What is a constructive trust, in plain terms?
A constructive trust is a remedy a court imposes on specific property, treating whoever holds it as a trustee of it for someone else. Nobody agrees to it and no document creates it. California puts the rule in its code: Civil Code section 2224 provides that one who gains a thing by fraud, accident, mistake, undue influence, the violation of a trust, or other wrongful act is, unless he or she has some other and better right to it, “an involuntary trustee of the thing gained, for the benefit of the person who would otherwise have had it.” The word involuntary is doing real work.
The elements are a matter of state law and they differ. Under New York law, the United States Court of Appeals for the Second Circuit wrote in In re Koreag, Controle et Revision S.A., 961 F.2d 341 (2d Cir. 1992), citing the New York Court of Appeals in Sharp v. Kosmalski, 40 N.Y.2d 119 (1976), that a claimant “must ordinarily establish four elements: (1) a confidential or fiduciary relationship; (2) a promise, express or implied; (3) a transfer made in reliance on that promise; and (4) unjust enrichment.” The word ordinarily is not decoration: the same opinion holds that “the absence of any one factor will not itself defeat the imposition of a constructive trust when otherwise required by equity,” and found no fiduciary relationship between the parties before it without ending the claim. A claimant in a state that frames the question around a fiduciary relationship still faces a different showing from one in a state that asks only about unjust enrichment. There is no national rule here.
The distinction between imposed and agreed drives the timing fight that follows. As the Sixth Circuit put it in XL/Datacomp, Inc. v. Wilson (In re Omegas Group, Inc.), 16 F.3d 1443 (6th Cir. 1994), a constructive trust, unlike an express trust, “is a remedy, it does not exist until a plaintiff obtains a judicial decision finding him to be entitled to a judgment ‘impressing’ defendant’s property or assets with a constructive trust.” Other courts treat the trust as arising by operation of law when the wrong occurs, with the decree merely recognizing it. Which description a court accepts decides a great deal once a bankruptcy petition is on file.
Why would a claimant want a constructive trust instead of a money judgment?
Because a money judgment is a claim against a person and a constructive trust is a claim to a thing, and only the second gets ahead of anybody. A judgment creditor stands in line. A claimant with an equitable interest in identified property asserts that the property was never the holder’s to give to that line.
The difference shows up before judgment as well. In Grupo Mexicano de Desarrollo, S.A. v. Alliance Bond Fund, Inc., 527 U.S. 308 (1999), the Supreme Court held that a federal district court has no authority to issue a preliminary injunction preventing a defendant from disposing of assets pending adjudication of a contract claim for money damages where the plaintiff asserts no lien on and no equitable interest in those assets. The route around that bar is the equitable claim itself. Great-West Life & Annuity Insurance Co. v. Knudson, 534 U.S. 204, 213 (2002) describes the category: restitution in equity, “ordinarily in the form of a constructive trust or an equitable lien, where money or property identified as belonging in good conscience to the plaintiff could clearly be traced to particular funds or property in the defendant’s possession.” The records work that identifies property is what makes the remedy available. See Can we freeze the accounts before we win?.
The advantage is real and narrow. In bankruptcy the Second Circuit in Koreag, quoting the Fifth Circuit’s In re Quality Holstein Leasing, 752 F.2d 1009, 1012 (5th Cir. 1985), described a constructive trust as conferring on the true owner of the property “an equitable interest in the property superior to the trustee’s.” That superiority is why the claim is worth bringing and why several courts treat it with suspicion.
What does a constructive trust depend on in the records?
On tracing — the ability to follow a claimant’s money or property into something that still exists. Great-West Life & Annuity Insurance Co. v. Knudson, 534 U.S. 204, 213 (2002) states both halves. Property “clearly traced to particular funds or property in the defendant’s possession” supports restitution in equity; where the property “or its proceeds have been dissipated so that no product remains,” the claim “is only that of a general creditor,” and no constructive trust or equitable lien can be enforced.
Where the money passed through a commingled account, the traceable amount is decided by an allocation convention rather than by arithmetic alone, and the conventions do not agree with one another. The lowest intermediate balance rule bites hardest: as the Tenth Circuit set the rule out in Hill v. Kinzler (In re Foster), 275 F.3d 924 (10th Cir. 2001), at its footnote 1, withdrawals draw first on the holder’s own funds, new deposits are not subject to the trust, and recovery is limited to “the lowest balance recorded after the fiduciary commingled funds.” A single dip can permanently limit what the remedy reaches no matter how much money moved through afterward. Tracing & Asset Recovery sets out how that analysis is built, and How much of the stolen money can we actually recover? covers why the conventions matter.
