Opinion
No. 99-2605, G/A Chapter 7.
March 31, 2000.
ORDER REVERZXNG BANKRUPTCY COURT AND GRANTING DEFENDANTS-APPELLANTS' MOTION FOR SUMMARY JUDGMENT
Before the court is an appeal by defendants J.C. Bradford Company and Bradford Co., Inc., (collectively "Bradford") from a judgment of the United States Bankruptcy Court for the Western District of Tennessee. The bankruptcy court entered judgment on February 26, 1999, in favor of plaintiff George Stevenson, trustee for the estate of debtor William Dunlap Cannon, III, (the "Trustee") and against Bradford for $1437,500, plus interest. The judgment was entered on the Trustee's claim to recover fraudulent conveyances pursuant to 11 U.S.C. § 548.
On February 23, 1996, the Trustee filed an eight-count complaint against Bradford. This appeal relates only to Count VIII, which seeks to recover fraudulent conveyances pursuant to 11 U.S.C. § 548. Count VIII was within the bankruptcy court's core jurisdiction pursuant to 28 U.S.C. § 157 (b) (2) (H). Counts I-VII of the Trustee's complaint, which are not at issue in this appeal, are claims brought by the Trustee, standing in the shoes of the debtor, for damages under statutory and common law theories that axe independent of the Bankruptcy Code. These claims were within the bankruptcy court's non-core jurisdiction pursuant to 28 U.S.C. § 157 (c)(1), which limits a bankruptcy court to submitting a proposed ruling to the district court for de novo review. Counts I-VII, and the banlcruptcy court's proposed ruling on them, are before the court in a separate case, no. 99-2400 G/V.
Cannon was a real estate attorney who practiced in the Memphis, Tennessee, area and averaged over 120 residential real estate closings per month. In connection with his practice, Cannon maintained two escrow bank accounts, one with United American Bank and the other with First Tennessee Bank, in which he deposited funds received from clients and mortgage lenders. His clients and their mortgage lenders gave these funds to Cannon to hold as an escrow agent until their real estate closings occurred, at which time Cannon was to disburse the funds to the appropriate party to complete the transaction.
Despite the escrow status of the accounts, in the mid-1980's Cannon began using funds from the accounts to finance his own personal business ventures. One business venture that Cannon financed with money from the escrow accounts was a commodity futures trading account that he maintained with Bradford. Cannon concealed his misappropriations for several years by using funds from pending real estate transactions to pay out on transactions that were already closing and by engaging in a check kiting scheme where he would cover one account's insufficiencies with checks from various other accounts that were also overdrawn.
In 1994, however, Cannon's elaborate scheme of misappropriation, paying for one transaction with funds from another, and check kiting unraveled. His business ventures had been unprofitable and by February 1994 the deficiencies in the escrow accounts totaled over 3.5 million. On February 25, 1994, Cannon filed a bankruptcy proceeding, and around that same time he voluntarily suspended his license to practice law. He was ultimately disbarred, and in June 1995 he pled guilty to criminal charges arising out of his misappropriation of funds from the escrow accounts.
During the year prior to his bankruptcy, which is the applicable time period for a fraudulent conveyance claim, Cannon wrote Bradford twenty checks from the escrow accounts totaling $1,137,500. Those payments were made to cover his margin calls and to continue trading commodities in hopes of recouping his losses. The Trustee's expert performed an analysis of the source of funds that were available in the escrow accounts to cover the checks Cannon wrote to Bradford in the year before his bankruptcy. That analysis revealed that the checks were paid out of a pool of deposits totaling $11,997,187. of this amount, $9,982,92B, or 83%, was traced directly to escrow deposits; $1,816,860, or 15%, was attributable to check kiting transactions; $67,390, or 0.6%, was traced to Cannon's personal funds, and the balance was from unidentified sources.
The Trustee moved the bankruptcy court for summary judgment on the fraudulent conveyance claim, alleging that the undisputed facts entitled the Trustee to recover the $11,997,187 that Cannon transferred to Bradford in the year before his bankruptcy. Bradford also moved the bankruptcy court for summary judgment on the fraudulent conveyance claim arguing, among other things, that Cannon did not have any ownership interest in the funds held in the escrow accounts, and, therefore, the funds transferred to Bradford from the escrow accounts were not subject to being recovered am part of Cannon's bankruptcy estate. The bankruptcy court granted in part and denied in part the Trustee's motion holding that the Trustee had established the other elements of his fraudulent conveyance claim but that an issue of fact still existed as to whether the transfers at issue were made by Cannon with the intent to hinder, delay, or defraud his creditors. (7/15/98 Bankr. Ct. Order at 2-3.) The bankruptcy court denied Bradford's motion in its entirety without addressing Bradford's argument regarding Cannon's lack of ownership interest in the funds in the escrow accounts. Id.
