Trust Funds and Property of the Debtor’s Estate in Bankruptcy
June 27, 2023
In this Surety Today Blog post we continue with our third post of a multi-part series on the surety and trust funds. In the first post we discussed the nature of trusts, the formation of trusts and the elements of an express trust. In the second post we looked at the various forms of trusts, such as statutory trust funds, contractually created trusts and trusts at common law. In this third post of the series we will explore the whether the surety’s trust funds are property of the debtor’s bankruptcy estate.
Every surety has had to wade into the waters of bankruptcy to protect its rights to bonded contract funds, seek recovery of losses and damages, fend-off a bankruptcy trustee seeking to assert its rights in the debtor’s property or spar with the IRS or a secured lender over bonded contract funds. The surety’s subrogation rights are a powerful weapon in the context of bankruptcy and are useful in a variety of contexts within the Bankruptcy Code. However, with an understanding of the general nature of trusts in hand, the question becomes what rights flow from the existence of a trust in bankruptcy that can supplement the surety’s subrogation rights? The drafters of the Bankruptcy Code recognized the special nature of trusts and the special duties flowing from the role of the trustee of trusts and crafted specific provisions to address trusts. These provisions of the Bankruptcy Code can be used by the surety as a beneficiary of a trust or through subrogation to the rights of a beneficiary of a trust.
Property of the Estate – Section 541 of the Bankruptcy Code.
Section 541 of the Bankruptcy Code provides that the commencement of a case under the Bankruptcy Code creates an estate. 11 U.S.C. § 541(a). The debtor’s estate is broadly defined as debtor’s property, wherever it is located and by whomever it is held. Specifically, the property of the debtor’s estate includes all of the debtor’s legal or equitable interests in property as of the commencement of the case. Property of the estate includes proceeds or profits of or from property of the estate. Despite the breadth of § 541. There are certain limitations on what may be property of the debtor’s estate. For example, property in which the debtor holds only legal title and not an equitable interest becomes property of the estate only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold. 11 U.S.C. § 541(d).
The Bankruptcy Code provides at §541(d):
Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property, or an interest in such a mortgage, sold by the debtor but as to which the debtor retains legal title to service or supervise the servicing of such mortgage or interest, becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.
As noted in the first blog post on the nature of trusts, a trustee holds only bare legal title to the trust property, while the beneficiaries of the trust hold equitable title. Thus, in circumstances where the debtor is holding property in trust as a trustee at the time of commencement of or during the pendency of the bankruptcy (like when the principal goes into bankruptcy), such trust property is subject to the debtor’s legal title only and the beneficiaries of the trust property (the surety, subcontractors and suppliers) hold the equitable title. Universal Bonding Ins. Co. v. Gittens & Sprinkle Enters., Inc., 960 F.2d 366, 371 (4th Cir. 1992); Ga. Pac. Corp. v. Sigma Serv. Corp., 712 F.2d 962 (5th Cir. 1983); In re Alcon Demolition, Inc., 204 B.R. 440 (Bankr. D.N.J. 1997); In re W. Urethanes, Inc., 61 B.R. 243 (Bankr. D. Colo. 1986).
