The Trouble with Constructive Trusts

In a recent decision, In re First Central Financial Corporation, 377 F.3d 209 (2d Cir. 2004), the Second Circuit, in affirming the U.S. District Court and the U.S. Bankruptcy Court, addressed the interplay between a constructive trust and a written agreement that purportedly granted an ownership interest in a tax refund to a subsidiary, FCIC, of a company that filed a Chapter 7 case, FCFC.

The agreement required that FCFC turn over such tax refunds to FCIC, as was the long-established practice between the related corporations. Id. at 211. The Chapter 7 trustee of FCFC received a tax refund in the amount of $2.5 million. FCIC commenced an adversary proceeding to recover the funds, asserting that the funds were not property of the debtor's estate.

The bankruptcy court granted summary judgment to the trustee, holding that the refund was not held in trust for two reasons. First, “the [a]greement itself did not give rise to a trust or agency relationship because it did not require the refund to be segregated or restricted in use.” Id. at 211-212. Second, because the parties' relationship was controlled by a written agreement, a constructive trust would not be imposed pursuant to New York law. Id. at 212.

Applying New York Law

Applying New York law, a party seeking to establish a constructive trust must show: 1) a confidential or fiduciary relationship; 2) an express or implied promise; 3) a transfer made in reliance on that promise; and 4) unjust enrichment. United States v. Coluccio, 51 F.3d 337 (2d Cir. 1995); Simonds v. Simonds, 45 N.Y.2d 233, 241-42 (1978); Koreag, 961 F.2d at 352 (2d Cir. 1992). Where a contractual claim between the parties exists, which provides an adequate remedy at law, the equitable remedy of constructive trust will not lie. First Central, 377 F.3d at 216.

The court held that constructive trust is intended to be “fraud-rectifying” rather than “intent enforcing,” and stated that no allegation of fraud or misconduct was present. Id. (citing Bankers Sec. Life Ins. Soc'y, 49 N.Y.2d 939, 940 (2d Cir.1980)). The court held that “[w]hile FCFC's estate may have been enriched, it was not unjustly enriched.” Id. at 218.

The court declined to impose a constructive trust because the trustee was not holding property “under such circumstances that in equity and good conscience he ought not to retain it.” Id. (citing Simonds, 45 N.Y.2d at 242 (internal quotation marks and citations omitted)). The remedy of a constructive trust is potent in bankruptcy because it can wreak havoc with the priority system established by the Bankruptcy Code. Southmark Corp. v. Grosz (In re Southmark Corp.), 49 F.3d 1111, 1119 (5th Cir. 1995); see also, In re Universal Money Order Co., 470 F.Supp. 869, 879 (S.D.N.Y. 1977).

A Familiar Result

Another decision dealing with constructive trust is LFD Operating, Inc. v. Ames Dept. Stores, Inc. (In re Ames Dept. Stores, Inc.), No. 01-42217, Adv. No. 01-8139A, 2004 U.S. Dist. LEXIS 17575; 43 Bankr. Ct. Dec. (CRR) 159 (S.D.N.Y. Sept. 1, 2004), which affirmed Bankruptcy Judge Arthur J. Gonzalez's decision in LFD Operating, Inc. v. Ames Dept. Stores, Inc. (In re Ames Dept. Stores, Inc.), 274 B.R. 600 (Bankr. S.D.N.Y. 2002).

In Ames, the debtor operated the Ames department store chain. Pre-bankruptcy, Ames and JBI Holding, Inc. (JBI) entered into an agreement in which JBI would operate shoe departments within Ames stores. Ames, 2004 U.S. Dist. LEXIS 17575, at *2. LFD Operating, Inc. was the assignee of the agreement. Although LFD staffed, furnished and operated the shoe departments, the sales were processed through Ames' cashiers and the normal channels of Ames' business. Id. at *3. Pursuant to the agreement, Ames turned over the funds earned by the shoe departments on a weekly basis to LFD, less its fees. Id. The agreement provided that: 1) all proceeds from shoe department sales were property of LFD from the point of sale; 2) Ames was an agent of LFD with respect to the funds collected; and 3) the proceeds were held in trust for LFD.

After Ames filed for Chapter 11 bankruptcy protection, LFD commenced an adversary proceeding against Ames to compel the turnover of $8.9 million that LFD claimed it was owed. Id. at *7. LFD asserted that it was entitled to an immediate payment of funds in their entirety (Pursuant to 11 U.S.C. ' 541(d), legal but not equitable title to property held by a debtor is not property of the bankruptcy estate), advancing contract, agency, trust and constructive trust theories. Id. The bankruptcy court denied relief to LFD.

