Other People’s Property In Bankruptcy – Insolvency/Bankruptcy/Re-structuring

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Almost sixty years ago, Judge Hugo Black wrote that the Bankruptcy Act of 1898 “simply does not authorize a trustee to distribute the property of others among the creditors of a bankrupt”. Pearlman v. Reliance Ins. Co., 371 US 132, 135-36 (1962). Although bankruptcy laws have been modernized and changed several times since, Justice Black’s observation remains true today.1

This article summarizes the courts’ approaches to three situations in which a bankrupt debtor may be in possession of property that legally or equitably belongs to someone else. What do the courts do when the rights of a third party arise or are not recognized until after the opening of bankruptcy proceedings? Well, it’s not that simple.

  1. Constructive trust. The treatment of express trusts by the Bankruptcy Code is straightforward: if the debtor holds “only legal title and not an equitable interest” in an asset, then the asset becomes the property of the bankruptcy estate only to the extent of the title. legal obligation of the debtor. 11 USC § 541 (d). Thus, if the debtor is the trustee of a valid express trust, the trustee in bankruptcy takes the place of the trustee-debtor; the trustee in bankruptcy does not obtain unlimited control over the fiduciary body. The same analysis applies to a legal trust. See Begier v. IRS, 496 United States 53, 59-60 (1990).

A constructive trust is different in many ways. Perhaps most importantly, “a constructive trust is not really a trust.” In the Omegas, Inc., 16 F.3d 1443, 1449 (6th Cir. 1994). Instead, it is “a legal fiction, a common law remedy in equity that can only exist through the grace of legal action.” Identifier.Although the details vary by state, a constructive trust can be used to restore ownership or control of an asset in the event of fraud, error, unjust enrichment, or other circumstances. And because it requires a court ruling, it may not be clear that a constructive trust exists for years after the triggering event occurs.

The delay inherent in recognizing 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) does not apply only to trusts; it applies in any situation in which legal and equitable property is shared. And the legislative history of the law indicates that Congress considered that a constructive trust would be respected in the event of bankruptcy. SeeHR Rep. No. 95-595, at 368 (1977), reprinted in 1978 USCCAN 5963, 6324.

Nevertheless, the Sixth Circuit had strong words on constructive trusts in Omega Group, qualifying them as “anathema to the equity capital of bankruptcy since they levy on the estate, and therefore directly on the competing creditors, and not on the defaulting debtor”.
Omega Group, 16 F.3d at 1452. Other courts have been more open to constructive trusts. For example, About Horton, 618 BR 22 (Bankr. DNM 2020), involved a competition between the liquidating trustee of a debtor company and the Chapter 7 trustee of the former owners of the company, who apparently spent more than $ 11 million in money of the company to build their personal residence. The court ruled that if the imposition of a constructive trust on the house was appropriate under state law, it would not conflict with the Bankruptcy Code. Identifier. to 27. Similarly, in In the Bake-Line, LLC group, 359 BR 566 (Bankr. D. Del. 2007), the court rejected the characterization of the Sixth Circuit as an “anathema” and treated the debtor’s deposit of funds belonging to another as creating a constructive trust.2

As in any bankruptcy litigation, the success of a constructive trust argument may depend on the court’s perception that someone is trying to recover more than their fair share. If, as in Omega Group, a creditor who has chosen to do business with the debtor seeks to raise an unsecured debt to a trust, ensuring full payment, the creditor may face headwinds. On the other hand, if a debtor obtains a windfall because he obtains assets that his creditors could not reasonably have expected to be available, as in Horton and
Cooking line, the argument that assets should be returned to their fair owner is much less controversial.

  1. Confiscation. Like a constructive trust, the government’s civil forfeiture power can have the effect of depriving a debtor of ownership of property. But the government is generally allowed to continue with the confiscation of a debtor’s assets, even though doing so can harm many creditors.

