Lead Opinion
Understandably, creditors of bankrupt debtors often feel like restaurant patrons who not only hate the food, but think the portions are too small.
I.
While the parties do not generally dispute the underlying facts of this case, they do characterize them quite differently. Both parties, XL/Datacomp (Datacomp) and debt- or Omegas
In early 1990, the two companies entered into a course of business dealings that Data-comp describes as a “unique relationship” and a “type of joint venture” and which the Debtor describes as a “clandestine relationship.” Both parties agree that Omegas agreed to act as a middleman of sorts, ordering IBMs on behalf of Datacomp, taking a percentage down payment, ordering the computers, then taking the rest of the payment and sending full payment to IBM at the time of delivery.
According to the Debtor, in early 1990, IBM paid Datacomp $8 million to terminate its IR agreement and sign on to a new IR agreement, which would eliminate the “competitive advantage which existed between the IRs and IBM’s regular sales force.” In order to come up with a new source of competitively priced IBMs, the Debtor explains, Da-tacomp approached Omegas (as well as other IRs still operating under the old IR agreements) and proposed that Omegas supply Datacomp with new IBM computers in exchange for a 4% of gross price commission. IBM would not know of this arrangement. Indeed, the Debtor claims that since Data-comp, as the purchaser from Omegas, the IR, would not be the “end-user” of the computers, this deal violated Omegas’s IR agreement with IBM; for this reason, the Debtor points out, most of the transaction was arranged orally.
According to Datacomp, Omegas initially proposed this arrangement with Datacomp as a means to save itself from financial ruin. Datacomp explains that due to a misappropriation of funds within Omegas, Omegas owed IBM Credit Corp. (ICC) over $1.8 million. ICC declared the credit line to be in default on April 27, 1990. Omegas arranged a repayment schedule with ICC, but had to increase its volume of computer sales in order to make the payments. However, Ome
Datacomp stresses that while Omegas was initiating this deal with Datacomp, it at no time disclosed to Datacomp any of these goings-on with ICC. Datacomp describes Omegas’s relationship to it as “fiduciary,” with Datacomp relying on Omegas’s trustworthiness and on the truth of its representations. The problems arose, Datacomp argues, because of Omegas’s inability to convince IBM to lift or extend the firm ceiling on Omegas’s credit line with ICC; without such an extension, Omegas could not process the orders Datacomp had placed. Omegas claims that ICC orally promised it a credit increase to $15 million at the time repayment was arranged, and that the Omegas principals/shareholders signed personal guarantees covering the $15 million credit line.
Between August 6 and 15,1990, Datacomp sent Omegas orders for new IBM computers and down payments totalling $259,137. On August 29, Omegas sent Datacomp invoices totalling $618,759; Datacomp sent Omegas $587,763 by September 10. Shortly thereafter, Datacomp sent Omegas the balance due on the computers it had ordered; the total it paid reached $1,149,042. On September 12, Omegas’s President, Jeffery Sanford, ordered the termination of all payments to IBM for computers on order. On September 19, representatives from the two companies met in Chicago; at the meeting Omegas informed Datacomp of its “financial problems,” and that Omegas was considering the option of filing bankruptcy. At the meeting, Omegas suggested that Datacomp lend it $1.6 million, which loan would, according to Omegas, “remove the prospects of bankruptcy ... and allow [it] to fulfill its contractual agreements with Datacomp.” Datacomp describes this suggestion as being more of a demand: “Omegas was holding Datacomp’s funds and would not pay IBM unless Data-eomp loaned Omegas [the money].”
After the meeting, Datacomp’s counsel sent Omegas a letter accusing Omegas of fraud and demanding the return of the money already paid. On October 15, without Datacomp’s knowledge or consent, Omegas requested that IBM cancel all deliveries. Omegas claims that this cancellation was necessary to render IBM’s 5% cancellation fee a prepetition debt.
Omegas filed bankruptcy on October 16, 1990. Datacomp filed its complaint in this adversary proceeding in the bankruptcy eourt on October 26,1990, seeking to recover the $1.1 million it paid Omegas by arguing that Omegas’s fraud rendered all money it received pursuant to the deal subject to a constructive trust in Datacomp’s favor, and thus not part of the bankruptcy estate, citing 11 U.S.C. § 541(d).
