August 12, 2022


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Other People’s Property in Individual bankruptcy | Bryan Cave Leighton Paisner

Virtually sixty yrs ago, Justice Hugo Black wrote that the Individual bankruptcy Act of 1898 “simply does not authorize a trustee to distribute other people’s property among the a bankrupt’s creditors.”  Pearlman v. Reliance Ins. Co., 371 U.S. 132, 135-36 (1962).  Although the individual bankruptcy statutes have been modernized and amended on a quantity of situations due to the fact, Justice Black’s observation continues to be legitimate today.[1]

This posting summarizes the courts’ ways to 3 conditions in which a debtor in bankruptcy may possibly be in possession of property that lawfully or equitably belongs to another person else.  What do the courts do when the 3rd party’s rights arise or are recognized only just after a bankruptcy case is underway?  Perfectly, that is not that basic.

Constructive rely on.  The Individual bankruptcy Code’s therapy of express trusts is uncomplicated:  if the debtor retains “only lawful title and not an equitable interest” in an asset, then the asset results in being home of the bankruptcy estate only to the extent of the debtor’s authorized title.  11 U.S.C. § 541(d).  Therefore, if the debtor is a trustee of a legitimate specific have faith in, the bankruptcy trustee methods into the footwear of the debtor-trustee the personal bankruptcy trustee does not get unfettered management over the belief corpus.  The very same examination applies to a statutory belief.  See Begier v. I.R.S., 496 U.S. 53, 59-60 (1990).

            A constructive have faith in is diverse in essential respects.  Possibly the most vital is that “a constructive belief is not actually a belief.”  In re Omegas Group, Inc., 16 F.3d 1443, 1449 (6th Cir. 1994).  Alternatively, it is “a legal fiction, a typical-law cure in fairness that might only exist by the grace of judicial action.”  Id.  While particulars vary by state, a constructive have confidence in may provide to restore possession or command of an asset in the occasion of fraud, mistake, unjust enrichment, or other conditions.  And due to the fact it needs a judicial ruling, it could not be apparent that a constructive rely on exists till a long time after the triggering party occurs.

            The designed-in hold off in the recognition of a constructive rely on can existing challenges in individual bankruptcy.  But the fact that a constructive believe in is “not genuinely a trust” is not definitely a problem.  Portion 541(d) doesn’t implement only to trusts it applies in any problem in which legal and equitable ownership are split.  And the legislative heritage of the statute implies that Congress contemplated that a constructive trust would be respected in personal bankruptcy.  See H.R. Rep. No. 95-595, at 368 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6324.

            Nonetheless, the Sixth Circuit experienced some sturdy text about constructive trusts in Omegas Group, contacting them “anathema to the equities of individual bankruptcy due to the fact they acquire from the estate, and consequently immediately from competing creditors, not from the offending debtor.”  Omegas Group, 16 F.3d at 1452.  Other courts have been a lot more open to constructive trusts.  For example, In re Horton, 618 B.R. 22 (Bankr. D.N.M. 2020), concerned a contest among the liquidating trustee of a company debtor and the Chapter 7 trustee of the company’s previous house owners, who seemingly used additional than $11 million of enterprise cash to develop their personalized residence.  The court docket held that if the imposition of a constructive trust about the residence have been proper beneath condition regulation, it would not conflict with the Individual bankruptcy Code.  Id. at 27.  Similarly, in In re Bake-Line Team, LLC, 359 B.R. 566 (Bankr. D. Del. 2007), the court turned down the Sixth Circuit’s “anathema” characterization and handled the debtor’s deposit of funds belonging to a different as making a constructive believe in.[2]

            As in any individual bankruptcy dispute, the results of a constructive rely on argument may well depend on the court’s perception that somebody is making an attempt to capture additional than its honest share.  If, as in Omegas Group, a creditor that selected to do small business with the debtor seeks to elevate an unsecured claim to a have confidence in, making certain payment in whole, the creditor could experience headwinds.  By distinction, if a debtor obtains a windfall because it obtains assets that its lenders would not reasonably have expected to be offered, as in Horton and Bake-Line, the argument that the property really should be returned to their equitable owner is substantially less controversial.

Forfeiture.  Like a constructive have faith in, the government’s civil forfeiture electricity may perhaps have the impact of depriving a debtor of ownership of an asset.  But the authorities normally is permitted to go after forfeiture of a debtor’s property, even while it could perform to the drawback of a lot of lenders.

