Nearly sixty years ago, Justice Hugo Black wrote that the Bankruptcy Act of 1898 “simply does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors.” Pearlman v. Reliance Ins. Co., 371 U.S. 132, 135-36 (1962). Though the bankruptcy statutes have been modernized and amended on a number of occasions since, Justice Black’s observation remains true today.[1]
This article summarizes the courts’ approaches to three situations in which a debtor in bankruptcy may be in possession of property that legally or equitably belongs to someone else. What do the courts do when the third party’s rights arise or are recognized only after a bankruptcy case is underway? Well, that’s not that simple.
Constructive trust. The Bankruptcy Code’s treatment of express trusts is straightforward: if the debtor holds “only legal title and not an equitable interest” in an asset, then the asset becomes property of the bankruptcy estate only to the extent of the debtor’s legal title. 11 U.S.C. § 541(d). Thus, if the debtor is a trustee of a valid express trust, the bankruptcy trustee steps into the shoes of the debtor-trustee; the bankruptcy trustee does not obtain unfettered control over the trust corpus. The same analysis applies to a statutory trust. See Begier v. I.R.S., 496 U.S. 53, 59-60 (1990).
A constructive trust is different in important respects. Probably the most important is that “a constructive trust is not really a trust.” In re Omegas Group, Inc., 16 F.3d 1443, 1449 (6th Cir. 1994). Instead, it is “a legal fiction, a common-law remedy in equity that may only exist by the grace of judicial action.” Id. Although details vary by state, a constructive trust may serve to restore ownership or control of an asset in the event of fraud, mistake, unjust enrichment, or other circumstances. And because it requires a judicial ruling, it may not be obvious that a constructive trust exists until years after the triggering event occurs.
The built-in delay in the recognition of a constructive trust can present problems in bankruptcy. But the fact that a constructive trust is “not really a trust” is not really a problem. Section 541(d) doesn’t apply only to trusts; it applies in any situation in which legal and equitable ownership are split. And the legislative history of the statute indicates that Congress contemplated that a constructive trust would be respected in bankruptcy. See H.R. Rep. No. 95-595, at 368 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6324.
Nevertheless, the Sixth Circuit had some strong words about constructive trusts in Omegas Group, calling them “anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.” Omegas Group, 16 F.3d at 1452. Other courts have been more open to constructive trusts. For example, In re Horton, 618 B.R. 22 (Bankr. D.N.M. 2020), involved a contest between the liquidating trustee of a corporate debtor and the Chapter 7 trustee of the company’s former owners, who apparently spent more than $11 million of company money to build their personal residence. The court held that if the imposition of a constructive trust over the home were appropriate under state law, it would not conflict with the Bankruptcy Code. Id. at 27. Similarly, in In re Bake-Line Group, LLC, 359 B.R. 566 (Bankr. D. Del. 2007), the court rejected the Sixth Circuit’s “anathema” characterization and treated the debtor’s deposit of funds belonging to another as creating a constructive trust.[2]
As in any bankruptcy dispute, the success of a constructive trust argument may depend on the court’s perception that someone is attempting to capture more than its fair share. If, as in Omegas Group, a creditor that chose to do business with the debtor seeks to elevate an unsecured claim to a trust, ensuring payment in full, the creditor may face headwinds. By contrast, if a debtor obtains a windfall because it obtains assets that its creditors would not reasonably have expected to be available, as in Horton and Bake-Line, the argument that the assets should be returned to their equitable owner is much less controversial.
Forfeiture. Like a constructive trust, the government’s civil forfeiture power may have the effect of depriving a debtor of ownership of an asset. But the government generally is permitted to pursue forfeiture of a debtor’s assets, even though it may work to the disadvantage of many creditors.
Forfeiture requires a judgment but is effective retroactive to the date of the underlying violation of the law. See United States v. 92 Buena Vista Ave., 507 U.S. 111, 125 (1993). If the debtor files a bankruptcy petition before the government has obtained a judgment, the asset becomes property of the bankruptcy estate, at least temporarily. See In re Chapman, 264 B.R. 565, 569 (B.A.P. 9th Cir. 2001). But the automatic stay does not bar the government from commencing or continuing a foreclosure action, which is an exercise of its “police and regulatory power” under 11 U.S.C. § 362(b)(4).[3]
Forfeiture thus may distort the bankruptcy process by removing assets that appear to belong to the estate and by allowing the government, rather than the court or the Bankruptcy Code, to determine which creditors should receive the proceeds of the sale of those assets. But “if that happens, it is because that is the appropriate result under the law.” Chapman, 264 B.R. at 572; see also In re WinPar Hospitality Chattanooga, LLC, 404 B.R. 291, 296 (Bankr. E.D. Tenn. 2009) (forfeiture is an exercise of police power “even if the government ultimately decides to use the forfeited fund to compensate all the victims of the underlying crimes in the case”).