After an expedited bench trial, the bankruptcy eourt held that Datacomp could recover $302,142 as held in a constructive trust by Omegas. In short, the bankruptcy court found that Datacomp entered into the agreement described above with Omegas, establishing a relationship which it characterized as “in a sense a joint venture,” and that, while Omegas was having some difficulty sorting out its credit line with IBM, things went more or less according to plan for a while. The court found, however, that on September 12, 1990, Jeffery Sanford, the president of Omegas, “realized he was in serious financial straits with IBM” and that Omegas would not be able to complete the deal. The court found that “on September 12, [sic] 13th and/or 14th,” Sanford terminated all further payments to IBM, but that after those dates Omegas continued to invoice Datacomp for the computers on order, and deposited a Datacomp cheek on September 17th. The court concluded that on September 12, “Sanford realized that Omegas was not going to be able to operate in its ordinary course of business with regard to its dealings with Datacomp,” and that this development gave rise to an affirmative “duty to disclose its financial problems to Datacomp.” The court therefore imposed a constructive trust on “all funds received [by Omegas] after September 12.”
Datacomp moved to amend the judgment to recover the full amount it had paid; the court denied this motion on February 13, 1991. The parties cross-appealed, the debtor seeking reversal and Datacomp continuing to argue that the entire amount paid should be included in the constructive trust and exclud
II.
On appeal from district court review, this Court reviews a bankruptcy court decision for clear error as to findings of fact, and de novo as to conclusions of lav/. Bankr.R. 8013; Martin v. Bank of Germantown (In re Martin),
III.
A.
The bankruptcy court’s disposition of Da-taeomp’s action, and the district court’s affir-mance, left no one satisfied. On appeal, Da-taeomp defends the judgment of the bankruptcy court, but argues that the court should have imposed the constructive trust on the entire amount of funds it tendered to Omegas prior to Omegas’s filing for bankruptcy. Under Kentucky law, Datacomp contends, money “wrongfully” appropriated from an innocent party does not become the property of the recipient, but is considered to be held in constructive trust for the benefit of the aggrieved party. Datacomp maintains that it did not have merely a debtor/creditor relationship with Omegas, but a joint venture arrangement that imposed fiduciary duties on Omegas, which Omegas breached. From the start, Omegas misrepresented its financial state and its ability to provide Datacomp with the computers it wanted; as its situation worsened and IBM made it crystal clear that no more computers would be forthcoming, Datacomp asserts, Omegas made no effort to inform Datacomp of the impending disaster, knowing all the while that Datacomp would continue in good faith to send its checks on time. Datacomp points out that the Bankruptcy Code provides that “[pjroperty in which the debtor holds ... 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.” 11 U.S.C. § 541(d). Datacomp argues that since by definition it has an equity interest in any funds held by Omegas in constructive trust, these funds are properly designated as remaining outside the bankrupt estate, and should therefore be returned to Datacomp rather than being incorporated into the estate and divided amongst the creditors.
Omegas, on the other hand, thinks its situation prior to bankruptcy was no different from that of the typical business threatened with insolvency. As Omegas tells the tale, its principals thought the deal with Data-comp would pull it out of financial danger. While the numbers seemed to work as the companies put the deal together, problems arose with getting IBM to process delivery of the computers Omegas ordered on behalf of Datacomp, and IBM Credit ultimately refused to permit Omegas to increase its credit fine so this could be accomplished. By the time its principals recognized that Omegas was sinking faster than they could bail, Omegas could not return Datacomp’s money or take other action to avoid immediate loss to its other creditors due to the Bankruptcy Code’s prohibition of preferential transfers immediately prior to filing for bankruptcy. Omegas denies that its principals committed fraud on Datacomp; instead, it maintains that all its people did was to try, in good faith, to salvage the deal until the last possible moment, and only then take prudent measures, as advised by counsel, to prepare for bankruptcy. To characterize this as fraud giving rise to a constructive trust, Omegas argues, does not comport with the Bankruptcy Code’s system of equitable and orderly distribution of the debtor’s assets; Omegas claims that Datacomp is not materially different from any other disappointed creditor.
B.
Nowhere in the Bankruptcy Code does it say, “property held by the debtor subject to a constructive trust is excluded from the debtor’s estate.” Title 11 U.S.C. § 541 defines the estate in bankruptcy broadly, including “all legal or equitable interests of the debtor in property as of the commencement of the case,” § 541(a)(1), and “any interest in property preserved for the benefit of or ordered transferred to the estate under [the trustee’s “strongarm” or “avoiding” powers as provided in] section 510(c) or 551 of this title,” § 541(a)(4). However, § 541(d) provides that
[property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property ... becomes property of the estate under subsection (a)(1) or (2) of this section 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.
