In re Leitner, Bankruptcy No. 93-20723-7. Adversary No. 95-6004.
| Decision Date | 11 March 1999 |
| Docket Number | Bankruptcy No. 93-20723-7. Adversary No. 95-6004. |
| Parties | In re Gary D. LEITNER, Debtor. Carl R. Clark, Trustee, Plaintiff, v. Leo G. Wetherill and L.G.W. Energy Resources, Inc., Defendants. |
| Court | United States Bankruptcy Courts. Tenth Circuit. U.S. Bankruptcy Court — District of Kansas |
Lentz & Clark, P.A., Overland Park, Kansas, for Carl R. Clark.
William S. Robbins, Jr., Kurlbaum, Stoll, Seaman, Reefer, Suter & Mustoe, P.C., Kansas City, Missouri, for Leo G. Wetherill and L.G.W. Energy Resources, Inc.
Eric C. Rajala, Overland Park, Kansas, for Debtor Gary D. Leitner.
This case is about constructive trusts in bankruptcy. In 1986, Leo G. Wetherill hired Gary D. Leitner to perform legal and accounting services for L.G.W. Energy Resources, Inc., Wetherill's closely held company. Between 1986 and 1992, Leitner embezzled a large sum of money from L.G.W. Energy Resources, Inc.2 Leitner put some of the purloined funds into a new home for himself and his wife. When Wetherill discovered the fraud in 1992, he (and his company) sued the Leitners, alleging Leitner's fraud created a constructive trust. To guard against Leitner conveying away the home, Wetherill also obtained a prejudgment attachment against it. Leitner filed Chapter 7 bankruptcy and the trustee, Carl Clark, brought this adversary proceeding contesting the existence of a constructive trust and seeking to avoid the attachment as a transfer subject to his avoiding powers. Mr. Clark now seeks summary judgment on the undisputed facts. The Court denies Mr. Clark's motion for summary judgment because Wetherill and L.G.W. are the beneficiaries of a constructive trust on the home, which prevents the home from becoming property of the estate.3
Wetherill sued Leitner in the District Court of Johnson County, Kansas, on November 20, 1992. His original petition sought monetary and injunctive relief. But on February 26, 1993, he amended the petition. The amended petition sought a constructive trust on a home at 15623 Acuff Lane in Olathe, Johnson County, Kansas, that Leitner had allegedly purchased with the embezzled funds. Wetherill also asked for a prejudgment attachment of the home, which he received by order dated March 5, 1993. He recorded the attachment order with the Register of Deeds of Johnson County, Kansas, on March 8, 1993.
Although at first Leitner resisted Wetherill's suit, he later admitted his fraud in his answer and filed an affidavit confessing his wrongdoing. Hoping for entry of a prompt judgment, Wetherill's counsel prepared a journal entry and delivered it to the state court judge, the Honorable Lawrence E. Sheppard. Before Judge Sheppard could sign the journal entry, however, Leitner filed this Chapter 7 bankruptcy case on April 15, 1993.
Carl R. Clark was appointed interim trustee, and Wetherill (and his company) moved for relief from the automatic stay to permit entry of judgment in state court. Carl Clark objected, but on October 28, 1993, the Court ordered the automatic stay lifted to allow Wetherill and L.G.W. to proceed in state court:
As the order reflects, not only did the Court lift the stay, it also abstained from considering the constructive trust issue pending before the state court.
Mr. Clark did not appeal the Court's order, nor did he defend Wetherill's state court action against Leitner. Rather, he agreed with Wetherill and other interested parties to sell the residence, pay off the mortgages against it, and hold the remaining sale proceeds pending further litigation. The residence ultimately sold for $410,000. From the sale proceeds, Clark disbursed $272,627.42 to Farm & Home Savings to discharge its first mortgage and $75,000.00 to Mark Twain Kansas Bank to discharge its second mortgage. Clark is currently holding the balance of the proceeds of $67,285.44 plus accrued interest.