Although the question of whether a debtor’s interest in property constitutes “property of the estate” is a federal question to be decided by federal law, courts must look to the applicable state law to determine the extent of the debtor’s legal or equitable interest in the property, including whether a valid trust exists. If there is valid trust property held by the debtor at the time of the filing of the petition, such trust property is generally considered not to be part of the bankruptcy estate. U.S. v. Whiting Pools, Inc., 462 U.S. 198, 205 n. 10 (1983); Official Comm. of Unsecured Creditors v. Columbia Gas Systems, Inc. (In re Columbia Gas Systems, Inc.), 997 F.2d 1039, 1059 (3d Cir. 1993); Gittens and Sprinkle Enters., Inc., 960 F.2d at 371; City of Farrell v. Sharon Steel Corp., 41 F.3d 92, 95 (3d Cir. 1994); Bank of Marin v. England, 385 U.S. 99 (1966); In re Wyatt, 6 B.R. 947 (Bankr. E.D. N.Y. 1980); In re Snider Bros., Inc., 12 B.R. 87 (Bankr. D. Mass. 1981). In Begier v. IRS, 496 U.S. 53, 59 (1990), the Supreme Court citing to § 541(d) concluded that “because the debtor does not own an equitable interest in property which he holds in trust for another, that interest is not ‘property of the estate.’” Accordingly, the trust property “can only be distributed to trust beneficiaries, and not to the creditors of the bankruptcy estate.” In re Marrs-Winn Company, Inc., 103 F.3d 584, 590 (7th Cir. 1996); In re Butts, 46 B.R. 292, 295 (D.N.D. 1985) (“legal title alone has been held to be of no value to the estate and the debtor will be required to reconvey the property or its substitute to the beneficial owner.”). Indeed, it has been held that the debtor’s “sole permissible administrative act” upon receipt of the trust funds is to pay the trust funds to the beneficiaries of the trust. In Mid-Atl. Supply, Inc. of Va. v. Three Rivers Aluminum Co., 790 F.2d 1121, 1126 (4th Cir. 1986), the court held that: “[I]f a trust, whether express, statutory, or constructive is established over property in the possession of the trustee or debtor-in-possession, the ‘sole permissible administrative act’ of the trustee or debtor-in-possession is to pay over or endorse over the property to the beneficiary or beneficiaries of the trust.” See also Ga. Pac. Corp. v. Sigma Serv. Corp., 712 F.2d 962 (5th Cir. 1983). Some courts dispute the assertion that trust property is excluded entirely from the estate. The Maxon Engineering Court held that property in which the debtor holds only legal title also becomes part of the bankruptcy estate, but only to the extent of the debtor’s legal title. In re Maxon Eng’g Servs., Inc., 332 B.R. 495, 500 (Bankr. D.P.R. 2005); In re Glover Constr. Co., Inc., 30 B.R. 873 (Bankr. W.D. Ky. 1983); In re Hughes-Bechtol, Inc., 2000 U.S. App. LEXIS 18741 (6th Cir. 2000).
The debtor’s rights and interests in property are determined as of the date of the commencement of the case. Section 541 of the Bankruptcy Code does not vest the debtor’s estate with any greater rights than those held by the debtor. Thus, to the extent that the legal or equitable interests in the debtor’s property included in the estate under section 541(a)(1) of the Bankruptcy Code are limited in the debtor’s hands, they are generally limited to the same extent in the hands of any bankruptcy trustee because the Bankruptcy trustee acquires only the rights that the debtor has and nothing more. Creasy v. Coleman Furniture Corp., 763 F.2d 656, 662 (4th Cir. 1985); Integrated Solutions, Inc. v. Serv. Support Specialties, Inc., 193 B.R. 722, 729 (D.N.J. 1996); In re Home Builders, Inc., 213 B.R. 475, 477 (Bankr. E.D. Va. 1997). Stated differently, the debtor gets no better interest in property after filing the bankruptcy case than the debtor had prior to filing the bankruptcy case.
- Section 541 and Trusts Established by Contract
As discussed in the second blog post on the forms of trustse, the contract between the obligee and the debtor, or the subcontract between the general contractor and the subcontractor debtor, frequently contains a trust fund provision in the contract or subcontract that requires the debtor to hold all contract funds in trust for the benefit of the debtor’s subcontractors and suppliers on the contract or subcontract. Some courts have held that such contract provisions are sufficient to create a valid and enforceable trust for purposes of bankruptcy law and that such funds to the extent of the equitable interest of the beneficiaries of the trust are not part of the debtor’s bankruptcy estate. Fed. Ins. Co. v. Fifth Third Bank, 867 F.2d 330 (6th Cir. 1989); In re Gonzales, 22 B.R. 58 (B.A.P. 9th Cir. 1982); T & B Scottdale Contractors, Inc. v. U.S., 866 F.2d 1372 (11th Cir. 1989)..