Courts, including the bankruptcy court in this case, which have excluded property from a debtor’s estate as being subject to constructive trust, have done so on the authority of § 541(d), usually over the protestations of trustees asserting their strongarm powers.
For example, in Vineyard, v. McKenzie (In re Quality Holstein Leasing),
When QHL’s bankruptcy trustee sought to sell the plane, Borg-Warner informed the court that it had the right to recoup the value of its original lien from the sale proceeds. It argued that either McKenzie or QHL had defrauded it, and that therefore under applicable state law the new plane was subject to a constructive trust. Assets held in constructive trust, Borg-Warner argued, did not become incorporated into the debtor’s estate. The Quality Holstein Leasing court ultimately held in favor of the trustee, since Borg-Warner could properly assert no rights to the aircraft or proceeds of its sale based on QHL’s having defrauded McKenzie, a bizarre allegation
In discussing Borg-Warner’s constructive trust argument, the Quality Holstein Leasing court observed a conflict between the trustee’s strongarm powers under 11 U.S.C. § 544, and § 541(d)’s exclusion of “equitable interest[s]” in the debtor’s property from the debtor’s estate. Id. at 1012. The court noted that a constructive trust is one such “equitable interest,” and that under § 541(d) constructive trusts are generally held to be superior in interest to the trustee, strongarm powers notwithstanding. Id. at 1013 (“Congress did not mean to authorize a bankruptcy estate to benefit from property that the debt- or did not own.”). The court “found” that the bankruptcy and district courts “erred in concluding that section 544 empowers a bankruptcy trustee to retain for the benefit of the estate property that the debtor obtained by fraud and upon which state law has imposed a valid constructive trust.” Id. at 1015.
The problem with the Fifth Circuit’s analysis in Quality Holstein Leasing, and 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.
[t]he constructive trust remedy developed in equity, by analogy to the express trust arrangements in which one person holds legal title to property for the benefit of another. The same concept of separate legal and beneficial interests in property suggested a remedy for unjust enrichment: if, under principles of unjust enrichment, the defendant holds title to property that ought to belong to the plaintiff, the court will treat the defendant as a trustee, holding title for the plaintiffs benefit. At that point, however, the analogy to an express trust ends. The result of a constructive trust is a judicial decree ordering the defendant to convey the property to the plaintiff- A constructive trust is merely a means by which the court can say that the defendant must relinquish to the plaintiff property that represents an unjust enrichment.
Sherwin, supra note 3, at 301. The distribution of assets in a bankruptcy case is based on an identification of what assets and liabilities the debtor has “as of the commencement of the case,” this being the exact moment the debtor files. Shirkey v. Leake,
Thus, the essence of the argument put forth by Borg-Wamer and similarly situated claimants goes as follows: “Judge, due to debtor’s fraud (or whatever), our property rights as beneficiaries of the constructive trust arose prepetition. Therefore, we stand not in the position of unsecured creditors,
Datacomp points out, correctly, that property rights in bankruptcy are determined only by reference to the state law of the jurisdiction. Datacomp further claims that under Kentucky law, Omegas’s alleged fraud would give rise to a constructive trust imposed over all the money Omegas took unlawfully from Datacomp.
We cannot find a more succinct manner of making our point than did Judge Aspen of the Northern District of Illinois: “[A] constructive trust is fundamentally at odds with the general goals of the Bankruptcy Code.” The Oxford Organisation, Ltd. v. Peterson (In re Stotler and Co.),
The reluctance of Bankruptcy Courts to impose constructive trusts without a substantial reason to do so stems from the recognition that each unsecured creditor desires to have his particular claim elevated above the others. Imposition of a constructive trust clearly thwarts the policy of ratable distribution and should not be impressed cavalierly.