On April 16, 1996, before this Court could address Mr. Clark's summary judgment motion, Judge Sheppard, freed from the automatic stay, signed the journal entry confessing judgment that Wetherill's counsel had previously submitted.5 The journal entry of judgment declared that Leitner held the residence in constructive trust for Leo G. Wetherill and L.G.W. Energy Resources, Inc.
Mr. Clark has stipulated in the pretrial order that Leitner purchased the home at 15623 Acuff Lane, Olathe, Kansas, with money stolen from L.G.W. Energy Resources, Inc.
One solution to this problem is that the constructive trust issue has been decided. Relying on the state court's issuance of a prejudgment attachment of the home, this Court abstained from considering the constructive trust question and lifted the automatic stay.
Although the state court did not enter final judgment until after the bankruptcy case was filed, it did grant a prejudgment attachment against the home. The prejudgment attachment was sufficient judicial action to recognize Wetherill's equitable interest in the home, which Leitner held in constructive trust. Presumably, since prejudgment attachments are not granted lightly, the court based the attachment on Leitner's affidavit confessing his wrongdoing and on the admissions in his answer. This prebankruptcy activity was sufficient to establish the constructive trust. The state court, freed from the stay, has decided the trust question in Wetherill's favor postbankruptcy.
Another solution considers whether a bankruptcy court should ever impose a constructive trust based on state law when a state court has not done so before a debtor has filed a bankruptcy. In 1994, the Sixth Circuit answered this question negatively in XL/Datacomp, Inc. v. Wilson (In re Omegas Group, Inc.).6 The Court observed: "A constructive trust is fundamentally at odds with the general goals of the Bankruptcy Code."7 The decision held that a constructive trust is an equitable remedy that is effective only from the entry of a final judgment. Hence, if a debtor files bankruptcy before a state court imposes a constructive trust on specific property, no constructive trust exists to prevent that property from becoming property of the bankruptcy estate.
The Omegas view has not been universally accepted, however. In a recent article, Andrew Kull criticized the Omegas Group decision as misunderstanding the historical roots of constructive trust law as a branch of restitution law.8 A bankruptcy court in Maine concluded: "Properly applied, constructive trust theory does not conflict with the Code's distribution scheme."9 And a Virginia bankruptcy judge announced:
Omegas notwithstanding, I can only conclude that the concept of constructive trust is not inherently incompatible with the fair treatment of creditors in bankruptcy. I further find that it is within the discretion of the bankruptcy court to allow a constructive trust claim that is otherwise compatible with applicable state property law.10
Under state constructive trust law generally, if a wrongdoer obtains property by fraud or other improper means, a court can impose a constructive trust to protect the injured party. The constructive trust is a legal fiction that adopts the analogy of a trust and declares that a beneficiary owns an equitable interest in property. The constructive trust imposes a duty on the trustee to hold the equitable property interest in trust for its owner, the beneficiary.
When a debtor has been declared a constructive trustee before filing a petition in bankruptcy, there is no problem. The beneficiary's equitable interest in the property does not enter the bankruptcy estate. This is so because the equitable interest held in constructive trust for the beneficiary is not property of the debtor. Under § 541(a), the commencement of a bankruptcy case creates an estate that includes all legal and equitable interests of the debtor in property wherever located as of the date the case is commenced. And under section § 541(d), property in which the debtor holds no equitable interest, because he holds it in trust for the beneficiary, does not enter the bankruptcy estate. Only the bare legal title to the property held by the debtor enters the bankruptcy estate, and the debtor/constructive trustee holds that legal title subject to a duty to convey it to the beneficiary of the constructive trust. The beneficiary's equitable interest does not become property of the estate.
But when a debtor has not been declared a constructive trustee before filing a petition in bankruptcy, there is a problem. The problem involves the status of state law on when a constructive trust becomes effective. The majority rule on this question is announced by the Pennsylvania bankruptcy court in Electric M & R, Inc. v. Aultman:
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