Tracing is necessary and not sufficient. In Hill v. Kinzler (In re Foster), 275 F.3d 924 (10th Cir. 2001), the Tenth Circuit reversed and remanded an order that had imposed a constructive trust on funds traced under the lowest intermediate balance rule, holding that a bankruptcy court “must weigh the claims of the remaining creditors before employing an equitable fiction such as the lowest intermediate balance rule” and that the court below “erred in employing the tracing fiction” without first determining whether the other creditors were similarly situated. Colorado law supplied the elements. The court cited, for the principle, the Tenth Circuit’s earlier In re M & L Business Machine Co., 59 F.3d 1078, 1082 (10th Cir. 1995): “Absent direct identification of the defrauded funds, it is to the detriment of all similarly situated creditors to favor one defrauded party over another.”
What happens to a constructive trust claim when the person holding the money files bankruptcy?
It runs into 11 U.S.C. section 541, written broadly and then qualified. Section 541(a)(1) brings into the estate “all legal or equitable interests of the debtor in property as of the commencement of the case.” Section 541(d) is the qualification claimants reach for: 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.”
The argument that follows is about what section 541(d) covers. A claimant says the debtor held nothing but bare legal title from the moment of the wrong, so the equitable interest never entered the estate. A trustee says the claimant is asking a court to create an interest after the petition and then backdate it. Both descriptions are available on the same facts, which is why the answer turns on the circuit and on the state law supplying the elements.
There is a second front. Section 544(b)(1) lets the trustee avoid any transfer of an interest of the debtor in property “that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502,” and section 544(a) gives the trustee the status of a hypothetical lien creditor or bona fide purchaser. Whether those powers reach property said to be held in constructive trust is contested, and in several circuits the answer comes from state property law rather than the Bankruptcy Code. The trustee’s and receiver’s side of the problem is covered in Clawback & Distribution.
Do the federal courts of appeals agree on whether a bankruptcy court can impose a constructive trust after the petition?
No, and the disagreement is old and unresolved. The Sixth Circuit is the strictest. In XL/Datacomp, Inc. v. Wilson (In re Omegas Group, Inc.), 16 F.3d 1443 (6th Cir. 1994), the court held that “a creditor’s claim of entitlement to a constructive trust is not an ‘equitable interest’ in the debtor’s estate existing prepetition, excluded from the estate under Sec. 541(d),” reasoning that because the remedy does not exist until a court declares it, there was no pre-existing interest to exclude. The opinion expressly did not address “property already impressed with a constructive trust by a court in a separate proceeding prepetition, in which case the claimant would be entitled to priority (although not superpriority to the trustee) as a secured creditor by virtue of the judgment.”
The Fifth Circuit had gone close to the other way nine years earlier. In Vineyard v. McKenzie (In re Quality Holstein Leasing, Inc.), 752 F.2d 1009 (5th Cir. 1985), the court held that where a constructive trust attached under state law before the petition date, the beneficiary normally may recover its equitable interest through the bankruptcy proceedings, section 541(d) prevailing over the trustee’s strong-arm powers because Congress did not intend estates to benefit from property the debtor never owned.
Between those poles the courts weigh equities rather than apply a rule. The Ninth Circuit in Torres v. Eastlick (In re North American Coin & Currency, Ltd.), 767 F.2d 1573 (9th Cir. 1985) declined to impose a constructive trust on funds customers had paid for precious metals in the week before the Chapter 11 filing, writing that a court must “act very cautiously in exercising such a relatively undefined equitable power in favor of one group of potential creditors at the expense of other creditors, for ratable distribution among all creditors is one of the strongest policies behind the bankruptcy laws.” A 2016 survey by Amelia L. Bueche and Megan N. Young in The Federal Lawyer, “Beneficiary or Creditor? Where State Constructive Trust Law and the Bankruptcy Distribution Scheme Collide,” maps the remaining circuits.
Why do some courts call a constructive trust a disfavored priority-jumping device?
Because in an insolvency the remedy does not take from the person who did the wrong — it takes from the other people who are owed money. The Sixth Circuit said it in one line in In re Omegas Group: “Constructive trusts are anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.”
It has the most force where the other claimants are in the same position as the one asking. That was the Tenth Circuit’s point in In re Foster, which quoted the Supreme Court’s Cunningham v. Brown, 265 U.S. 1, 13 (1924): the rule “is useful to work out equity between a wrongdoer and a victim; but when the fund with which the wrongdoer is dealing is made up of the fruits of frauds perpetrated against a myriad of victims, the case is different.” Where a recovered fund has many claimants, the question stops being whose dollar it was and becomes which distribution method the court adopts.
So a claimant is generally asked for four things, in order. Establish the elements the relevant state imposes, naming that state rather than a general rule. Trace the money or property into specific property that still exists, and be candid about where the trace stops. Show why the equities favor this claimant over the others waiting. And survive whatever the forum allows a trustee to do with the strong-arm powers. None of that decides whether anyone did anything wrong: AICPA Statement on Standards for Forensic Services No. 1 reserves the ultimate conclusion of fraud to the trier of fact and prohibits a member performing forensic services from opining on it. What a loss is worth, as opposed to what property can still be identified, is a damages question and belongs to our Economic Damages Institute.