The Agreement

LFD argued that the agreement established the agency relationship and its status as beneficial owner of the funds. The bankruptcy court looked beyond the terms of the agreement and held that the mere conclusory labels did not ipso facto establish such status. Id. at *8. The court, in relying upon Pan Am World Airways, Inc. v. Shulman Transp. Enters., Inc. (In re Shulman Transp. Enters.), 744 F.2d 293, 295 (2d Cir. 1984), stated that “[w]hether contracting parties have established an agency or trust must be determined by the true character of their relationship rather than by the formal language of a contract.” Ames, 2004 U.S. Dist. LEXIS 17575, at *9. “[T]alismanic language could not throw a protective mantle over these receipts in the absence of a genuine trust mechanism. Here the relationship remained in practical fact that of debtor-creditor.” Id. (citing In re Morales Travel Agency, 667 F.2d 1069, 1071 (1st Cir. 1981)).

Trust clauses alone do not establish a trust. Id. at *9 (citing Carlson Inc. v. Commercial Disc. Corp., 382 F.2d 903, 905 (10th Cir. 1967)). The court stated it was not required to “robotically adopt” the contractual language and ignore the substance of the actual relationship between the parties. Ames, 2004 U.S. Dist. LEXIS 17575, at *11 (citing Shulman, 744 F.2d at 295).

Ames established that the funds were its property by demonstrating that it had control over the funds at all times, the funds were never segregated at any time and were commingled with all of Ames' general operating funds prior to disbursement to LFD. Ames, 2004 U.S. Dist. LEXIS 17575, at *11-12. The court found that the parties' conduct established that the funds were the property of Ames. Id. at *12. The bankruptcy court rejected LFD's argument that Ames was LFD's agent. The essential element of the agent acting under the direction and control of the principal was lacking. Shulman, 744 F.2d at 295; In re Drexel Burnham Lambert Group Inc., 113 B.R. 830, 841-842 (Bankr. S.D.N.Y. 1990). The commingling of the funds and tender of payment to LFD from Ames' general operating accounts established that LFD did not have any control over the proceeds. Ames, 2004 U.S. Dist. LEXIS 17575, at *13.

Express or Contructive Trust

The court found no evidence to support LFD's claims of either an express or constructive trust. As for an express trust, the court found that the proceeds were commingled with the debtor's funds as a regular practice and payments were made to LFD out of the general operating funds of the debtor. Id. at *14. Thus, LFD failed the test that if a recipient of funds is not prohibited from using the funds as his own and not prohibited from commingling the funds, a trust does not exist. In re Black & Geddes, Inc., 35 B.R. 830, 836 (Bankr. S.D.N.Y. 1984). Rather, a mere debtor-creditor relationship is established. Id. LFD's assertions that the funds were held in constructive trust failed as well. Applying the test addressed above in First Central, the court found the record devoid of any evidence of the requisite elements to grant relief to LFD. Judge Gonzalez found that no fiduciary relationship was present between Ames and LFD, and no conversion of funds or unjust enrichment inured to Ames' benefit. Ames, 2004 U.S. Dist. LEXIS 17575, at *15.

Fiduciary Relationship

A party seeking to have a constructive trust imposed should seek to establish that a fiduciary or confidential relationship existed between the parties. Koreag, 961 F.2d at 353-354. Where parties have a contractual relationship characterized by ordinary and arms-length dealing, a fiduciary relationship will not be found. Id.; See also Rodgers v. Roulette Records, Inc., 677 F.Supp. 731, 738-39 (S.D.N.Y. 1988).

In Ames, the court held that the parties' course of conduct established a classic debtor-creditor relationship only. Id. What occurred was simply the failure to pay a debt. See In re Penn-Dixie Steel Corp., 6 B.R. 817, 825 (Bankr. S.D.N.Y. 1980).

Conclusion

Rather than taking the risks of proving a constructive trust, a better course of action for a non-debtor party to a contract may be to enter into a secured transaction.

The equitable remedy of constructive trust is employed when “property has been acquired in such circumstances that the holder of the legal title may not in good conscience retain the beneficial interest,” and therefore equity converts him into a trustee. In re Koreag, Controle et Revision S.A., 961 F.2d 341, 353 (2d Cir. 1992). This legal theory arises in bankruptcy cases when a non-debtor party with a pre-petition contract, which ostensibly grants such party an ownership interest in funds or which establishes an agency relationship with a debtor, seeks, in the bankruptcy case, to assert its ownership rights to the funds held by the debtor.