After a trial, the bankruptcy court found in favor of the Trustee on his fraudulent conveyance claim and referred to its earlier auxiliary judgment ruling as a determination that "the funds in Cannon's escrow accounts at United American Bank and First Tennessee Bank which were transferred to Bradford were property of the estate pursuant to 11 U.S.C. § 548." (2/22/99 Bankr. Mem. Op. at 88.) The bankruptcy court offered no further analysis regarding Bradford's argument that the funds in the escrow accounts were not subject to being included in Cannon's bankruptcy estate.
Bradford argues in this appeal that the Bankruptcy court erred in ruling that the funds transferred from the escrow accounts are recoverable as property of Cannon's bankruptcy estate. Bradford asserts that the funds transferred from the escrow accounts are the property of the clients and mortgage lenders for whose benefit Cannon was acting as an escrow agent. Therefore, Bradford contends that the Trustee, a representative of all Cannon's general creditors, lacks standing to recover these funds. Bradford argues that these funds may only be recovered by the clients and mortgage lenders for whose benefit Cannon was acting as an escrow agent. Bradford requests that this court reverse the bankruptcy court's summary judgment rulings in favor of the Trustee and grant summary judgment in favor of Bradford on the fraudulent conveyance claim.
The Trustee's fraudulent conveyance claim is based on 11 U.S.C. § 548 (a). This statute permits a Trustee under certain circumstances to "avoid any transfer of an interest of the debtor in property." 11 U.S.C. § 548 (a). The purpose of this statute is to prevent a debtor from protecting his property from creditors by transferring it shortly before filing for bankruptcy. "Of course, if the debtor transfers property that would not have been available for distribution to his creditors in a bankruptcy proceeding, the policy behind the avoidance power is not implicated."Begier v. I.R.S., 496 U.S. 53, 58 (1990) (discussing 11 U.S.C. § 547 (b), which like 11 U.S.C. § 548 (a) permits a trustee under certain circumstances to avoid transfers of "an interest of the debtor in property"). Thus, 11 U.S.C. § 548 (a) only applies to transfers of property that would have been part of a debtor's estate had it not been transferred before the commencement of bankruptcy proceedings. See id.: In Re Maple Mortgage. Inc., 81 F.3d 592, 595 (5th Cir. 1996).
Section 547 (b) permits a trustee to avoid "preferential" transfer and § 548 (a) permits a trustee to avoid "fraudulent transfers. Thus § 547 (b) prevents the debtor from favoring one creditor over others, while § 545 (a) prevents the debtor from eluding all creditors. Both provisions, however, are limited to avoiding transfers of "an interest of the debtor in property," and, thus, the Begier Court's analysis of this limitation in the context of § 547 (b) is equally applicable to § 548 (a). See e.g., In Re Maple Mortgage, Inc., 81 F.3d 592, 595 (5th Cir. 1996) (applying Begier in the context of a § 548 (a) action).
The Supreme Court has held that property a debtor holds in trust for another is not part of the debtor's bankruptcy estate, and the transfer of such property is not subject to a trustee's avoidance power under 11 U.S.C. § 548 (a). See Begier, 496 U.S. at 59, 67 (interpreting 11 U.S.C. § 541 (d)). See also In Re Omegas Group, Inc., 16 F.3d 1443, 1449 (6th Cir. 1994) (distinguishinq between a constructive trust and an express trust and stating that a bankruptcy trustee has no right to assets held by the debtor pursuant to an express trust). Thus, the relevant issue in this appeal becomes whether the funds Cannon transferred from the escrow accounts to Bradford were funds that Cannon held in an express trust for his clients, thereby making such funds unrecoverable by the Trustee.
Property rights in bankruptcy are determined by reference to state law. See In Re Omegas Group, Inc., 16 F.3d at 1450. Thus, Tennessee law controls whether the funds Cannon transferred from the escrow accounts to Bradford were funds that Cannon held in an express trust for his clients. To prove the existence of an express trust under Tennessee law, three elements must be established; "(1) a trustee who holds trust property and who is subject to the equitable duties to deal with it for the benefit of another, (2) a beneficiary to whom the trustee owes the equitable duties to deal with the trust property for his benefit, and (3) identifiable trust property." Kopombut-Myint Buddhist Ctr, v. State Bd. of Equaliztion, 728 S.W.2d 327, 333 (Tenn.Ct.App. 1986).
Neither party disputes that Tennessee law controls this issue.