In T & B Scottdale Contractors, Inc., supra., the Eleventh Circuit held that certain funds were not part of a subcontractor’s bankruptcy estate because the general contractor paid those monies into a joint bank account for the sole purpose of paying the subcontractor’s materialmen. The general contractor T & B and the subcontractor R & R entered into a contract requiring T & B to create and control a bank account in R & R’s name for the sole purpose of paying the subcontractor’s suppliers. Relying upon § 541 of the Bankruptcy Code, the court held that R & R held these funds in trust for its materialmen and therefore, those funds were not part of the bankruptcy estate. While these cases did not involve a surety, through its subrogation rights, a surety could seek to enforce trusts in the manner noted above to its advantage.
- Section 541 and Trusts Established in the Indemnity Agreement
As noted in the second blog post on the forms of trusts, indemnity agreements frequently contain a trust fund provision. If a valid express trust is created by the trust fund provision in the agreement of indemnity, those trust rights will be protected under the Bankruptcy Code.
In re Alcon Demolition, Inc., supra., the court found that the four elements for the establishment of an express trust under New Jersey law were met by the trust fund provision in the agreement of indemnity, thus establishing a valid and enforceable trust under New Jersey law. The indemnity agreement at issue in Alcon Demolition provided in relevant part:
It is expressly understood and declared that all monies due or to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of [debtor] or otherwise for the benefit of and for payment of all such obligations in connection with any such contract or contracts for which [Surety] would be liable under any of said Bonds, for which said trust also inures to the benefit of [Surety] for any liability of loss it may have to sustain under any said Bonds, and this Agreement and Declaration shall also constitute notice of such trust.
The Court noted that the language of the indemnity agreement expressly states that a trust is to be created, that the trust res will consist of “all monies due or to become due” for any bonded contracts, that the materialmen and laborers, along with the surety are the beneficiaries of the trust and that the debtor was the trustee. The Alcon Demolition Court concluded that pursuant to § 541 the debtor had no beneficial interest in the contract funds to the extent of the payments made by the surety, and the debtor was bound by its fiduciary duty to pay the contract funds to the surety as the beneficiary of the trust under the trust fund provision of the agreement of indemnity. Courts in other jurisdictions have similarly found that the surety’s indemnity agreement can create a valid trust for purposes of the Bankruptcy Code under the applicable state law. Favre v. Lyndon Prop. Ins. Co., 2008 U.S. Dist. LEXIS 105334 (S.D. Miss. August 6, 2008); Safeco Ins. Co. of Am. v. Hastings (In re Hastings), 2008 Bankr. LEXIS 3507 (Bankr. N.D. Ala. December 23, 2008); In re Fox, 357 B.R. 770 (Bankr. E.D. Ark. 2006); In re Herndon, 277 B.R. 765 (Bankr. E.D. Ark. 2002); In re McCormick, 283 B.R. 680 (Bankr. W.D. Penn. 2002); In re Wright, 266 B.R. 848, 851 (Bankr. E.D. Ark. 2001); In re McIntosh, 320 B.R. 22 (Bankr. M.D. Fla. 2005); Cumberland Sur. Ins. Co. v. Smith (In re Smith), 238 B.R. 664, 672 (Bankr. W. D. Ky. 1999); Gillespi v. Jenkins (In re Jenkins), 110 B.R. 74, 76-77 (Bankr. M.D. Fla. 1990). Courts in other jurisdictions, for a variety of reasons, including the specific indemnity provision language or peculiar state law, have held that a surety’s indemnity agreement did not create a valid express trust for purposes of the Bankruptcy Code. Capitol Indem. Corp. v. U.S., 41 F.3d 320 (7th Cir. 1994); Acuity, A Mut. Ins. Co. v. Planters Bank, Inc., 362 F. Supp. 2d 885 (W.D. Ken. 2005); Int’l Fid. Ins. Co. v. Marques (In re Marques), 358 B.R. 188 (Bankr. E.D. Pa. 2006); E. Concrete Paving Co. v. Jacob’s Elec. Constr., Inc., 293 B.R. 704 (E.D. Mich. Bankr. 2003); In re Wm. Cargile Contractor, Inc., 151 B.R. 854, 859-860 (Bankr. S.D. Ohio 1993); In re: Suprema Specialties, Inc., 370 B.R. 517 (S.D.N.Y. 2007), aff’d, In re Suprema Specialties, Inc. v. Bank of Am. N.A., 2009 U.S. App. LEXIS 3359 (2d Cir. 2009).