As case law in the U.S. Court of Appeals for the Second Circuit holds, such contractual language, without other factors, will likely result in a determination that the imposition of a constructive trust is not warranted and consequently, the funds are property of the debtor's estate. Such a result affords the non-debtor party to the contract merely the rights of a general unsecured creditor.

First Central Financial Corporation

In a recent decision, In re First Central Financial Corporation, 377 F.3d 209 (2d Cir. 2004), the Second Circuit, in affirming the U.S. District Court and the U.S. Bankruptcy Court, addressed the interplay between a constructive trust and a written agreement that purportedly granted an ownership interest in a tax refund to a subsidiary, FCIC, of a company that filed a Chapter 7 case, FCFC.

The agreement required that FCFC turn over such tax refunds to FCIC, as was the long-established practice between the related corporations. Id. at 211. The Chapter 7 trustee of FCFC received a tax refund in the amount of $2.5 million. FCIC commenced an adversary proceeding to recover the funds, asserting that the funds were not property of the debtor's estate.

The bankruptcy court granted summary judgment to the trustee, holding that the refund was not held in trust for two reasons. First, “the [a]greement itself did not give rise to a trust or agency relationship because it did not require the refund to be segregated or restricted in use.” Id. at 211-212. Second, because the parties' relationship was controlled by a written agreement, a constructive trust would not be imposed pursuant to New York law. Id. at 212.

Applying New York Law

Applying New York law, a party seeking to establish a constructive trust must show: 1) a confidential or fiduciary relationship; 2) an express or implied promise; 3) a transfer made in reliance on that promise; and 4) unjust enrichment. United States v. Coluccio , 51 F.3d 337 (2d Cir. 1995); Simonds v. Simonds , 45 N.Y.2d 233, 241-42 (1978); Koreag, 961 F.2d at 352 (2d Cir. 1992). Where a contractual claim between the parties exists, which provides an adequate remedy at law, the equitable remedy of constructive trust will not lie. First Central, 377 F.3d at 216.

The court held that constructive trust is intended to be “fraud-rectifying” rather than “intent enforcing,” and stated that no allegation of fraud or misconduct was present. Id. (citing Bankers Sec. Life Ins. Soc'y, 49 N.Y.2d 939, 940 (2d Cir.1980)). The court held that “[w]hile FCFC's estate may have been enriched, it was not unjustly enriched.” Id. at 218.

The court declined to impose a constructive trust because the trustee was not holding property “under such circumstances that in equity and good conscience he ought not to retain it.” Id. (citing Simonds, 45 N.Y.2d at 242 (internal quotation marks and citations omitted)). The remedy of a constructive trust is potent in bankruptcy because it can wreak havoc with the priority system established by the Bankruptcy Code. Southmark Corp. v. Grosz (In re Southmark Corp.), 49 F.3d 1111, 1119 (5th Cir. 1995); see also, In re Universal Money Order Co., 470 F.Supp. 869, 879 (S.D.N.Y. 1977).

A Familiar Result

Another decision dealing with constructive trust is LFD Operating, Inc. v. Ames Dept. Stores, Inc. (In re Ames Dept. Stores, Inc.), No. 01-42217, Adv. No. 01-8139A, 2004 U.S. Dist. LEXIS 17575; 43 Bankr. Ct. Dec. (CRR) 159 (S.D.N.Y. Sept. 1, 2004), which affirmed Bankruptcy Judge Arthur J. Gonzalez's decision in LFD Operating, Inc. v. Ames Dept. Stores, Inc. (In re Ames Dept. Stores, Inc.), 274 B.R. 600 (Bankr. S.D.N.Y. 2002).

In Ames, the debtor operated the Ames department store chain. Pre-bankruptcy, Ames and JBI Holding, Inc. (JBI) entered into an agreement in which JBI would operate shoe departments within Ames stores. Ames, 2004 U.S. Dist. LEXIS 17575, at *2. LFD Operating, Inc. was the assignee of the agreement. Although LFD staffed, furnished and operated the shoe departments, the sales were processed through Ames' cashiers and the normal channels of Ames' business. Id. at *3. Pursuant to the agreement, Ames turned over the funds earned by the shoe departments on a weekly basis to LFD, less its fees. Id. The agreement provided that: 1) all proceeds from shoe department sales were property of LFD from the point of sale; 2) Ames was an agent of LFD with respect to the funds collected; and 3) the proceeds were held in trust for LFD.

