Daily Development for Tuesday, November 25, 2003 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu BANKRUPTCY; CONSTRUCTION CONTRACTS; CONSTRUCTIVE TRUSTS: Although landowner has paid monies to contractor for the specific purpose of third party subcontractors and others who, if not paid, would have mechanic's lien claims on owner's property; and although contractor, now bankrupt, has failed to fulfill its obligation to its these third parties, the court need not impose a constructive trust on such amounts paid to the debtor . In re Kamand Construction, Inc. v. Property Management, Inc., 298 B.R. 251, (Bankr.M.D.Pa.) Prior to filing for Chapter 11, the debtor construction company entered in an oral agreement with the creditor property manager to renovate the creditor's building. The agreement called for 1) payment for "time and materials" including the debtor's employees' wages and amounts paid to subcontractors and suppliers, and 2) "fifteen percent profit." The property manager paid three invoices submitted by the debtor. The issue here was whether the portion of the payments not earmarked for the debtor's profit could be held in a constructive trust for the contractors and suppliers. The court explained that while the Court of Appeals for the Sixth Circuit has held that constructive trusts are an anathema to the equities of bankruptcy and may not be imposed after a petition for bankruptcy, the Third Circuit court has held that property subject to a constructive trust can be excluded from the estate under the federal Bankruptcy Code. The Third Circuit Court has looked to state law to determine whether a property right exists to determine whether to establish a constructive trust and thereby exclude that property from the bankruptcy estate. In re Nejberger, 934 F.2d 1300, 1302 (3d Cir. 1991). Under Pennsylvania law, a constructive trust can be established with respect to a specific trust res when a party acquired property as a result of fraud or duress or other circumstances suggesting unjust enrichment. Louis Dolente & Sons v. USF & G, 252 F.Supp.2d 178, 182 (E.D.Pa. 2003). Here, the creditors and objectants failed to meet this heavy burden of showing fraud, duress or other circumstances evincing unjust enrichment. The court found that the facts of the case did not allow the objectants to overcome the presumption that the funds received from the property manager belonged to the estate. The debtor diverted these funds to pay other creditors whose obligations were guaranteed by the debtor's principals. Reporter's Comment: This case is noteworthy because the court was willing to impose a constructive trust on the debtor's property given a different set of facts; federal Courts of Appeals are split on the issue of whether to impose constructive trust in the bankruptcy context. While here the United States Bankruptcy Court for the Middle District of Pennsylvania might have been willing to impose a constructive trust under more compelling facts, Federal Courts of Appeals remain split on this issue Editor's Comment 1: There is some uncertainty as to the exact nature of the owner's expectation regarding these monies. Here is what the court said: Objectants infer that by including the amounts owed to each subcontractor on the invoices submitted to the [construction manager], Debtor agreed that it was not entitled to the funds and was only a conduit for transmittal to the subcontractors. Therefore, by failing to remit the amounts due to subcontractors, Debtor "diverted" funds to pay other creditors whose obligations were guaranteed by Debtor's principals. Although this is one possible interpretation of the detailed information on the invoice, Debtor's explanation that the invoices simply justify Debtor's claim for "materials" used in completing the job is equally plausible. If, on the other hand, it was clear that these monies were to be paid over to the subcontractors, then would there be an argument for a resulting trust, rather than a constructive trust? Maybe the court was looking at the wrong Pennsylvania authority. Editor's Comment 2: What about those mechanic's liens? The court specifically notes that several of the parties to whom the monies were to be paid were threatening lien claims. It appears to be taking that fact into account. It says that if this should occur, the claims of the owner and the construction manager against the debtor would be "no longer contingent" (whatever that means). It probably doesn't mean that the mechanic's liens against the owner would be uncollectable, which would mean that the owner would have had to pay for the work twice. Editor's Comment 3: The court, in its preamble comments, notes that no effort had been made by the owner to control strictly the flow of payments to the subcontractors. It indicates that there were no "joint checks" cut both to the contractor and the subs and there were no lien waivers sought or required by the owner or its construction manager. The editor is not aware what Pennsylvania law or practice is in this area, so its hard to know whether there was anything unusual about what the owner did. Readers are encouraged to respond to or criticize this posting. 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