The undisputed facts are that Cannon was a Tennessee real estate attorney and that the funds at issue cams from escrow accounts which Cannon set up to hold his clients' money pending real estate closings. As an attorney practicing law in Tennessee, Cannon owed a fiduciary duty to his clients to hold their money in a separate, clearly-identified escrow account and to disburse money from stich an account in accordance with his clients' directions and for their benefit. See Tenn. Sup. Ct. Rule 8 § DR 9-1027 Rule 9 § 29.1 (A) (1). At the time his clients provided funds to Cannon to be escrowed, both Cannon and his clients understood that the money in the escrow accounts did not belong to Cannon. (5/1/96 Cannon Dep. at 64-65.) Both Cannon and his clients also understood that he had no right to keep or use the money for any purpose other than funding his clients' real estate transactions. (10/30/97 Cannon Dep. at 11; 4/22/98 Cannon Aff. ¶ 4.) Cannon understood that he was a fiduciary with respect to these funds. Id.
Therefore, money in the escrow accounts, which were both clearly-labeled escrow accounts, was money that Cannon was holding in an express trust for his clients. See F.D.I.C. v. Knostman, 966 F.2d 1133, 1140 (7th Cir. 1992) (defining "escrow" and finding that whenever property is delivered in escrow, an express trust is created). This conclusion is bolstered by the court's findings in another case arising from Cannon's misappropriations. See Lawyers Title Ins. v. United Am. Bank, 21 F. Supp.2d 785, 790, 803 (W.D. Tenn. 1998) (finding that Cannon's escrow account with (United American Bank was clearly-identified as such and that the bank recognized the funds in the account were being held in trust for others when the bank refused to garnish the account stating that as an escrow account, the account was not subject to garnishment by Cannon's creditors). Therefore, the funds Cannon transferred from the escrow accounts to Bradford were funds in which Cannon held no equitable interest. Consequently, the Trustee cannot recover such funds for Cannon's bankruptcy estate. See Begier, 496 U.S. at 67; Maple Mortgage, 81 F.3d at 597.
The Trustee argues that this court should not reverse the bankruptcy court on the basis of an express trust theory because Bradford failed to argue this express trust theory to the bankruptcy court. Generally, an appellate court should not rule on issues not raised at the trial level.See In re Charfoos, 979 F.2d 390, 395 (6th Cir. 1992). The purpose of this rule is to prevent parties from being surprised on appeal by issues on which they have had no opportunity to introduce evidence. See id. In this case, however, Bradford did raise before the bankruptcy court the issue of Cannon's ownership interest in the funds transferred from the escrow accounts to Bradford. Instead of offering an express trust theory, Bradford argued before the bankruptcy court that escrow is a form of conditional delivery from a grantor to a grantee through an escrow agent, and that, as a result, Cannon, as an escrow agent, acquired no title to funds in the escrow accounts. The court finds that Bradford's shift in legal theories does not unfairly surprise the Trustee as both theories concern the issue of Cannon's ownership interest in the transferred funds and the same evidence is relevant to opposing either theory. The Trustee had a full opportunity to present evidence to the bankruptcy court relevant to the issue of Cannon's interest in the transferred funds.
Even assuming Bradford raised this issue for the first time on appeal, the principle that an appellate court should not rule on issues not raised at the trial level does not apply to the issue of whether a plaintiff has constitutional standing to bring a case. See Newsome v. Batavia Local Sch. Dist., 842 F.2d 920, 922 (6th Cir. 1988) (holding that the issue of a plaintiff's standing can be addressed for the first time by an appellate court). The court's determination that 3.1 U.S.C. § 548 (a) does not grant the Trustee the power to recover the funds at issue in this case requires a finding that the Trustee lacks standing to recover such funds. See Hirsch v. Arthur Anderson Co., 72 F.3d 1085, 1091-94 (2d Cir. 1995) (holding that a bankruptcy trustee's constitutional standing to bring a suit coincide with the scope of powers the Bankruptcy Code grants a trustee); E.F. Hutton Co., Inc. v. Hadley, 901 F.2d 979, 984-87 (11th Cir. 1990) (holding that a bankruptcy trustee does not have standing to recover money owed to particular creditors, rather than the bankruptcy estate).
The Trustee also argues that Bradford lacks standing to assert a defense based on a trust of which it is not the beneficiary. In support of this argument the Trustee cites In Re Advent Management, 178 B.R. 480, 487 n. 3 (B.A.P. 9th Cir. 1995), which questions whether allowing a fraudulent conveyance defendant to base its defense on a constructive trust of which it is not the beneficiary is compatible with the equitable nature of the constructive trust remedy. The present case, however, involves an express trust, which is not an equitable remedy. See In Re Omegas Group, Inc., 16 F.3d at 1449 (distinguishing between a constructive trust and an express trust and stating that a bankruptcy trustee has no right to assets held by the debtor pursuant to an express trust), In addition, Bradford's challenge to the Trustee's constitutional standing to bring this suit is not a defense to livability it is an issue of the court's jurisdiction to hear the matter. See Warth v. Seldin, 422 U.S. 490, 498 (1975) (finding that standing is a constitutional principle based on Article III's "case or controversy" requirement).
