Transfer of Funds By Debtor To Rightful Owner Did Not Create Preference Liability Under 11 U.S.C. § 547(b) Where Debtor Acquired Funds By Conversion
Claybrook v. Consolidated Foods, Inc. (In re Bake-Line Group, LLC), 359 B.R. 566 (Bankr D. Del. Feb. 5, 2007) (Judge Peter J. Walsh)
The debtor came into possession of a check made payable to the preference defendant when the postman mistakenly delivered the check to the debtor. The debtor converted the check, depositing it into the debtor’s bank account. The defendant learned of the debtor’s actions, and demanded and received from the debtor a check to cover the funds that the debtor had converted. Days later, the debtor commenced its bankruptcy case.
The plaintiff in this adversary proceeding, the trustee of the debtor’s estate, sued the defendant to recover the payment as a preferential transfer. The court granted summary judgment in favor of the defendant, finding that the debtor converted the funds, and never had any interest in them that it could transfer.
Consolidated thereafter learned what had happened, and requested and received from the debtor a check in the amount of the funds that the debtor wrongly deposited into its own account. Several days later, the debtor filed its bankruptcy petition.
The trustee of the debtor’s estate commenced a preference action against Consolidated to recover this reimbursement payment from the debtor to Consolidated. Consolidated then filed a motion for summary judgment.
The court granted the motion for summary judgment, finding that the trustee’s prima facie case failed for three reasons: (1) the transfer was not a transfer of an interest of the debtor in property because the debtor never had any interest in the money; (2) the transfer was not a transfer of an interest of the debtor in property because the debtor was holding the money in constructive trust for Consolidated while it was in the debtor’s bank account; and (3) Consolidated was not a creditor of the debtor, as contemplated by 11 U.S.C. § 547(b)(1).
The court held that, under Illinois state law, the debtor never acquired any equitable or legal interest in the funds. Therefore, they were not funds of the estate that would have been available for distribution to creditors. Accordingly, the trustee could not recover those funds in a preference action.
The court also found that the money was held in constructive trust by the debtor for Consolidated. Addressing an issue that is in controversy under Illinois law, the court found that a constructive trust came into existence when the debtor obtained possession of the funds, not, as the trustee urged, at such time as a judicial pronouncement was made that a constructive trust existed. Therefore, the funds went into constructive trust when the debtor deposited the funds into its own account. Accordingly, when the debtor transferred the funds to Consolidated, it was not transferring an interest of the debtor in property.
The trustee claimed that he could nonetheless recover the money under his strong arm power of section 544(a), arguing that a hypothetical creditor that obtained a judicial lien or an execution at the time of the petition date would have a right to the funds superior to Consolidated’s equitable interest. The court rejected this position, finding that Consolidated would have had superior rights to a hypothetical creditor who obtains a judicial lien or an execution. Because a constructive trust arose at the time that the debtor came into possession of the check, the constructive trust existed before any other hypothetical rights could have arisen.
Finally, the Court held that, independent of any of these other reasons, there could be no recovery because, under section 547(e)(3), no transfer could occur until the debtor has acquired rights in the property transferred. No matter how the debtor came into possession of the funds, it never had any rights in the check. The debtor merely converted the funds, and no rights in the funds could arise from conversion. For that same reason, the trustee’s strong arm powers could not defeat Consolidated’s title to the funds.