- Section 541 and Trusts Established by Statute
As noted in the second blog post on the forms of trusts, many states have trust fund statutes that give subcontractors and suppliers a trust interest in any contract funds paid by an owner to a contractor or by a contractor to a subcontractor. In Universal Bonding Insurance Co. v. Gittens & Sprinkle Enterprises, Inc., supra. the debtor contractor, Gittens, filed for bankruptcy protection and attempted, as debtor in possession, to collect outstanding contract balances due from state, municipal and federal agencies, for the purposes of reorganizing and using such funds as capital in new ventures. The surety objected and argued that the contract balances constituted statutory trusts for the benefit of laborers and materialmen and therefore could not become part of debtor’s general estate under § 541. Both the bankruptcy court and the district court rejected the surety’s arguments. The Third Circuit Court of Appeals vacated the lower court holding and held that funds paid by state and municipal agencies were statutory trust funds for the benefit of laborers and materialmen.
The New Jersey Trust Fund Act at that time provided in relevant part:
all money paid by the State of New Jersey or by any agency commission or department thereof, or by any county, municipality or school district in the state, to any person pursuant to the provisions of any contract for any public improvement . . . shall constitute a trust fund in the hands of such person . . . until all claims for labor, materials and other charges incurred in connection with the performance of such contract shall have been fully paid.
N.J.Stat. Ann. 2A:44-148.
The court found that the contract balances were subject to the New Jersey Trust Fund Act and that Gittens as debtor-in-possession was required to hold those funds subject to the statutory trust. The court, citing § 541(d) noted that “property in which the debtor holds only legal title, and does not hold an equitable interest, such as trust funds, is included in the bankrupt’s estate only to the extent of the debtor’s legal title to the property and not to the extent of any interest in the property that the debtor does not hold.” Whether Gittens received the contract balances either before or after the filing of its bankruptcy case, the court determined that there was no difference in the trust fund nature of the contract balances. Finally, the court went on to hold that “when and if [the surety] pays Gittens’ indebtedness to laborers or materialmen, it may pursue the statutory remedies of the laborers or materialmen by proceeding against such trust funds.”
Other courts have expressly held that the various state trust fund statutes create enforceable trusts and that the beneficial interests in subcontractors and materialmen in the trust property are not property of the debtor or of the bankruptcy estate pursuant to § 541. In re Kennedy & Cohen, Inc., 612 F.2d 963, 965 (5th Cir. 1980); Selby v. Ford Motor Co., 590 F.2d 642, 645, 649 (6th Cir. 1979); In re Casco Elec. Corp., 28 B.R. 191, 193-194 (Bankr. E.D.N.Y. 1983), aff’d, 35 B.R. 731, 732 (E.D.N.Y. 1983); In re: Dunwell Heating & Air Conditioning Contractors Corp., 78 B.R. 667 (Bankr. E.D.N.Y. 1987).
The practical applications of the use of an express trust under § 541 should not be underestimated. If the argument can be made that a trust exists and that the bonded contract funds at issue are, therefore, not property of the bankruptcy estate the surety, as a direct beneficiary or through subrogation, can prevail over the bankruptcy trustee’s “strong-arm powers” (11 U.S.C. § 544) because those powers do not prevail over the funds that are not property of the estate pursuant to § 541(d). Similarly, if the bonded contract funds can be deemed to be trust funds, then under § 541(d) the surety can prevail over the bankruptcy trustees preference actions under § 547. Selby v. Ford Motor Co., 590 F.2d 642 (6th Cir. 1979); In re Short, 818 F.2d 693, 695 (9th Cir. 1987). Further, the surety can seek to use § 541 affirmatively to force the bankruptcy trustee or debtor in possession to release trust funds to the proper beneficiaries because such funds are not property of the estate.
If you have any questions regarding the issues addressed in this blog post please contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.