When Bankruptcy And Equity Collide

Even though bankruptcy courts have traditionally been courts of equity, it is unclear under the Bankruptcy Code how equitable interests, such as property rights created under common law when a constructive trust is imposed, are to be treated. Section 541(a) of the Bankruptcy Code broadly defines property of the bankruptcy estate to include “all legal or equitable interests of the debtor in property as of the commencement of the case.” The expansive scope of the estate is tempered, however, by ' 541(d), which provides that:

Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate ' only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.

The legislative history of ' 541(d) indicates that the purpose of the provision was to ensure that the secondary mortgage market, where mortgage servicing companies typically hold legal but not equitable title to mortgages, is shielded from the trustee's avoidance powers. 124 Cong. Rec. S 17,413 (Oct. 6, 1978).

Confusion in the Bankruptcy Courts

Most bankruptcy courts that recognize the enforceability of constructive trusts in the bankruptcy context rely upon the authority of ' 541 in distinguishing between legal and equitable interests when determining whether assets should or should not be included in a debtor's bankruptcy estate. According to this view, ” 541(a) and (d) should be read to exclude from the estate property that the debtor holds in constructive trust for another. Adherents to this approach commonly require, in addition to the factors establishing the existence of a constructive trust relationship, that the property at issue be traceable in the hands of the debtor. See, e.g., In re Financial Federated Title and Trust, Inc., 347 F.3d 880, 891 (11th Cir. 2003).

Many courts are divided over whether property subject to a constructive trust is subject to the trustees' strong arm powers ' in particular, the trustee's status under ' 544(a)(3) of the Bankruptcy Code as a bona fide purchaser of real property. Courts disagree as to whether a bankruptcy court has the power, through the imposition of a constructive trust, to prevent the trustee from utilizing ' 544(a) to avoid an unperfected security interest or unrecorded interest in real property. Some courts, including the Seventh and Ninth Circuits, have adopted the view that ' 544(a)(3) trumps the affirmative defense of a constructive trust, reasoning that, as a hypothetical bona fide purchaser, the trustee has a defense that defeats the claimant's equitable interest. See Nat'l Bank of Alaska v. Erickson (In re Seaway Express Corp.), 912 F.2d 1125 (9th Cir. 1990); Belisle v. Plunkett, 877 F.2d 512 (7th Cir. 1989). Other courts have deemed this interpretation untenable because it would mean that the trustee could defeat constructive trust claims to real but not personal property, as ' 544(a)(3) is limited to the former. These courts, representing the minority view, find that the strong-arm powers of ' 544(a)(3) cannot be utilized to avoid an equitable interest. See, e.g., In re Mills Concepts, 123 B.R. 938 (Bankr. D. Mass. 1991).

Some courts have concluded that the constructive trust is fundamentally at odds with basic principles incorporated in the Bankruptcy Code, such as equality of distribution to creditors. This approach was initially articulated in a landmark ruling handed down by the Sixth Circuit Court of Appeals in 1994. In XL/Datacomp, Inc. v. Wilson (In re Omegas Group Inc.), 16 F.3d 1443 (6th Cir. 1994), the court of appeals emphasized that “[t]he equities of bankruptcy are not the equities of the common law,” concluding that property subject to a claim of constructive trust is excluded from the bankruptcy estate only if such a trust has been imposed by a court “in a separate proceeding prepetition.” Constructive trusts, the Sixth Circuit explained, “are anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.” The court of appeals elaborated on this point as follows:

The problem with the ' analyses of the vast majority of courts which have addressed bankruptcy claims based on constructive trust, is that a constructive trust is not really a trust. A constructive trust is a legal fiction, a common-law remedy in equity that may only exist by the grace of judicial action.

* * *

[A] claim filed in bankruptcy court asserting rights to certain assets “held” in “constructive trust” for the claimant is nothing more than that: a claim. Unless 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.

Id. at 1449.

