Constructive trusts and the construction loan.

• Author: Tesiero, Donald E., II

In the whitewater world of commercial lending, commercial construction loans can be the equivalent of class IV rapids. Because a construction project may involve many parties, progress payments may pass through several hands before reaching the entity that performed the work. If a general contractor or subcontractor files for bankruptcy while such funds are in transit, the funds may become part of the bankruptcy estate.(1) If, however, payment does reach the intended payee, but the party through which the funds passed files for bankruptcy protection within 90 days, the payment may be subject to disgorgement as a preferential transfer.(2)

An owner's lender has at least three reasons for concern if either of the above events occur. First, the lender wants to have the proceeds of a construction loan applied to actual construction costs to ensure that the lender receives its bargained-for collateral. If loan proceeds are not applied to the project, the loan to value ratio of the project will decrease. Second, there is a risk that the owner will have to pay twice for the same service: once if the bankrupt party applies the funds for another purpose, and a second time to the entity whose invoice still has not been satisfied. This hurts the lender by weakening the borrower's financial position and increasing the possibility of default. Third, if progress payments do not reach the intended party, that entity will likely file a lien on the project. Although the mortgage is usually superior to the lien, if the borrower does not pay the lienor or bond off the lien, the lender may have to foreclose the mortgage to extinguish the lien. Therefore, lenders should be aware of a weapon available to these otherwise unsecured creditors called the constructive trust remedy which may keep these payments out of a bankruptcy estate.

Elements of a Constructive Trust and How They Occur

Constructive trusts are established to prevent unjust enrichment of one party at the expense of another. Typically clear and convincing evidence of some variation of the following elements is needed to find a constructive trust: 1) a promise, express or implied; 2) a transfer of property and reliance thereon; 3) a confidential relationship; and 4) unjust enrichment.(3) Even though the property at issue was acquired without fraud, a constructive trust is employed when "it is against equity that it should be retained by him who holds it."(4)

There are three ways a constructive trust may occur in a bankruptcy setting. First, money may be paid or property transferred by mistake to the debtor. Second, a constructive trust may occur through wrongdoing, e.g., the debtor converts money or property belonging to another. Third, a statute may create a trust in favor of certain creditors.(5) Many states require general contractors who collect funds from an owner or lender to use those funds to pay subcontractors or vendors. The failure to do so can create a constructive trust.

Constructive Trusts in Bankruptcy

Constructive trusts, for all their advantages in righting cases of unjust enrichment, are not looked upon favorably by many bankruptcy courts. There are two reasons for this negative judicial view. First, a major underlying policy of the Bankruptcy Code is the even distribution of assets to creditors of the same class. A debtor or trustee who prevails over a constructive trust claimant will place recovered funds in the bankruptcy estate for pro rata distribution. In other words, if $50,000 is available for distribution to unsecured creditors with claims totaling $250,000, each unsecured creditor is entitled to 20 percent of the amount of his or her allowed claim...