A debtor sold cattle for the account of a cattle producer and then remitted the proceeds to the producer. A chapter 7 trustee sought to recover the payments as preferential transfers. The trustee lost in both the bankruptcy and district courts, and then appealed to the 7th Circuit.
The debtor was in the business of buying and selling livestock for slaughter and processing. It had an arrangement with a particular cattle producer (J&R) to sell some of J&R’s cattle to a specific buyer (Swift). Shortly before the debtor’s bankruptcy, it remitted ~$900,000 to J&R for completed sales.
The debtor only had possession of the J&R cattle, and was not a purchaser or owner. However, it used the J&R cattle to satisfy part of its obligation to sell cattle to Swift, and did not inform Swift of this fact due to poor relations between Swift and J&R. Swift made checks out to the debtor, which deposited them into its general account and then sent its own check to J&R for the proceeds attributable to J&R’s cattle.
Resolution of the trustee’s preference claim turned on whether the funds were part of the bankruptcy estate. J&R argued that the sale proceeds were held by the debtor in trust and never became part of the estate. The trustee countered that the bankruptcy estate did have an interest since the funds were comingled in the debtor’s general account.
The bankruptcy court granted summary judgment in favor of J&R on the basis that the debtor held property only as a bailee and did not have any equitable or legal interest in the funds. The district court affirmed. On appeal, the 7th Circuit determined that additional analysis was required. In particular, imposition of a constructive trust was not automatic, and it was necessary to trace the payments to the sale of J&R’s cattle.
As a threshold question, the court reviewed whether there was a bailment as determined by state law. Under state law “bailment is ‘the delivery of goods for some purpose, upon a contract, express or implied, that after the purpose has been fulfilled [the goods] shall be redelivered to the bailor, or otherwise dealt with according to his directions, or kept until he reclaims them.’” The essential characteristics include intent to create a bailment, delivery of possession and acceptance of the items by the bailee.
The court distinguished bailment from conditional sales: the key issue was whether (1) the bailor had a right to compel a return of the bailed items or (2) the transferee had an option to keep the goods by paying for them. In this case, the debtor was in effect an undisclosed agent for J&R. The debtor did not have any ownership interest and did not have an option to purchase. Rather, it had possession of J&R’s cattle solely for purposes of selling them to Swift.
If J&R had requested return of the cattle, that would have been the end of the matter. However the issues were complicated by the fact that the debtor remitted cash, which is fungible. So J&R had to create a link between its cattle and the funds it received.
The initial question was whether the funds were subject to a constructive trust. Under state law a constructive trust was an equitable remedy for circumstances where a person obtains money that (1) it is not entitled to and (2) it should not be allowed to retain in order to avoid unjust enrichment. The court noted that this is a legal fiction and constitutes a trust imposed by law, rather than one created by a voluntary act.
The court commented that a “transferee in possession does not own the property any more than a parking garage owns a customer’s car, or a pickpocket owns the wallet he swiped from a purse. Nor does the transferee become the rightful owner of such property by filing a bankruptcy petition.” The assets subject to a constructive trust are protected from the creditors of the debtor since the Bankruptcy Code “simply does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors.”
The 7th Circuit acknowledged that some courts have rejected this view. In particular the 6th Circuit views constructive trust as “fundamentally at odds with the general goals of the Bankruptcy Code” and an “anathema to the equities of bankruptcy.”
Rejecting the 6th Circuit’s approach, the court noted that the question is not whether the debtor has an ownership interest (since it does not), but rather whether the law should presume that the debtor was holding property for the benefit of another – in which case the owner would have a claim for restitution which could result in return of the property unless there is a good defense.
The court went on to explain that the bankruptcy estate might have defenses not available to the debtor itself. For example, the failure to notify third parties about J&R’s ownership of the cattle would not affect J&R’s claims against the debtor itself, but might have a bearing in determining the priority of its claims against the claims of the debtor’s other creditors. Similarly, there might be an argument that J&R had unclean hands. Consequently, the bankruptcy court needed to take a closer look at J&R’s claim to the payment and whether there might be state law defenses that could be asserted on behalf of the bankruptcy estate.
In addition, J&R was required to trace the funds it received to its cattle. When funds are comingled in an account, a special rule is applied to tracing the funds – i.e., the “lowest-intermediate-balance rule.” Basically a debtor is assumed to withdraw its own funds first. If the account balance dips below the balance of the trust funds, the trust claim is reduced and is not revived if additional funds are later deposited in the account (since the trust claimant does not have any priority over other creditors with respect to the additional deposits). Since the record did not address the tracing issue, the 7th Circuit left it to the bankruptcy court to determine whether J&R could trace the payments to its cattle.
Establishing that there was a bailment can certainly put a creditor in a stronger position. However, in addition to the question of whether a constructive trust can be established and whether it will be recognized in the applicable court, there is also the question of whether the relationship is more properly characterized as a consignment subject to the Uniform Commercial Code. In that case the UCC itself makes the consigned goods potentially subject to claims of the debtor/consignee’s creditors notwithstanding the claims of the consignor.