Robert Marcus, the liquidating trustee of the Las Uvas Valley Dairies sued Dean L. Horton and Frances H. Horton in the U.S. Bankruptcy Court of New Mexico. Mr. Marcus sought declaration that the main assets in the bankruptcy estate at issue were held in constructive trust for the estate he represents. Dean and Frances Horton applied for motion for judgment on the pleadings requesting the proceedings be dismissed for failure to state a claim. Mr. Marcus asserted he had a valid claim for recognition of a constructive trust.
The Hortons were the sole owners of Las Uvas Valley Dairies, a New Mexico general partnership (LUVD). The partnership filed a chapter 11 case in September 2017. The court confirmed a plan of liquidation in June 2018 with Marcus Coll as the liquidating trustee under the plan. The Hortons built a house paid for by LUVD. After they “lived a lavish lifestyle” supported by contributions from LUVD, the partnership’s total debt accounted for over $21 million.
The Hortons argued Mr. Marcus’ complaint did not state a viable claim because of the following: he did not allege unfair retention of the House; constructive trusts are disfavored in bankruptcy; no constructive trust was imposed prepetition; and Mr. Coll’s “strong arm” power under 11 U.S.C. § 544(a)(3) can avoid constructive trusts.
Constructive trusts are used “to prevent the unjust enrichment that would result if the person having the property were permitted to retain it.” They arise where a person who holds title to property is subject to an equitable duty to convey it to another. This is due to the property holder being unjustly enriched if permitted to retain it.
Courts first begin with state law to determine whether a party meets the burden of establishing constructive trust requirements. The State of New Mexico recognizes the use of constructive trusts. There is no test in New Mexico to determine whether a constructive trust should be recognized. Case law indicates constructive trust claimants must show wrongdoing. Gushwa v. Hunt, 2008-NMSC-064, 145 N.M. 286, 197 P.3d 1. Examples include fraud, duress, undue influence, breach of fiduciary duty, or abuse of confidence. Entitlement to a constructive trust must be proven by clear and convincing evidence.
Constructive Trust in Bankruptcy
The Hortons questioned the viability of constructive trust claims in bankruptcy. The court noted the view held by Justice Black in Pearlman v. Reliance Ins. Co., 371 U.S. 132, 135, 83 S. Ct. 232, 234, 9 L. Ed. 2d 190 (1962) where he stated the Bankruptcy Act does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors. It found that if a constructive trust is recognized in appropriate circumstances, the trust is then “other people’s property” and should not be used to pay the debtor’s creditors. The bankruptcy court concluded that if “equity and good conscience” dictate the recognition of a constructive trust, doing so would not conflict with the Bankruptcy Code. The court noted the Code does not authorize the trustee to distribute another person’s property. The bankruptcy court found the Hortons’ claim inappropriate and dismissed it.
The Hortons argued for a constructive trust to be effective in a bankruptcy case, it must be recognized by pre-petition. They stated post-petition recognition is ineffective. The bankruptcy court held this argument “must be overruled.” It noted a constructive trust arises on the date of the wrongful transfer, not the date it is recognized by the court.
“Strong arm” Power
The Hortons sought dismissal of the proceeding on the basis the “strong arm” power gave to Mr. Coll under 11 U.S.C. § 544(a)(3). The court indicated the statute allowed Mr. Coll to avoid constructive trusts encumbering estate property. It noted Mr. Coll did not seek to avoid Mr. Marcus’ claim for equitable ownership of the house. It found until he does, it would be premature to rule on his right to do so. The bankruptcy court concluded it was not clear whether the strong-arm power could avoid constructive trusts. It stated that at the time of the bankruptcy filing, the trustee in bankruptcy assumes the position of a bona fide purchaser of real property from the debtor. After doing so, the purchaser would be able to avoid liens on the property.
In June 2020, the U.S. Bankruptcy Court denied the Hortons’ motion. It concluded the ability of Coll asserting his 11 U.S.C. § 544(a)(3) strong arm power to avoid the alleged constructive trust is not a sufficient reason for dismissing Marcus’ claim.
The COVID-19 pandemic has placed a strain on the economy affecting people’s wellbeing. The attorneys at Whitcomb Selinsky PC have the experience that can help you manage the complicated world of bankruptcy and protect your assets. If the pandemic has also affected your financial outlook and you are considering bankruptcy, contact us, we can help.