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DEFENSE OF PREFERENCE ACTIONS THROUGH THE CONSTRUCTIVE TRUST DOCTRINE

The District Court for the District of Nebraska recently upheld the application of a constructive trust as a means to shield payments made by a bailee-debtor from avoidance as a preferential transfer. In re Big Drive Cattle, L.L.C. v. Overcash, 2014 U.S. Dist. LEXIS 80853 (D. Neb. June 13, 2014). In In re Big Drive Cattle, a rancher shipped cattle to a commercial feedlot. The feedlot would keep the cattle for feeding and care unt il they reached the appropriate weight, at which point they were sold to third parties on the rancher's behalf. The feedlot then, without the rancher's consent, deposited the proceeds from the sale of the cattle with one of its lenders. The lender applied the deposited proceeds against the feedlot's debt. Thereafter, the feedlot paid an equivalent amount of the cattle-proceeds, minus the cost of feed, to the rancher. The feedlot filed for bankruptcy under Chapter 11 on September 9, 2011, and the trustee sought to avoid the payments made to rancher, one year preceding the bankruptcy filing, as a preferential transfer.

Title 11 U.S.C. § 547(b), which governs preferential transfers, requires that in order for a transfer to be subject to avoidance as preference, there must be a transfer of an interest of the debtor in property. The District Court held that since the feedlot was a bailee, the proceeds of the sale might have been held in a constructive trust on behalf of the rancher; if so, there was no transfer of the debtor's property for purposes of 11 U.S.C. § 547(b)(1). The court reasoned that under Nebraska's "swollen assets" doctrine, the rancher could theoretically establish a constructive trust tracing the funds to the debtor's estate, even though the proceeds of the sale had been used to pay the feedlot's debt, because the use of the trust funds to pay the trustee's personal debts relieved him from using his individual property for that purpose and consequently increased the amount it had on hand at insolvency.

The constructive trust doctrine is an often forgotten means of defending preference actions as well as establishing superior rights to estate assets. In re Unicom Computer Corp., 13 F.3d 321 (9th Cir. 1994) (accepting constructive trust theory). 11 U.S.C. § 541(a)(1) broadly defines property of a debtor's estate as including all legal or equitable interests of the debtor in property. However, it does not include any power that the debtor may exercise solely for the benefit of another, 11 U.S.C. § 541(b)(1), nor does it include property in which the debtor holds only legal title and not an equitable interest. 11 U.S.C. § 541(d). Thus, something held in trust by a debtor, for another, is neither property of the bankruptcy estate under § 541(d), nor property of the debtor for purposes of 11 U.S.C. § 547(b). When a debtor holds property in constructive trust under applicable non-bankruptcy law, the equitable interest in that property belongs to the trust beneficiary, not the debtor.

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