Clark v. Wetherill (In Re Leitner)
1999 WL 557059, 1999 Bankr. LEXIS 907, 236 B.R. 420 (1999)
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Rule of Law:
Under Kansas law, an equitable interest in property arising from a constructive trust due to a debtor's pre-petition fraud relates back to the time of the wrongful conduct, preventing that equitable interest from becoming property of the bankruptcy estate, even if the constructive trust is not formally declared by a state court until after the bankruptcy petition is filed.
Facts:
- In 1986, Leo G. Wetherill hired Gary D. Leitner to provide legal and accounting services for L.G.W. Energy Resources, Inc., Wetherill's company.
- Between 1986 and 1992, Leitner embezzled a substantial sum of money from L.G.W. Energy Resources, Inc.
- Leitner used some of the embezzled funds to purchase a new home for himself and his wife at 15623 Acuff Lane in Olathe, Kansas.
- Wetherill discovered Leitner's fraud in 1992.
- Leitner later admitted his wrongdoing and fraud in an affidavit and his answer to Wetherill's lawsuit.
- Carl Clark, the bankruptcy trustee, stipulated in the pretrial order that Leitner purchased the home with money stolen from L.G.W. Energy Resources, Inc.
Procedural Posture:
- Leo G. Wetherill and L.G.W. Energy Resources, Inc. (collectively, 'Wetherill') sued Gary D. Leitner in the District Court of Johnson County, Kansas (state trial court) on November 20, 1992, alleging fraud and seeking monetary and injunctive relief.
- On February 26, 1993, Wetherill amended the petition, seeking a constructive trust on Leitner's home and a prejudgment attachment against the home.
- The state trial court granted Wetherill a prejudgment attachment against the home on March 5, 1993, which Wetherill recorded on March 8, 1993.
- Leitner filed for Chapter 7 bankruptcy on April 15, 1993, before the state trial court could formally enter judgment.
- 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 allow entry of judgment in state court, which Trustee Clark opposed.
- On October 28, 1993, the bankruptcy court lifted the automatic stay to permit Wetherill to proceed in state court, abstaining from ruling on the constructive trust issue.
- Trustee Clark did not appeal the bankruptcy court's order and agreed to sell the residence, pay off mortgages, and hold the remaining proceeds pending further litigation.
- On April 16, 1996, the state trial court entered a judgment declaring that Leitner held the residence in constructive trust for Wetherill and L.G.W. Energy Resources, Inc.
- Trustee Clark initiated an adversary proceeding in the bankruptcy court, contesting the existence of the constructive trust and seeking to avoid the prejudgment attachment as a preferential transfer.
- Trustee Clark moved for summary judgment in the adversary proceeding.
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Issue:
Does property subject to a constructive trust, which arises from a debtor's fraudulent conduct occurring pre-bankruptcy but is not formally declared by a state court until post-bankruptcy, become property of the bankruptcy estate under § 541 of the Bankruptcy Code?
Opinions:
Majority - John T. Flannagan
No, property subject to a constructive trust that arises from pre-bankruptcy fraud does not become property of the bankruptcy estate, even if the trust is not formally declared until after the bankruptcy petition is filed. The court first notes that the constructive trust issue was effectively decided by the state court, and the pre-bankruptcy prejudgment attachment was sufficient judicial action to recognize Wetherill's equitable interest. Addressing the broader legal question, the court rejects the Sixth Circuit's `Omegas` view, which held that a constructive trust is effective only upon final judgment, leading to property entering the estate if bankruptcy intervenes. Instead, this court adopts the majority state law rule that a constructive trust arises at the inception of the wrongful transaction giving rise to the duty to reconvey the property. Applying this principle, the court predicts that the Kansas Supreme Court would follow this 'relation back' rule to prevent fraud, given Leitner's admitted fraud and the traceability of the stolen funds to the home. Therefore, Wetherill owned the equitable interest in the residence when Leitner filed bankruptcy, and Leitner held only bare legal title as a constructive trustee. Under § 541(a) and (d) of the Bankruptcy Code, only the debtor's legal and equitable interests enter the estate. Since Leitner had no equitable interest in the property, the equitable interest and its proceeds did not become property of the bankruptcy estate. The trustee's strong-arm powers under § 544(a) are inapplicable because Wetherill's state court action and recorded prejudgment attachment provided constructive notice, preventing the trustee from assuming the status of a hypothetical judicial lien creditor or bona fide purchaser. Furthermore, the trustee's preference avoidance powers under § 547(b) do not apply, as neither the constructive trust nor the attachment constituted a 'transfer of an interest of the debtor in property,' because Leitner never held the equitable interest to transfer.
Analysis:
This case is significant for its stance on the 'relation back' doctrine for constructive trusts in bankruptcy, directly challenging the more restrictive view taken by some appellate courts like the Sixth Circuit. By affirming that an equitable interest arising from pre-petition fraud vests at the time of the wrongdoing, even if a formal declaration occurs post-petition, the decision limits the scope of assets available to a bankruptcy trustee and reinforces the notion that a bankruptcy estate should not include 'other people's property.' This ruling provides a strong mechanism for victims of fraud to reclaim specific assets, ensuring that state law principles of restitution are respected within the federal bankruptcy framework and preventing wrongdoers from shielding ill-gotten gains through bankruptcy.