After Ames filed for Chapter 11 bankruptcy protection, LFD commenced an adversary proceeding against Ames to compel the turnover of $8.9 million that LFD claimed it was owed. Id. at *7. LFD asserted that it was entitled to an immediate payment of funds in their entirety (Pursuant to 11 U.S.C. ' 541(d), legal but not equitable title to property held by a debtor is not property of the bankruptcy estate), advancing contract, agency, trust and constructive trust theories. Id. The bankruptcy court denied relief to LFD.

The Agreement

LFD argued that the agreement established the agency relationship and its status as beneficial owner of the funds. The bankruptcy court looked beyond the terms of the agreement and held that the mere conclusory labels did not ipso facto establish such status. Id. at *8. The court, in relying upon Pan Am World Airways, Inc. v. Shulman Transp. Enters., Inc. (In re Shulman Transp. Enters.), 744 F.2d 293, 295 (2d Cir. 1984), stated that “[w]hether contracting parties have established an agency or trust must be determined by the true character of their relationship rather than by the formal language of a contract.” Ames, 2004 U.S. Dist. LEXIS 17575, at *9. “[T]alismanic language could not throw a protective mantle over these receipts in the absence of a genuine trust mechanism. Here the relationship remained in practical fact that of debtor-creditor.” Id. (citing In re Morales Travel Agency, 667 F.2d 1069, 1071 (1st Cir. 1981)).

Trust clauses alone do not establish a trust. Id. at *9 (citing Carlson Inc. v. Commercial Disc. Corp. , 382 F.2d 903, 905 (10th Cir. 1967)). The court stated it was not required to “robotically adopt” the contractual language and ignore the substance of the actual relationship between the parties. Ames, 2004 U.S. Dist. LEXIS 17575, at *11 (citing Shulman, 744 F.2d at 295).

Ames established that the funds were its property by demonstrating that it had control over the funds at all times, the funds were never segregated at any time and were commingled with all of Ames' general operating funds prior to disbursement to LFD. Ames, 2004 U.S. Dist. LEXIS 17575, at *11-12. The court found that the parties' conduct established that the funds were the property of Ames. Id. at *12. The bankruptcy court rejected LFD's argument that Ames was LFD's agent. The essential element of the agent acting under the direction and control of the principal was lacking. Shulman, 744 F.2d at 295; In re Drexel Burnham Lambert Group Inc., 113 B.R. 830, 841-842 (Bankr. S.D.N.Y. 1990). The commingling of the funds and tender of payment to LFD from Ames' general operating accounts established that LFD did not have any control over the proceeds. Ames, 2004 U.S. Dist. LEXIS 17575, at *13.

Express or Contructive Trust

The court found no evidence to support LFD's claims of either an express or constructive trust. As for an express trust, the court found that the proceeds were commingled with the debtor's funds as a regular practice and payments were made to LFD out of the general operating funds of the debtor. Id. at *14. Thus, LFD failed the test that if a recipient of funds is not prohibited from using the funds as his own and not prohibited from commingling the funds, a trust does not exist. In re Black & Geddes, Inc., 35 B.R. 830, 836 (Bankr. S.D.N.Y. 1984). Rather, a mere debtor-creditor relationship is established. Id. LFD's assertions that the funds were held in constructive trust failed as well. Applying the test addressed above in First Central, the court found the record devoid of any evidence of the requisite elements to grant relief to LFD. Judge Gonzalez found that no fiduciary relationship was present between Ames and LFD, and no conversion of funds or unjust enrichment inured to Ames' benefit. Ames, 2004 U.S. Dist. LEXIS 17575, at *15.

Fiduciary Relationship

A party seeking to have a constructive trust imposed should seek to establish that a fiduciary or confidential relationship existed between the parties. Koreag, 961 F.2d at 353-354. Where parties have a contractual relationship characterized by ordinary and arms-length dealing, a fiduciary relationship will not be found. Id.; See also Rodgers v. Roulette Records, Inc. , 677 F.Supp. 731, 738-39 (S.D.N.Y. 1988).

In Ames, the court held that the parties' course of conduct established a classic debtor-creditor relationship only. Id. What occurred was simply the failure to pay a debt. See In re Penn-Dixie Steel Corp., 6 B.R. 817, 825 (Bankr. S.D.N.Y. 1980).

Conclusion

Rather than taking the risks of proving a constructive trust, a better course of action for a non-debtor party to a contract may be to enter into a secured transaction.