As a rule, debtors ask the Bankruptcy Court to protect them. In return for its iron-clad protection the Bankruptcy Court demands that all rules be obeyed and debtors refrain from hiding or giving away assets that could be used to satisfy creditors.
To ensure that nothing slips through the cracks Bankruptcy law empowers the case Trustee to claw back anything paid or given away by a debtor within 90 days of filing. In essence, Bankruptcy law treats all such transfers as attempts to shed assets. So payments in that period automatically constitute preferential transfers (“preferences”). Preferences can be sucked back into the Bankruptcy Estate by the Trustee; so unsuspecting vendors can be ambushed and forced to give back money they actually earned!
Finally, to make things even more confusing there are exceptions to the preference rule such as payments in the ordinary course of business, a contemporaneous exchange for value, and receiving new value for the payment.
In re Mississippi Value Livestock
In re Mississippi Valley Livestock, decided recently by the 7th Circuit Court of Appeals, involved payments made by the debtor within 90 days of an involuntary bankruptcy filing. But since the debtor had not planned on filing, it would be hard to say that it was purposely trying to get rid of property or playing hide-and-seek with assets. So this was not exactly the kind of case the law was meant to prevent. No, this was one of those cases that pushed the Bankruptcy law to its limits.
Mississippi Valley Livestock (“Debtor) was in the business of buying and selling cattle for slaughter. J&R Farms (“J&R”) hired the Debtor to sell its cattle and remit the proceeds – essentially a consignment arrangement. The two entities enjoyed a long, prosperous commercial relationship until the Debtor started to fall behind in payments: first to J&R, then to all its other creditors.
While J&R was prepared to wait for things to turn around, a group of creditors got together and petitioned the Debtor into involuntary bankruptcy; but not before it paid around $900,000 to J&R. The Trustee in the Debtor’s case objected that the constituted a “transfer” of “property of the estate” on account of an existing (i.e. “antecedent”) debt: the dictionary definition of a preference.
Finally, no exception applied because this was not an “ordinary” payment – it represented an extraordinary payment to a particular creditor while the other creditors were poised to get nothing at all. The upshot, said the Trustee, was that the Debtor had chosen to pay J&R with money that should have been used to pay all creditors pro rata.
The first issue in the case was whether or not the money paid by the Debtor was really its property, and therefore property of the Bankruptcy Estate. If this was the Debtor’s money, then paying it all to J&R – even though it was owed – was a derogation of the pro rata payment obligation of the Trustee: a Bankruptcy no-no.
But J&R argued that the Debtor was really just giving it back its own property (or at least the proceeds from the sale of that property). So if the sold cattle had never belonged to the Debtor, the proceeds from the sale of those cattle didn’t belong to the Debtor either. And when the Debtor paid J&R, it was just returning what it didn’t own: certainly, that did not constitute a preference, right?
As usual however, there was a fly in the ointment. The Debtor had placed the proceeds from the sale of J&R’s cattle into the same account it used for other monies. The result was comingling of funds, making them indistinguishable when paid out.
So the second issue in the case was whether the Debtor paying J&R back with the proceeds from the cattle sale (J&R’s own money) or with its operating funds and savings (which should have gone to the Trustee and been distributed to other creditors)?
Bankruptcy Court and District Court Agree: The Proceeds Were Not the Debtor’s Property
The Bankruptcy Court and District Court agreed with J&R that the Debtor was merely holding the proceeds of the cattle sale as a bailee and did not have a legal or equitable interest in them. This was especially true because property interests in Bankruptcy are created and defined by State law – not Bankruptcy law. In its evaluation of the case, the 7th circuit does a very thorough analysis of the law on this subject, focusing on the distinction between bailor/bailee relationships and conditional sales in Illinois. The Court concludes that a bailor/bailee relationship existed here.
Time For A Constructive Trust
While that conclusion could have been the end of the story, in this case it was not. Had the Debtor returned the consigned cattle, there would be no dispute. But here the proceeds were returned to J&R, not the cattle. The Court concluded that a link had to be found between those cattle and the money returned, or the Debtor would be back in preference territory.
The method used to create that link was the constructive trust – an equitable device in Illinois law that is used when one party has money to which it is not entitled. A constructive trust prevents unjust enrichment of that party. Here, if a constructive trust were construed then the funds in question would never have been part of the Debtor’s Bankruptcy Estate.
Of course a constructive trust actually circumvents the Bankruptcy Code since it prioritizes some creditors over others (which is why it is used so sparingly in Bankruptcy Court). Here however, it was the perfect vehicle because it permitted the Debtors payments to J&R to be characterized as a kind of restitution claim. The Court noted that in order for a restitution claim to lie, the funds had to be traced to the creditor’s specific interest; which is just what happened here.
But since the funds in this case were comingled, there were insufficient findings at the Trial Court level to support the necessary tracing. As a result the case was remanded for further findings.
The moral of the story here is 2-fold:
First, comingling proceeds or fungible items of personal property is a danger to all parties – Debtors, Creditors, and everyone involved.
Second, even where the parties maintain solid practices, proceeds should be remitted in the ordinary course of business and not permitted to pile up.
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