Stotler,
We do not address here property already impressed with a constructive trust by a court in a separate proceeding prepetition, in which case the claimant would be entitled to priority (although not superpriority to the trustee) as a secured creditor by virtue of the judgment. See 11 U.S.C. § 506. Nor do we address property that a state by statute has declared to be held in trust for particular purposes, such as builders trust funds creáis ed by statute in many states to remedy specific problems in the construction industry. See Selby v. Ford Motor Co.,
Datacomp claims that Omegas defrauded it. If that be the case, then the Code already provides a remedy. The Code specifically excepts from discharge “any debt ... for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by ... false pretenses, a false representation, or actual fraud,” 11 U.S.C. § 523(a)(2)(A), as well as “any debt ... for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny,” id. § 523(a)(4), and “any debt ... for willful and malicious injury by the debtor to another entity or to the property of another entity,” id. § 523(a)(6). The purpose of § 523(a)(2)(A), according to the leading treatise, is “to prevent the bankrupt from retaining the benefits of property acquired by fraudulent means.” 3 Collier on Bankruptcy ¶ 523.08[1], at 523-46 (quoting Rudstrom v. Sheridan,
So why would a creditor who thinks the debtor has defrauded him bother to base his claim on constructive trust? The answer is simple: it is harder to prevail by arguing that a debt is nondischargeable. For example, to prove an exception under § 528(a)(2)(A), the creditor must prove
that the debtor obtained money through a material misrepresentation that at the time the debtor knew was false or made with gross recklessness as to its truth. The creditor must also prove the debtor’s intent to deceive. Moreover, the creditor must prove that it reasonably relied on the false representation and that its reliance was the proximate cause of loss.
In re Phillips,
C.
The equities of bankruptcy are not the equities of the common law. Constructive trusts are anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.
Bankruptcy courts have believed themselves justified in imposing constructive trusts and ladling out portions of debtors’ estates’ assets because they are traditionally “courts of equity.” See, e.g., Quality Holstein Leasing,
[w]e necessarily act very cautiously in exercising such a relatively undefined equitable power in favor of one group of potential creditors at the expense of other creditors, for ratable distribution among all creditors is one of the strongest policies behind the bankruptcy laws.
IV.
In light of these provisions and in light of the overall purposes of the Code, § 541(d) cannot properly be invoked as an equitable panacea whenever the bankruptcy court thinks a claimant has been particularly burdened by a debtor’s bad faith or bad acts. Since the bankruptcy court here erred in doing so, the judgment of the district court affirming the bankruptcy court’s judgment is REVERSED.
Notes
. Attributed to Woody Allen in Annie Hall (United Artists Entertainment 1977), but possibly dating from the Mesozoic Era.
. While the trustee is now the actual party to this litigation, for clarity’s sake we refer to his side as Omegas or Debtor. Omegas initially filed its bankruptcy petition under Chapter 11. The case was converted to a Chapter 7 liquidation in April 1991. The decision of the bankruptcy court appealed here was rendered during the Chapter 11 proceedings.
. Ironically, Quality Holstein Leasing is considered one of the leading cases analyzing constructive trusts in bankruptcy, see, e.g., Emily L. Sherwin, Constructive Trusts in Bankruptcy, 1989 U.Ill.L.Rev. 297 (1989); Carlos J. Cuevas, Bankruptcy Code Section 544(a) and Constructive Trusts, 21 Seton Hall L.Rev. 678, 687 (1991), despite the fact that it had no reason to reach that issue on the facts of the case and on the grounds upon which its ultimate holding rested. However, its oft-cited dicta makes it the logical choice as an example of how courts in general have been looking at the issue.
. See Quality Holstein Leasing,
. Even courts that have criticized Quality Holstein Leasing seem to make the same erroneous assumption. See, e.g., Belisle v. Plunkett,
. The legislatures of a number of states have created such a right with regard to construction funds paid to contractors. See discussion infra p. 1451.
. Inasmuch as the bankruptcy court followed existing precedent in permitting Datacomp’s claim to go forward based on a constructive trust argument, it did not err in looking to Kentucky law, since the existence of parties' property rights in bankruptcy depends on state law. See, e.g., Butner v. United States,
. As mentioned in note 2, supra, Omegas's bankruptcy was converted from Chapter 11 to Chapter 7 during the pendency of this appeal. Inasmuch as the constructive trust would now be asserted against assets to be finally liquidated, we believe our arguments against the propriety of its application to be even stronger.
. Indeed, since constructive trust is a remedy employed to prevent "unjust enrichment” on the part of the defrauding party, to use the estate's funds to restore a defrauded claimant violates this principle, since it permits the defrauder to get away scot-free. Once the debtor files his petition, he cares little, if at all, who gets what from the estate. While a creditor prevailing on a claim that a debt is nondischargeable due to fraud must wait longer for satisfaction, at least the party responsible for the fraud remains liable for the debt, thus preserving the punitive aspect of a constructive trust imposed outside bankruptcy. Even viewed from the perspective that the bankruptcy courts’ highest goal is promoting equity (not a proper view, as explained infra), constructive trusts therefore have no place in bankruptcy.