This approach to the constructive trust quandary has been adopted by some courts, but it has been rejected by others, exacerbating the confusion and uncertainty clouding the issue. For example, in CRS Steam, Inc. v. Engineering Resources, Inc. (In re CRS Steam, Inc.), 225 B.R. 833 (Bankr. D. Mass. 1998), the bankruptcy court held that the Bankruptcy Code's definition of “claim” is an express indication by Congress that courts must treat parties asserting constructive trust rights as nothing more than unsecured creditors, even if the constructive trust was imposed by a state court pre-petition. Thus, the CRS Steam court concluded, property returned to the court-imposed trust beneficiary by a debtor within 90 days of a bankruptcy filing was avoidable as a preference. The Second Circuit Court of Appeals has had several opportunities to weigh in on the question, the most recent of which came in Ades and Berg.

Ades and Berg

Bennett Funding Group, Inc. (“BFG“), a leasing and funding company based in Syracuse, NY, that, until 2008, was the perpetrator of the largest ponzi scheme in U.S. history, filed for Chapter 11 protection in New York in 1996. The ensuing storm of litigation commenced by the Chapter 11 trustee appointed in the bankruptcy cases included a suit against Sphere Drake Insurance PLC (“Sphere Drake“) seeking to recover the proceeds due under a reinsurance policy issued to BFG and asserting a variety of tort claims for aiding and abetting fraud and breach of fiduciary duty. The complaint also sought a declaration that BFG, and not its investors, was the sole and rightful recipient of any policy proceeds. Certain investors counterclaimed against the trustee seeking the imposition of a constructive trust over policy proceeds.

In December 2002, the trustee, Sphere Drake and various other litigants, including the investors, finalized a settlement pursuant to which Sphere Drake agreed to pay approximately $28 million for a release of all claims asserted by the trustee and other litigants. A New York district court approved the settlement and remanded the litigation to the bankruptcy court to determine how the settlement proceeds should be distributed. In 2004, the bankruptcy court entered an order directing that a portion of the settlement proceeds be allocated to BFG creditors with Sphere Drake-related investments, with the remainder to be paid to BFG's general unsecured creditors. However, the court delayed distribution of the proceeds until such time that the investors' constructive trust counterclaim could be adjudicated.

The bankruptcy court ultimately dismissed the constructive trust counterclaim. Observing that “bankruptcy courts are generally reluctant to impose constructive trusts without a substantial reason to do so,” the court ruled that the investors could not satisfy the criteria for a constructive trust under New York law because they could not establish unjust enrichment. According to the court, “[t]here is nothing inequitable or unconscionable” in allowing a Chapter 11 trustee to act “in accordance with the Bankruptcy Code in marshaling and preserving assets.” In doing so, the bankruptcy court relied upon the Second Circuit's decision in Superintendent of Ins. v. Ochs (In re First Central Financial Corp.), 377 F.3d 209 (2d Cir. 2004), where the court of appeals considered whether a constructive trust should be imposed on a tax refund issued to the trustee of a debtor that had been party to a tax allocation agreement for the consolidated filing of tax returns and the sharing of any resulting refunds. Concluding that a constructive trust was not warranted under New York law, the Second Circuit observed that a constructive trust creates “a separate allocation mechanism outside the scope of the bankruptcy system,” and thus can “wreak ' havoc with the priority system ordained by the Bankruptcy Code.” Moreover, the court of appeals explained:

[A]lthough we do not disturb the general rule that constructive trusts must be determined under state law, we believe it important to carefully note the difference between constructive trust claims arising in bankruptcy as opposed to those that do not, as the “equities of bankruptcy are not the equities of the common law.”

Id. at 218. The investors in Ades and Berg appealed the bankruptcy court's ruling. The district court affirmed in 2007, endorsing the bankruptcy court's approach to the constructive trust issue and characterizing First Central as “unquestioned, binding precedent.” The investors then appealed to the Second Circuit.

