When a creditor seeks equitable relief in a bankruptcy court, must the court always follow common law principles of equity? Not according to several courts, including the Second Circuit. Concluding that the granting of equitable remedies may circumvent the Bankruptcy Code's equitable distribution system, courts have limited the application of equitable remedies in the bankruptcy context.
In a recently decided case1, the Second Circuit dismissed the claim of a group of investors in a bankrupt debtor for the imposition of a constructive trust on the debtor's reinsurance policy proceeds, which proceeds allegedly covered the investors' losses. Emphasizing the instruction that a bankruptcy court should "act very cautiously" when applying certain equitable remedies in the context of a bankruptcy case, both the bankruptcy court and, on appeal, the district court found that the investors could not satisfy one of the required elements for imposition of a constructive trust, unjust enrichment. The investors appealed, challenging the district court's dismissal of the constructive trust claim on the grounds that the United States Supreme Court, in Travelers Casualty & Surety Company of America v. Pacific Gas & Electric Company2, had reaffirmed that state law, not bankruptcy law, should determine property interests. The investors argued that, by evaluating the requirements for imposition of a constructive trust differently in the bankruptcy context, the bankruptcy court and district court had failed to adhere to the basic rule reiterated in Travelers. The Second Circuit, however, did not agree.
The Second Circuit reasoned that, although constructive trusts are imposed pursuant to equitable principles arising under state law, the equities of bankruptcy are not those of the common law. The equities of bankruptcy may affect the grant of equitable relief otherwise available under state law. For example, in the case at bar, although the bankruptcy trustee allegedly was enriched at the expense of the investors' alleged right to the reinsurance policy proceeds, under principles of bankruptcy the trustee was not unjustly enriched. On the contrary, the trustee received the proceeds from the reinsurance policy for equitable distribution to the debtor's creditors and investors pursuant to the Bankruptcy Code. As the trustee was not unjustly enriched, the investors could not establish their common law claim for imposition of a constructive trust in their favor.
To understand the Second Circuit's rationale, one must understand the purpose of constructive trusts and the purpose of bankruptcy. In a non-bankruptcy case, the imposition of a constructive trust prevents a party who fails to meet an obligation or commits fraud from becoming unjustly enriched at the expense of another party. The imposition of a constructive trust therefore seeks to correct inequity between only two parties. The Bankruptcy Code, on the other hand, seeks to maximize equity among multiple constituencies. These different purposes can affect the determination whether a claimant can establish the unjust enrichment required to obtain a constructive trust. When a trustee receives property of the estate, the trustee is deemed not unjustly enriched, even if the trustee receives the property at the expense of a single creditor or group of creditors, because the trustee will distribute the property to the debtor's creditors or other parties in interest in accordance with the provisions of the Bankruptcy Code.
The Second Circuit's opinion confirms that courts are reluctant to impose constructive trusts in bankruptcy cases, even when the remedy would be available in a similar non-bankruptcy situation. The courts have found that the imposition of common law equitable remedies in bankruptcy proceedings can conflict with the Bankruptcy Code's priority scheme for the distribution of estate assets. Thus, notwithstanding the Supreme Court's deference to state law espoused in Travelers3, that case has not changed the courts' hostility to imposition of common law equitable remedies in bankruptcy.