The Trustee next contends that Cannon had an interest in the funds at issue cognizable under 11. U.S.C. § 548 (a) because Cannon acquired the funds by fraud rather than theft. In a case involving a classic Ponsi scheme, the Sixth circuit held that the perpetrator of a fraud, versus a theft, obtains some interest in the fraudulently acquired property cognizable under 11 U.S.C. § 548 (a), such that a bankruptcy trustee can void the perpetrator's transfer of the property at issue. In Re Mark Benskin Co., Inc., 1995 WL 381741, at *6 (6th Cir. June 26, 1993). This holding, however, was dependent on the court's finding that an express trust was not created when investors gave the money at issue to the debtor, who was operating a Ponzi scheme. Id. at *7. The Sixth Circuit acknowledged that if an express crust had been created, the money at issue would be excluded from the bankruptcy estate and not recoverable by the trustee. Id. at *7. In contrast to Benskin, where investors had given money to the debtor for the purpose of discretionary investment in the stock market, in the present case clients gave money to Cannon, their lawyer, for the express purpose of shortterm holding as an escrow agent with no discretion in how to disburse the funds. As has already been discussed1 these circumstances created an express trust between Cannon and his clients. See In Re Newpower, 229 3.R. 691, 704-05 (W.D. Mich. 1999) (distinguishing Benskin and holding that an express trust exists when the funds at issue were given to the debtor for a specific purpose and the debtor was not given discretionary control over the funds).
In addition, the Trustee asserts that even if Cannon had no equitable interest in the 83% of relevant funds in the escrow accounts that were directly traceable to client escrow deposits, Cannon did have an interest in the 15% of funds attributable to check kiting transactions and the Less than 1% of funds that were traced to Cannon's deposits of his own money. The Trustee cites In Re Montgomery, 983 F.2d 1389 (6th Cir. 1993), for the proposition that funds generated by a debtor's check kiting scheme are property of the bankruptcy estate. The issue inMontgomery was whether illegally created credits in a bank account can constitute property of the account holder such that they can be included in the account holder's bankruptcy estate. The Sixth Circuit decided that if the debtor exercised sufficient control over the funds represented by the credits in his account, then they would be considered property of the bankruptcy estate. The Sixth Circuit specifically noted, however, that the case in front of it did not involve any contention that the credits at issue were generated in a trust fund account. Id. at 1393, 1396 (distinguishing the Supreme Court's holding in Begier that property held in trust is not property of the bankruptcy estate). In the present case, Cannon employed a check kiting scheme to illegally create credits in the escrow accounts so he could complete his clients' pending real estate transactions. Because these credit:, and the funds represented by them were generated in accounts that Cannon held in express trust for his clients, Cannon gained no equitable interest in them and they are not recoverable as part of his bankruptcy estate. See Begier, 496 U.S. at 59.
Regarding the less than 1% of relevant funds in the escrow accounts that were traced to Cannon's deposits of his own money, the uncontradicted evidence is that Cannon made these deposits to pay back funds he had taken from the accounts. (10/30/97 Cannon Dep. at 61.) When a trustee makes deposits of his own money in a trust account as restitution for previously misappropriated funds, those deposits become trust funds and are no longer property of the trustee. See Goldberg v. New Jersey Lawyers' Fund, 932 F.2d 273, 280 (3rd Cir. 1991) (holding that whatever money an attorney added to an attorney trust account to compensate for what he had misappropriated became part of the account and was not part of the attorney's bankruptcy estate); In Re California Trade Technical Schs., Inc., 923 F.2d 641, 646 (9th Cir. 1991).
The Trustee asserts that the "lowest intermediate balance test" adopted by the Sixth Circuit in First Federal of Michigan v. Barrow, 878 F.2d 912, 916 (6th Cir. 1989), contradicts the rule announced in Goldgerg andCalifornia Trade. The lowest intermediate balance test, however, only applies when a debtor has deposited funds that he holds in trust for another in his general bank account, rather than in a trust account. See Barrow 878 F.2d at 916. Furthermore, the court in Barrow was addressing the issue of whether certain investors could impose a constructive trust on money they gave the debtor, such that the money could be removed from the bankruptcy estate. The present case, as previously noted, involves an express trust and is distinguishable from cases where creditors attempt to remove property from the bankruptcy estate by imposing a constructive trust. See In Re Omegas Group, Inc., 16 F.3d at 1449 (6th Cir. 1994).
For all these reasons, the bankruptcy court's summary judgment rulings in favor of the Trustee are REVERSED and summary judgment is GRANTED in favor of Bradford on the fraudulent conveyance claim.
IT IS SO ORDERED.