The Second Circuit's Ruling

According to the investors, the U.S. Supreme Court's 2007 decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 127 S.Ct. 1199 (2007), undermines the continued validity of First Central, including the Second Circuit's admonition that courts should “act very cautiously” in applying constructive trust law in the bankruptcy context. In Travelers, the Supreme Court reaffirmed the “basic federal rule” that state law governs the substance of claims in bankruptcy, emphasizing that “[u]nless some federal interest requires a different result, there is no reason why [property] interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” After Travelers, the investors argued, it is erroneous to evaluate constructive trust claims differently in the bankruptcy content than outside of bankruptcy “because doing so undermines a system explicitly premised on applicable nonbankruptcy law to define property interests.”

The Second Circuit rejected this argument, explaining that the investors misread both Travelers and First Central. Its ruling in First Central, the court of appeals explained, expressly acknowledged that the existence of a constructive trust relationship must be determined under state law, but counseled courts to be cognizant that equitable principles in bankruptcy are not equivalent to those under applicable state law:

Recognizing different equities in different contexts is not an impermissible transformation of the substantive law. It is simply a recognition that an equitable remedy is more or less appropriate when different interests are in play. Context-sensitivity is part and parcel of equity under New York law as much as it is under bankruptcy law.

Ades and Berg, 2008 WL 5220529 at *4. Moreover, the Second Circuit, explained, First Central premised “its bankruptcy-sensitive analysis of New York unjust enrichment law in the purposes of the Bankruptcy Code, giving its reasoning the tie to the Code that was utterly lacking in the ' rule rejected by Travelers.” According to the court of appeals, in both First Central and the case before it, the courts carefully adhered to substantive state law in light of the special equities of bankruptcy in concluding that “retention by the bankruptcy estate of assets that, absent bankruptcy, would go to a particular creditor is not inherently unjust.” Emphasizing that the New York State Court of Appeals has recognized that “there is no inequity in treating [a constructive trust claimant] in the same manner as any other depositor/creditor who was unfortunate enough to have placed its money” with a debtor, the Second Circuit concluded that the lower courts did not err either in characterizing First Central as “unquestioned, binding precedent” or in refusing to impose a constructive trust.

Outlook

The approach articulated in Ades and Berg sets the bar extremely, if not insurmountably high for constructive trust claimants seeking to exclude property from a debtor's bankruptcy estate. The decision provides no guidance regarding any possible scenario that could allow a constructive trust claimant to establish unjust enrichment, an element essential to a constructive trust claim not only in New York, but in every jurisdiction. Although the ruling pays lip service to underlying substantive law, its message is unequivocal: the bankruptcy policy of equality of distribution ordinarily trumps the equitable interest emanating from a constructive trust claim. Ades and Berg and other recent rulings like it indicate that the continued validity of equitable ownership interests in property, such as the constructive trust, are questionable in modern bankruptcy jurisprudence.

Charles M. Oellermann is a partner in the Business Restructuring and Reorganization Practice in the Columbus, OH, office of Jones Day. Mark G. Douglas is the firm's Restructuring Practice Communications Coordinator and Managing Editor of the Jones Day Business Restructuring Review. The views expressed in this article are solely those of the authors and should in no manner be attributed to Jones Day or its clients.

The constructive trust, an equitable remedy designed to prevent unjust enrichment, is a vestige of a U.S. legal system that was originally comprised of separate courts of law and equity. The remedy survived the merger of courts of equity and law in the late 19th century and remains today an important part of the common law of restitution. However, its vitality in the bankruptcy context is unclear, fueling an enduring debate that has evolved during the 30 years since the Bankruptcy Code was enacted in 1978 to polarize and confuse courts and practitioners alike on the question. A ruling recently handed down by the Second Circuit Court of Appeals indicates that the controversy is far from over. In Ades and Berg Group Investors v. Breeden (In re Ades and Berg Group Investors), 550 F.3d 240 (2d Cir. 2008), the court of appeals affirmed a decision below refusing to impose a constructive trust on proceeds from a settlement of reinsurance claims that were paid to a Chapter 11 debtor. According to the Second Circuit, “retention by the bankruptcy estate of assets that, absent bankruptcy, would go to a particular creditor is not inherently unjust.”