. Not surprisingly, the record of this very case provides us with a perfect example of how constructive trusts burden not the offending debtor, but only competing creditors. Other creditors of Omegas’s had apparently also argued their claims under constructive trust theories; when the bankruptcy court found in favor of Data-comp, Omegas decided to settle with them. The court approved these settlements, but declared that if Datacomp were to prevail on appeal in arguing that more, or all, of the funds it tendered to Omegas were held in constructive trust, and if Omegas's bank account could not satisfy such judgment, these other creditors might be “required to disgorge a portion of the funds paid to them” in settlement. This disgorgement illustrates the weakness of the fiction that the constructive trusts existed prepetition. If all of the settled claims were constructive trusts in their own right, the funds never became property of the bankruptcy estate. Why then would-they be subject to disgorgement because of Datacomp’s constructive trust?
Concurrence Opinion
concurring in the result.
Although I concur in the result reached by the court, I would travel a different route to reach that result.
Section 544(a) of the Bankruptcy Code (11 U.S.C. § 544(a)) establishes the so-called “strong-arm” power of a trustee in bankruptcy. It
gives a bankruptcy trustee the rights and powers of a judicial lien creditor or a bona fide purchaser of real property and allows the trustee to avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by a judicial lien creditor or a bona fide purchaser of real property. This section therefore permits the trustee to bring property of the debtor into the bankruptcy estate.
In re Crabtree,
This strong-arm power, however, sometimes comes in conflict with the provisions of section 541(d) of the Bankruptcy Code (11 U.S.C. § 541(d)). Section 541(d)
*1454 excludes certain equitable interests from the bankruptcy estate; it provides that property in which the debtor holds only legal title and not an equitable interest (such as a mortgage) 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.
Id. at 37-38.
The federal courts have differed in their resolution of the apparent conflict between section 544(a) and section 541(d). Some courts
have held ... that § 541(d) prevails over the trustee’s strong-arm powers under § 544(a). Other courts have rejected this approach, holding that sections 541(d) and 544(a) operate independently; specifically, these courts have reasoned that § 541(d) does not limit the trustee’s avoidance powers under § 544(a) but instead qualifies § 541(a), which specifies the interests of the debtor in property that comprise the bankruptcy estate.
Id. at 38 (citations omitted).
The bankruptcy trustee would have us embrace the latter position, contending that Congress did not intend the extent of the strong-arm power to be narrowed by section 541(d). He argues that to deprive the bankruptcy estate of funds that state law might find subject to a constructive trust, especially one created post-petition, would be to ignore the priorities set out in the Bankruptcy Code to the detriment of the debtor’s other unsecured creditors. See In re North American Coin & Currency, Ltd.,
Datacomp, however, asserts that the trustee’s powers as a judicial lien creditor are not as substantial with regard to personal property as they would be as a hypothetical bona fide purchaser of real property. See In re Mill Concepts Corp.,
Even if, arguendo, we were to accept Da-tacomp’s characterization of the bankruptcy trustee’s powers, this would be of little help to plaintiff. Those circuits which have determined that the force of section 544(a) is overcome by a constructive trust created consistent with section 541(d) have only so held as to those trusts which came into being pre-petition. “Where state law impresses property that a debtor holds with a constructive trust in favor of another, and the trust attaches prior to the petition date, the trust beneficiary normally may recover its equitable interest in the property through bankruptcy court proceedings.” Matter of Quality Holstein Leasing,
It is well established that “[o]ne must look to state law ... to determine whether to impose a constructive trust on property within the debtor’s possession.” In re Howard’s Appliance Corp.,
After the district court affirmed the decision of the bankruptcy court, the Kentucky Court of Appeals, in Commonwealth Cabinet for Human Resources v. Security of America Life Insurance Co.,
Accordingly, the most authoritative expression of Kentucky law provides that a constructive trust only comes into being at the time of its judicial creation. Therefore, at the time of debtor’s bankruptcy filing, Data-comp did not have an equitable interest in the deposits it paid to Omegas. As this was so, the bankruptcy trustee’s section 544(a) strong-arm power could not have been compromised by the operation of a post-petition constructive trust. The trust created by the bankruptcy court in the case at bar must be dissolved and the funds contained within committed to Omegas’ bankruptcy estate.
. Datacomp contends that we need not follow Security of America because there are earlier cases which arguably reach an inconsistent result. However, I believe that under the factual circumstances presented here the most recent pronouncement of the Kentucky Court of Appeals is the one we should apply. The cases relied upon by Datacomp are distinguishable.