            Forfeiture demands a judgment but is helpful retroactive to the day of the underlying violation of the legislation.  See United States v. 92 Buena Vista Ave., 507 U.S. 111, 125 (1993).  If the debtor files a individual bankruptcy petition ahead of the authorities has acquired a judgment, the asset turns into residence of the bankruptcy estate, at minimum temporarily.  See In re Chapman, 264 B.R. 565, 569 (B.A.P. 9th Cir. 2001).  But the computerized keep does not bar the governing administration from commencing or continuing a foreclosures action, which is an exercising of its “police and regulatory power” under 11 U.S.C. § 362(b)(4).[3]

            Forfeiture so may well distort the individual bankruptcy approach by eliminating belongings that appear to belong to the estate and by making it possible for the authorities, fairly than the courtroom or the Individual bankruptcy Code, to determine which collectors ought to get the proceeds of the sale of individuals belongings.  But “if that occurs, it is since that is the suitable result underneath 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 law enforcement electrical power “even if the government ultimately decides to use the forfeited fund to compensate all the victims of the fundamental crimes in the case”).

Escheat.  Each and every condition has guidelines governing abandoned and unclaimed property, which may involve assets this sort of as uncashed payroll checks, credit history balances in customer accounts, and securities that have not been claimed by their entrepreneurs.  These guidelines commonly deem assets to be abandoned right after a statutory waiting period of time, at which stage the small business ought to switch in excess of the residence to the point out.  See, e.g., N.Y. Deserted House Regulation § 1315.

            In a collection of massive Chapter 11 instances in the early 1990s, the bankruptcy courts grappled with two distinctive situations:  residence that was deemed abandoned pre-petition but had not however been handed in excess of to the point out, and house as to which the statutory abandonment deadline was approaching but had not still passed at the time of the individual bankruptcy submitting.  In Condition of Arkansas v. Federated Dep’t Retailers, Inc., 175 B.R. 924 (S.D. Ohio 1992), the personal bankruptcy court docket held that different states’ promises to assets deemed abandoned pre-petition have been preempted by the Bankruptcy Code.  The district courtroom reversed, stating that “the Individual bankruptcy Code contemplates and in some respects relies upon on the procedure of state regulation, and in certain point out legislation defining residence interests.”  Id. at 933.  The court docket also rejected arguments that it would be “unfair” to permit deserted-home claimants to get well in whole via the states’ processes, pointing out that disallowing the states’ statements “would end result in a windfall to the other lenders.”  Id.  But the district court upheld the individual bankruptcy court’s disallowance of states’ claims centered on put up-petition abandonment in a brief dialogue, concluding that the states have been not lenders mainly because their statements experienced not arisen prior to the petition day.  See id.

            This last keeping is curious, due to the fact when the deserted-house clock is counting down at the time of a bankruptcy petition, the pertinent state has at minimum a contingent claim—that is, a appropriate to payment that will grow to be mounted upon the passage of the remaining statutory period—and a contingent declare is sufficient to make the condition a creditor.  See 11 U.S.C. § 101(5), (10) but see In re Continental Airways, Inc., 161 B.R. 101, 106 (Bankr. D. Del. 1993) (also adopting “not a creditor” rationale).  The court docket in In re Drexel Burnham Lambert Group Inc., 151 B.R. 684 (Bankr. S.D.N.Y. 1993), uncovered a unique motive to disallow states’ promises arising from submit-petition abandonment.  The Drexel court held that the Individual bankruptcy Code’s distribution scheme—thou shalt file a evidence of claim by the bar date or recover nothing—preempted the state’s own distribution protocol, which would act as “the equivalent of a point out imposed extension of the bar date.”  Id. at 692.

            Whatever the rationale, barring states from using benefit of post-petition abandonment in all probability is vital as an administrative make any difference.  A business of even moderate complexity is probable to have abandonment durations expiring often during its stay in personal bankruptcy.  If the passage of the deadline as to a distinct creditor induced a dischargeable assert to change into a comprehensive restoration for a point out government—or even if it just modified a time-barred claim into a typical unsecured assert held by the state—debtors would discover it quite complicated to prepare significant reorganization programs and disclosure statements, and collectors would experience very similar challenges in being familiar with their rights.

[1] For example, even when a trustee is permitted to market an asset in which another individual has an possession curiosity, the Bankruptcy Code directs the trustee to distribute an proper part of the sale proceeds to the other human being fairly than to the debtor’s lenders.  11 U.S.C. § 363(j).

[2] The judges in Horton and Bake-Line acknowledged the possibility that an unadjudicated constructive have faith in may be avoidable underneath the trustee’s Part 544(a) potent-arm electrical power.  That raises the query why the Sixth Circuit expressed these types of antipathy toward constructive trusts in Omegas Group when the potent-arm electrical power presented a more simple resolution to the concern.  As a concurring decide pointed out, a lien creditor in Kentucky has precedence if its lien attaches right before a courtroom decrees a constructive have confidence in.  See 16 F.3d at 1455 (Male, J., concurring in judgment).

[3] Part 362(b)(4) permits the authorities to implement “a judgment other than a cash judgment.”  For the reason that forfeiture is an in rem continuing, this restriction does not call for the govt to return to the individual bankruptcy courtroom just before having possession of a forfeited asset.

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