Escheat. Each state has laws governing abandoned and unclaimed property, which may include assets such as uncashed payroll checks, credit balances in customer accounts, and securities that have not been claimed by their owners. These laws typically deem property to be abandoned after a statutory waiting period, at which point the business must turn over the property to the state. See, e.g., N.Y. Abandoned Property Law § 1315.
In a series of large Chapter 11 cases in the early 1990s, the bankruptcy courts grappled with two different scenarios: property that was deemed abandoned pre-petition but had not yet been handed over to the state, and property as to which the statutory abandonment deadline was approaching but had not yet passed at the time of the bankruptcy filing. In State of Arkansas v. Federated Dep’t Stores, Inc., 175 B.R. 924 (S.D. Ohio 1992), the bankruptcy court held that various states’ claims to property deemed abandoned pre-petition were preempted by the Bankruptcy Code. The district court reversed, stating that “the Bankruptcy Code contemplates and in some respects depends on the operation of state law, and in particular state law defining property interests.” Id. at 933. The court also rejected arguments that it would be “unfair” to allow abandoned-property claimants to recover in full through the states’ processes, pointing out that disallowing the states’ claims “would result in a windfall to the other creditors.” Id. But the district court upheld the bankruptcy court’s disallowance of states’ claims based on post-petition abandonment in a brief discussion, concluding that the states were not creditors because their claims had not arisen before the petition date. See id.
This last holding is curious, because when the abandoned-property clock is counting down at the time of a bankruptcy petition, the relevant state has at least a contingent claim—that is, a right to payment that will become fixed upon the passage of the remaining statutory period—and a contingent claim is sufficient to make the state a creditor. See 11 U.S.C. § 101(5), (10); but see In re Continental Airlines, Inc., 161 B.R. 101, 106 (Bankr. D. Del. 1993) (also adopting “not a creditor” rationale). The court in In re Drexel Burnham Lambert Group Inc., 151 B.R. 684 (Bankr. S.D.N.Y. 1993), found a different reason to disallow states’ claims arising from post-petition abandonment. The Drexel court held that the Bankruptcy Code’s distribution scheme—thou shalt file a proof of claim by the bar date or recover nothing—preempted the state’s own distribution protocol, which would act as “the equivalent of a state imposed extension of the bar date.” Id. at 692.
Whatever the rationale, barring states from taking advantage of post-petition abandonment probably is necessary as an administrative matter. A business of even moderate complexity is likely to have abandonment periods expiring frequently during its stay in bankruptcy. If the passage of the deadline as to a particular creditor caused a dischargeable claim to transform into a full recovery for a state government—or even if it merely changed a time-barred claim into a general unsecured claim held by the state—debtors would find it very difficult to prepare meaningful reorganization plans and disclosure statements, and creditors would face similar challenges in understanding their rights.
[1] For example, even when a trustee is permitted to sell an asset in which another person has an ownership interest, the Bankruptcy Code directs the trustee to distribute an appropriate portion of the sale proceeds to the other person rather than to the debtor’s creditors. 11 U.S.C. § 363(j).
[2] The judges in Horton and Bake-Line acknowledged the possibility that an unadjudicated constructive trust might be avoidable under the trustee’s Section 544(a) strong-arm power. That raises the question why the Sixth Circuit expressed such antipathy toward constructive trusts in Omegas Group when the strong-arm power presented a simpler solution to the issue. As a concurring judge pointed out, a lien creditor in Kentucky has priority if its lien attaches before a court decrees a constructive trust. See 16 F.3d at 1455 (Guy, J., concurring in judgment).
[3] Section 362(b)(4) permits the government to enforce “a judgment other than a money judgment.” Because forfeiture is an in rem proceeding, this restriction does not require the government to return to the bankruptcy court before taking ownership of a forfeited asset.
[View source.]