Constructive Trusts

A constructive trust is a relationship with respect to property that subjects the person who holds title to property to an equitable duty to convey it to another because the holder's acquisition or retention of the property would constitute unjust enrichment. Whether such a relationship exists is governed by state law. For example, New York law generally requires four elements for a constructive trust: 1) a confidential or fiduciary relationship; 2) a promise, express or implied; 3) a transfer of property made in reliance on that promise; and 4) unjust enrichment. The fourth element is the most important because the purpose of a constructive trust is to prevent unjust enrichment. The standards applied in other states are substantially similar. Sharp v. Kosmalski , 351 N.E.2d 721, 723 (N.Y. 1976).

Even though bankruptcy courts have traditionally been courts of equity, it is unclear under the Bankruptcy Code how equitable interests, such as property rights created under common law when a constructive trust is imposed, are to be treated. Section 541(a) of the Bankruptcy Code broadly defines property of the bankruptcy estate to include “all legal or equitable interests of the debtor in property as of the commencement of the case.” The expansive scope of the estate is tempered, however, by ' 541(d), which provides that:

Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate ' only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.

The legislative history of ' 541(d) indicates that the purpose of the provision was to ensure that the secondary mortgage market, where mortgage servicing companies typically hold legal but not equitable title to mortgages, is shielded from the trustee's avoidance powers. 124 Cong. Rec. S 17,413 (Oct. 6, 1978).

Confusion in the Bankruptcy Courts

Most bankruptcy courts that recognize the enforceability of constructive trusts in the bankruptcy context rely upon the authority of ' 541 in distinguishing between legal and equitable interests when determining whether assets should or should not be included in a debtor's bankruptcy estate. According to this view, ” 541(a) and (d) should be read to exclude from the estate property that the debtor holds in constructive trust for another. Adherents to this approach commonly require, in addition to the factors establishing the existence of a constructive trust relationship, that the property at issue be traceable in the hands of the debtor. See, e.g., In re Financial Federated Title and Trust, Inc., 347 F.3d 880, 891 (11th Cir. 2003).

Many courts are divided over whether property subject to a constructive trust is subject to the trustees' strong arm powers ' in particular, the trustee's status under ' 544(a)(3) of the Bankruptcy Code as a bona fide purchaser of real property. Courts disagree as to whether a bankruptcy court has the power, through the imposition of a constructive trust, to prevent the trustee from utilizing ' 544(a) to avoid an unperfected security interest or unrecorded interest in real property. Some courts, including the Seventh and Ninth Circuits, have adopted the view that ' 544(a)(3) trumps the affirmative defense of a constructive trust, reasoning that, as a hypothetical bona fide purchaser, the trustee has a defense that defeats the claimant's equitable interest. See Nat'l Bank of Alaska v. Erickson (In re Seaway Express Corp.), 912 F.2d 1125 (9th Cir. 1990); Belisle v. Plunkett , 877 F.2d 512 (7th Cir. 1989). Other courts have deemed this interpretation untenable because it would mean that the trustee could defeat constructive trust claims to real but not personal property, as ' 544(a)(3) is limited to the former. These courts, representing the minority view, find that the strong-arm powers of ' 544(a)(3) cannot be utilized to avoid an equitable interest. See, e.g., In re Mills Concepts, 123 B.R. 938 (Bankr. D. Mass. 1991).