Confiscation requires judgment but is effective retroactively to the date of the underlying violation of the law. See United States v. 92 Buena Vista Ave., 507 US 111, 125 (1993). If the debtor files for bankruptcy before the government has obtained a judgment, the asset becomes the property of the bankruptcy estate, at least temporarily. See In re Chapman, 264 BR 565, 569 (BAP 9th Cir. 2001). But the automatic stay does not prevent the government from starting or continuing a foreclosure action, which is an exercise of its “policing and regulatory power” under 11 USC § 362 (b) (4).3

Forfeiture can therefore distort the bankruptcy process by removing assets that appear to belong to the estate and allowing the government, rather than the court or the Bankruptcy Code, to determine which creditors should receive the proceeds from the sale of those assets. But “if this happens, it is because it is the appropriate result under the law.”
Chapman, BR 264 to 572; see also In re Win By Hospitality Chattanooga, LLC, 404 BR 291, 296 (Bankr. ED Tenn. 2009) (confiscation is an exercise of police power “even if the government ultimately decides to use the confiscated fund to compensate all victims of the underlying crimes in the case”).

  1. Escape. Every state has laws governing abandoned and unclaimed property, which can include assets such as uncashed paychecks, credit balances in accounts receivable, and securities that have not been claimed by their owners. These laws generally consider the property to be abandoned after a statutory waiting period, at which point the company must return the property to the state. See, for example, NY Abandoned Properties Act § 1315.

In a series of important Chapter 11 cases in the early 1990s, bankruptcy courts faced two different scenarios: assets that were considered abandoned before the petition but had not yet been turned over to the state , and goods for which the legal abandonment period was approaching but had not yet passed at the time of filing for bankruptcy. In State of Arkansas v Federated Dep’t Stores, Inc., 175 BR 924 (SD Ohio 1992), the bankruptcy court ruled that various state claims on property deemed abandoned before the petition were preempted by the Bankruptcy Code. The district court backed down, stating that “the Bankruptcy Code contemplates and in some ways depends on the application of state law, and in particular state law defining property interests.”
Identifier. at 933. The tribunal also rejected arguments that it would be “unfair” to allow claimants for abandoned property to recover in full through state processes, noting that dismissing state claims “would result in a windfall for others. creditors. ” Identifier. But the district court upheld the bankruptcy court’s dismissal of the states’ claims on the basis of a post-petition waiver in a brief discussion, concluding that the states were not creditors because their claims were not. not occurred before the date of the request. See id.

This last detention is curious, because when the clock of the abandoned property counts down at the time of an application for bankruptcy, the State concerned has at least one contingent claim, that is to say a right to payment which will become fixed when the remaining legal term passes – and a conditional claim is enough to make the State a creditor.
See 11 USC § 101 (5), (10); but see In re Continental Airlines, Inc., 161 BR 101, 106 (Bankr. D. Del. 1993) (also adopting the “not a creditor” reasoning). The court in In re Drexel Burnham Lambert Group Inc., 151 BR 684 (Bankr. SDNY 1993), found a different reason for rejecting state claims arising from post-petition abandonment. the
Drexel The court ruled that the Bankruptcy Code’s distribution system – you must file proof of claim before the statute of limitations or collect nothing – pre-empted the state’s own distribution protocol, which would act as “the equivalent of ‘a state-imposed extension of the prescription date. ” Identifier. at 692.

Whatever the rationale, preventing States from benefiting from post-petition abandonment is probably necessary as an administrative matter. Even a business of even moderate complexity is likely to have periods of abandonment that expire frequently during its time in bankruptcy. If exceeding the time limit for a particular creditor turned a dischargeable debt into full collection for a state government – or even if it simply changed a prescribed debt into an unsecured general debt held by the state – debtors would find it. It is very difficult to prepare reorganization plans and meaningful disclosure statements, and creditors would face similar challenges in understanding their rights.


1 For example, even where a trustee is authorized to
to sell property in which another person has an interest, the Bankruptcy Code directs the trustee to distribute an appropriate portion of the proceeds of the sale to the other person rather than to the debtor’s creditors. 11 USC § 363 (j).

2 The judges of Horton and Cooking linerecognized the possibility that an unauthorized constructive trust could be avoided under the trustee’s compulsory power under section 544 (a). This raises the question of why the Sixth Circuit expressed such antipathy towards constructive trusts in Omega Group when the strong power presented a simpler solution to the problem. As one concurring judge noted, a preferred creditor in Kentucky has priority if their lien is attached before a court enacts a constructive trust. See 16 F.3d to 1455 (Guy, J., contributing to the judgment).

3 Section 362 (b) (4) allows the government to enforce “a judgment other than a monetary judgment”. Because confiscation is a in rem procedure, this restriction does not require the government to return to bankruptcy court before taking possession of confiscated property.

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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