denied.[5] Id.

Circumstances in Which Bankruptcy Courts Have Imposed a Constructive Trust

Clearly, the remedy of constructive trust is tightly circumscribed in a bankruptcy case. Still, there are circumstances in which bankruptcy courts have been willing to enforce a constructive trust. For example, bankruptcy courts are much more likely to enforce a constructive trust that was created prepetition than they are to impose one after a case has been filed, with some courts having gone so far as to hold that this is the only time a constructive trust may be enforced in a bankruptcy case.See In re Omegas Group, 16 F.3d 1443, 1449 (6^th Cir. 1994)(“[u]nless a court has already impressed a constructive trust upon certain assets or a legislature has created a specific statutory right to have particular kinds of funds held as if in trust, the claimant cannot properly represent to the bankruptcy court that he was, at the time of the commencement of the case, a beneficiary of a constructive trust held by the debtor”); In re Paul J. Paradise & Assocs., 217 B.R. 452, 456 (Bankr. D. Del. 1997)(adopting the reasoning of Omegas Group, and calling it the majority view), aff’d 249 B.R. 360 (D. Del. 2000).

However, some bankruptcy courts will impose a constructive trust post-petition despite the heightened level of scrutiny applied to constructive trusts in a bankruptcy case. For example, in In re Visiting Nurse Ass’n, 143 B.R. 633, 639 (Bankr. W.D. Penn. 1992), the debtor-health care provider continued to receive Medicare payments despite the fact that it was no longer providing health care. The court found that (1) a confidential relationship existed between the health care provider and Medicare such that “the party in whom the trust and confidence are reposed must act with scrupulous fairness and good faith in his dealings with the other and remain [sic] from using his position to the other’s detriment and his own advantage” and (2) this confidential relationship had been abused by the health care provider’s continued acceptance of the undeserved Medicare payments. The court held that the health care provider had been unjustly enriched; therefore, even after recognizing that constructive trusts are used “sparingly” in bankruptcy, the court imposed a constructive trust on certain funds in the health care provider’s estate. Id. at 641 (“This court affirms the imposition of a constructive trust … given its affirmation of the bankruptcy court’s confidential relation and unjust enrichment findings” (emphasis added). Thus, although constructive trusts are viewed more skeptically in a bankruptcy case, depending on the state and circuit, they may still be imposed.

Conclusion

The equitable remedy of constructive trust is generally less available in a bankruptcy case. Whether a bankruptcy court will impose a constructive trust depends on both state law (which prescribes the elements of a constructive trust) and bankruptcy law (to the extent the circuit in which the bankruptcy was filed permits the imposition of a constructive trust in a bankruptcy case). Given this uncertainty, the constructive trust remedy must be viewed with some reservation in bankruptcy. Nonetheless, if the proper elements of a constructive trust under state law can be established, a constructive trust remains one of few options available to a creditor to elevate itself above its unsecured status in the bankruptcy.