Some courts have concluded that the constructive trust is fundamentally at odds with basic principles incorporated in the Bankruptcy Code, such as equality of distribution to creditors. This approach was initially articulated in a landmark ruling handed down by the Sixth Circuit Court of Appeals in 1994. In XL/Datacomp, Inc. v. Wilson (In re Omegas Group Inc.), 16 F.3d 1443 (6th Cir. 1994), the court of appeals emphasized that “[t]he equities of bankruptcy are not the equities of the common law,” concluding that property subject to a claim of constructive trust is excluded from the bankruptcy estate only if such a trust has been imposed by a court “in a separate proceeding prepetition.” Constructive trusts, the Sixth Circuit explained, “are anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.” The court of appeals elaborated on this point as follows:

The problem with the ' analyses of the vast majority of courts which have addressed bankruptcy claims based on constructive trust, is that a constructive trust is not really a trust. A constructive trust is a legal fiction, a common-law remedy in equity that may only exist by the grace of judicial action.

* * *

[A] claim filed in bankruptcy court asserting rights to certain assets “held” in “constructive trust” for the claimant is nothing more than that: a claim. Unless 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.

Id. at 1449.

This approach to the constructive trust quandary has been adopted by some courts, but it has been rejected by others, exacerbating the confusion and uncertainty clouding the issue. For example, in CRS Steam, Inc. v. Engineering Resources, Inc. (In re CRS Steam, Inc.), 225 B.R. 833 (Bankr. D. Mass. 1998), the bankruptcy court held that the Bankruptcy Code's definition of “claim” is an express indication by Congress that courts must treat parties asserting constructive trust rights as nothing more than unsecured creditors, even if the constructive trust was imposed by a state court pre-petition. Thus, the CRS Steam court concluded, property returned to the court-imposed trust beneficiary by a debtor within 90 days of a bankruptcy filing was avoidable as a preference. The Second Circuit Court of Appeals has had several opportunities to weigh in on the question, the most recent of which came in Ades and Berg.

Ades and Berg

Bennett Funding Group, Inc. (“BFG“), a leasing and funding company based in Syracuse, NY, that, until 2008, was the perpetrator of the largest ponzi scheme in U.S. history, filed for Chapter 11 protection in New York in 1996. The ensuing storm of litigation commenced by the Chapter 11 trustee appointed in the bankruptcy cases included a suit against Sphere Drake Insurance PLC (“Sphere Drake“) seeking to recover the proceeds due under a reinsurance policy issued to BFG and asserting a variety of tort claims for aiding and abetting fraud and breach of fiduciary duty. The complaint also sought a declaration that BFG, and not its investors, was the sole and rightful recipient of any policy proceeds. Certain investors counterclaimed against the trustee seeking the imposition of a constructive trust over policy proceeds.

In December 2002, the trustee, Sphere Drake and various other litigants, including the investors, finalized a settlement pursuant to which Sphere Drake agreed to pay approximately $28 million for a release of all claims asserted by the trustee and other litigants. A New York district court approved the settlement and remanded the litigation to the bankruptcy court to determine how the settlement proceeds should be distributed. In 2004, the bankruptcy court entered an order directing that a portion of the settlement proceeds be allocated to BFG creditors with Sphere Drake-related investments, with the remainder to be paid to BFG's general unsecured creditors. However, the court delayed distribution of the proceeds until such time that the investors' constructive trust counterclaim could be adjudicated.

The bankruptcy court ultimately dismissed the constructive trust counterclaim. Observing that “bankruptcy courts are generally reluctant to impose constructive trusts without a substantial reason to do so,” the court ruled that the investors could not satisfy the criteria for a constructive trust under New York law because they could not establish unjust enrichment. According to the court, “[t]here is nothing inequitable or unconscionable” in allowing a Chapter 11 trustee to act “in accordance with the Bankruptcy Code in marshaling and preserving assets.” In doing so, the bankruptcy court relied upon the Second Circuit's decision in Superintendent of Ins. v. Ochs (In re First Central Financial Corp.), 377 F.3d 209 (2d Cir. 2004), where the court of appeals considered whether a constructive trust should be imposed on a tax refund issued to the trustee of a debtor that had been party to a tax allocation agreement for the consolidated filing of tax returns and the sharing of any resulting refunds. Concluding that a constructive trust was not warranted under New York law, the Second Circuit observed that a constructive trust creates “a separate allocation mechanism outside the scope of the bankruptcy system,” and thus can “wreak ' havoc with the priority system ordained by the Bankruptcy Code.” Moreover, the court of appeals explained:

[A]lthough we do not disturb the general rule that constructive trusts must be determined under state law, we believe it important to carefully note the difference between constructive trust claims arising in bankruptcy as opposed to those that do not, as the “equities of bankruptcy are not the equities of the common law.”

