Clark v. Wetherill (In Re Leitner)
236 B.R. 420, 1999 WL 557059, 1999 Bankr. LEXIS 907 (1999)
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Rule of Law:
A constructive trust, arising from a debtor's pre-petition fraud and established under state law, relates back to the time of the wrongful conduct, preventing the equitable interest in the trust property from becoming part of the bankruptcy estate.
Facts:
- In 1986, Leo G. Wetherill hired Gary D. Leitner to perform legal and accounting services for L.G.W. Energy Resources, Inc.
- Between 1986 and 1992, Leitner embezzled a large sum of money from L.G.W. Energy Resources, Inc.
- Leitner used some of the purloined funds to purchase a new home for himself and his wife.
- Wetherill discovered Leitner's fraud in 1992.
- Leitner later admitted his fraud in an affidavit and his answer to the state court lawsuit.
- The misappropriated money used by Leitner was traceable to the home he purchased.
Procedural Posture:
- On November 20, 1992, Leo G. Wetherill and L.G.W. Energy Resources, Inc. (hereinafter 'Wetherill') sued Gary D. Leitner in the District Court of Johnson County, Kansas, seeking monetary and injunctive relief.
- On February 26, 1993, Wetherill amended the state court petition to seek a constructive trust on the home Leitner allegedly purchased with embezzled funds.
- On March 5, 1993, Wetherill obtained a prejudgment attachment against the home from the state court.
- On March 8, 1993, Wetherill recorded the prejudgment attachment order with the Register of Deeds of Johnson County, Kansas.
- On April 15, 1993, before a final judgment could be entered in the state court case, Leitner filed a Chapter 7 bankruptcy petition.
- Carl R. Clark was appointed interim trustee in Leitner's Chapter 7 bankruptcy case.
- Wetherill moved the bankruptcy court for relief from the automatic stay to permit entry of judgment in state court, which Trustee Clark objected to.
- On October 28, 1993, the bankruptcy court granted Wetherill's motion for relief from the automatic stay, allowing Wetherill to proceed in state court on all issues, including the constructive trust claim, and abstained from ruling on those issues.
- Trustee Clark did not appeal the bankruptcy court's order.
- Trustee Clark, Wetherill, and other interested parties agreed to sell the residence, pay off existing mortgages, and hold the remaining proceeds pending further litigation.
- On April 16, 1996, Judge Lawrence E. Sheppard of the Johnson County District Court signed the journal entry of judgment, declaring that Leitner held the residence in constructive trust for Wetherill.
- Trustee Clark filed a motion for summary judgment in this adversary proceeding, contesting the existence of a constructive trust and seeking to avoid the attachment as a transfer subject to his avoiding powers.
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Issue:
Does an equitable interest in property, subject to a constructive trust under state law due to a debtor's pre-petition fraud, become property of the bankruptcy estate, or does the constructive trust relate back to the time of the wrongful conduct, preventing the property from entering the estate?
Opinions:
Majority - John T. Flannagan
No, an equitable interest in property subject to a constructive trust under state law due to a debtor's pre-petition fraud does not become property of the bankruptcy estate because the constructive trust relates back to the time of the wrongful conduct. The court denied the trustee's motion for summary judgment, concluding that Wetherill and L.G.W. are the beneficiaries of a constructive trust on the home, preventing it from becoming property of the estate. The court reasoned that the state court's pre-petition grant of a prejudgment attachment against the home, based on Leitner's admitted fraud, was sufficient judicial action to recognize Wetherill's existing equitable interest. Furthermore, applying the majority rule in state constructive trust law, a constructive trust arises at the time of the wrongful conduct, not upon a final judgment, meaning the equitable interest was never Leitner's to transfer to the bankruptcy estate. The court predicted that the Kansas Supreme Court would follow this 'relation back' rule to prevent fraud. Under Bankruptcy Code § 541(d), property in which the debtor holds only bare legal title as a trustee for a beneficiary does not enter the bankruptcy estate. The trustee's strong-arm powers under § 544(a) were ineffective because Wetherill's pre-petition filing of the state court action (creating lis pendens) and recording the prejudgment attachment provided constructive notice to third parties, including the trustee, of Wetherill's equitable interest. Lastly, the court determined that the constructive trust and attachment were not preferential transfers under § 547(b) because Wetherill already held the equitable ownership, and Leitner had no equitable interest to transfer; the attachment was merely an enforcement tool.
Analysis:
This case establishes that the 'relation back' doctrine for constructive trusts, prevalent in state law, takes precedence in bankruptcy proceedings over the trustee's avoiding powers. It provides a significant protection for victims of fraud, allowing them to reclaim specific property purchased with embezzled funds, even if the wrongdoer files for bankruptcy before a state court formally declares the trust. The decision underscores that the bankruptcy estate is limited to the debtor's actual equitable interests, preventing trustees from distributing 'other people’s property' among creditors. It clarifies that a trustee, as a hypothetical bona fide purchaser or lien creditor, cannot defeat an equitable interest that was subject to pre-petition notice through lis pendens or recorded attachments.