Id. at 218. The investors in Ades and Berg appealed the bankruptcy court's ruling. The district court affirmed in 2007, endorsing the bankruptcy court's approach to the constructive trust issue and characterizing First Central as “unquestioned, binding precedent.” The investors then appealed to the Second Circuit.

The Second Circuit's Ruling

According to the investors, the U.S. Supreme Court's 2007 decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. , 127 S.Ct. 1199 (2007), undermines the continued validity of First Central , including the Second Circuit's admonition that courts should “act very cautiously” in applying constructive trust law in the bankruptcy context. In Travelers, the Supreme Court reaffirmed the “basic federal rule” that state law governs the substance of claims in bankruptcy, emphasizing that “[u]nless some federal interest requires a different result, there is no reason why [property] interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.” After Travelers, the investors argued, it is erroneous to evaluate constructive trust claims differently in the bankruptcy content than outside of bankruptcy “because doing so undermines a system explicitly premised on applicable nonbankruptcy law to define property interests.”

The Second Circuit rejected this argument, explaining that the investors misread both Travelers and First Central. Its ruling in First Central, the court of appeals explained, expressly acknowledged that the existence of a constructive trust relationship must be determined under state law, but counseled courts to be cognizant that equitable principles in bankruptcy are not equivalent to those under applicable state law:

Recognizing different equities in different contexts is not an impermissible transformation of the substantive law. It is simply a recognition that an equitable remedy is more or less appropriate when different interests are in play. Context-sensitivity is part and parcel of equity under New York law as much as it is under bankruptcy law.

Ades and Berg, 2008 WL 5220529 at *4. Moreover, the Second Circuit, explained, First Central premised “its bankruptcy-sensitive analysis of New York unjust enrichment law in the purposes of the Bankruptcy Code, giving its reasoning the tie to the Code that was utterly lacking in the ' rule rejected by Travelers.” According to the court of appeals, in both First Central and the case before it, the courts carefully adhered to substantive state law in light of the special equities of bankruptcy in concluding that “retention by the bankruptcy estate of assets that, absent bankruptcy, would go to a particular creditor is not inherently unjust.” Emphasizing that the New York State Court of Appeals has recognized that “there is no inequity in treating [a constructive trust claimant] in the same manner as any other depositor/creditor who was unfortunate enough to have placed its money” with a debtor, the Second Circuit concluded that the lower courts did not err either in characterizing First Central as “unquestioned, binding precedent” or in refusing to impose a constructive trust.

Outlook

The approach articulated in Ades and Berg sets the bar extremely, if not insurmountably high for constructive trust claimants seeking to exclude property from a debtor's bankruptcy estate. The decision provides no guidance regarding any possible scenario that could allow a constructive trust claimant to establish unjust enrichment, an element essential to a constructive trust claim not only in New York, but in every jurisdiction. Although the ruling pays lip service to underlying substantive law, its message is unequivocal: the bankruptcy policy of equality of distribution ordinarily trumps the equitable interest emanating from a constructive trust claim. Ades and Berg and other recent rulings like it indicate that the continued validity of equitable ownership interests in property, such as the constructive trust, are questionable in modern bankruptcy jurisprudence.

Charles M. Oellermann is a partner in the Business Restructuring and Reorganization Practice in the Columbus, OH, office of Jones Day. Mark G. Douglas is the firm's Restructuring Practice Communications Coordinator and Managing Editor of the Jones Day Business Restructuring Review. The views expressed in this article are solely those of the authors and should in no manner be attributed to Jones Day or its clients.