Opinion
Case No. 01-14020 (ALG), Adv. Proc. No. 01-2980
December 20, 2002
Attorneys for Plaintiff PLASMANET, INC., PHILIPPE ADLER, ESQ., FREIDMAN KAPLAN SEILER ADELMAN LLP, New York, N.Y.
Attorneys for Debtor and Defendants PHASE2MIEDIA, INC., SCOTT B. FISHER, ESQ., HAROLD D. JONES, ESQ., JASPAN SCHLESINGER HOFFMANN, LLP, Garden City, N.Y.
Attorneys for the Official Creditors Committee, A. PETER LUBITZ, ESQ., KATTEN, MUCHIN, ZAVIS, ROSENMAN, New York, NY, PAUL SCHWARTZBERG, ESQ., OFFICE OF THE UNITED STATES TRUSTEE, New York, N.Y.
Attorneys for Secured Creditor VECTOR CAPITAL II, L.P., AARON R. CAHN, ESQ., CARTER, LEDYARD MILBURN, New York, N.Y.
MEMORANDUM OF DECISION
PlasmaNet Inc. ("PlasmaNet", "Plantiff") seeks to impose a constructive trust over funds collected by the Debtor, Phase2Media, Inc. (the "Debtor"), for advertising posted on PlasmaNet's website. It relies on a clause in its contract with the Debtor, prohibiting the Debtor from commingling PlasmaNet's "funds with its own" and declaring that the Debtor "is not the beneficial owner of the advertising payments beyond its 30% (thirty percent) fee." PlasmaNet has moved for partial summary judgment in an adversary proceeding brought against the Debtor declaring that the Debtor has no beneficial interest in such funds.
Plaintiff seeks: (i) $520,099, from a segregated account the Debtor established under a post-petition stipulation on August 27, 2001; (ii) $135,352, from the Debtor-s other accounts representing the amount allegedly traceable into those accounts under constructive trust tracing principles; plus (iii) $307,735.00, equal to 70% of additional funds the Debtor received on PlasmaNet's behalf prior to August 1, 2001, and allegedly converted.
The Debtor has opposed the motion and has cross-moved for summary judgment against PlasmaNet, arguing that Plaintiff holds only a general unsecured claim. The Debtor has also filed a counterclaim alleging that PlasmaNet, in violation of the parties' contract, collected and is withholding commissions for sales that the Debtor arranged, but it has not moved for summary judgment on this claim. The Creditors Committee and a secured creditor, Vector Capital II, have filed memoranda in opposition to Plaintiff's motion arguing, generally, that Plaintiff is attempting to create a priority claim for itself without justification, to the prejudice of other creditors.
PlasmaNet is the only remaining creditor of the Debtor pursuing a constructive trust claim. MaximNet, Inc., and Hachette-Filipacchi Media U.S., Inc., other clients of the Debtor, initially brought adversary proceedings seeking to impose constructive trusts for their respective benefit on funds collected by the Debtor from advertisers on their websites, but they have since settled their claims with the Debtor. PlasmaNet appeared in opposition to the effort of Hachette to assert a constructive trust claim, principally on the ground that Hachette's contracts with the Debtor did not prohibit the commingling of funds.
For the reasons set forth below, Plaintiff's motion for summary judgment is denied, and the Debtor-s motion for judgment on the constructive trust claim is granted.
FACTS
The material facts are not in dispute and appear from the comprehensive affidavits and supporting documents submitted by the parties. The Debtor was an Internet advertising sales and marketing company that sold advertising inventory on the websites of branded web publishers, including the PlasmaNet website. Before it filed for bankruptcy and ceased doing business, the Debtor entered into agreements to sell advertising space on more than 60 websites, and it developed marketing and advertising strategies, based on each client's needs, that were targeted to attract visitors to the sites. It also possessed software to calculate the number of `hits' on the websites and thus the amount payable by the buyer of the advertising space. Most of the Debtor-s revenue came from commissions received for its Internet advertising sales.
PlasmaNet is the creator of an Internet sweepstakes game accessible at its website, freelotto.com, and the owner and operator of freelotto.com and Lottonet.com. In April 1999 and again in March 2000, PlasmaNet and the Debtor entered into advertising agreements under which PlasmaNet hired the Debtor, on an exclusive basis, to solicit and sell advertising on its websites, and in the case of the later agreement, on PlasmaNet's Click2win email newsletters. Both agreements provided that the Debtor would sell advertising for PlasmaNet and be responsible for invoicing, collecting and accounting for all amounts owed for the advertisements. Under both agreements, the Debtor was generally required to invoice and collect payments on a monthly basis.
PlasmaNet argues that the second agreement superceded the first, and the Debtor contends that the second agreement was a mere continuation of the first. It is unnecessary to resolve this issue, as the two agreements are substantially similar concerning the collection of proceeds and the requirement to segregate funds.
The April 1999 agreement provided that the parties were to establish a lockbox in PlasmaNet's name at PlasmaNet's bank, Republic Bank of New York, to which all payments by advertisers were to be made. Republic Bank was to send a notice to both the Debtor and PlasmaNet within 72 hours of receipt of a payment and then pay 30% to the Debtor, as commissions, and the remaining 70% to PlasmaNet. Apparently, however, such a lockbox was never created. When the parties again contracted for the exchange of services, in March 2000, they again provided for payment to the same type of lockbox; however, under the second agreement, the lockbox was to be created only upon PlasmaNet-s election, upon twenty (20) days written notice. The Debtor contends that PlasmaNet requested the creation of a lockbox account on only one occasion, in August of 2000, to which request the Debtor agreed. (Nachmias Aff ¶¶ 26-27.) The Debtor alleges that following that agreement, PlasmaNet made no effort to establish the lockbox account until December of 2000, at which point the parties were informed that governing banking regulations barred a distribution of funds deposited into a lockbox to two separate entities. ( Id. at 28.) PlasmaNet contends that it made repeated efforts over the course of the contract term to induce the Debtor to establish a lockbox, that the Debtor continued to drag its feet, and that this state of affairs continued until February 2001, when the Debtor terminated the contract for PlasmaNet's alleged default. In any event, a lockbox account was never created, and the Debtor was evidently in default as to this contractual requirement.
PlasmaNet also contends that the Debtor was continually in default for failing or refusing to pay over amounts received from advertisers, and that it was the Debtor's practice to withhold payments and make them only when compelled by the force of Plaintiffs remonstrances and demands for the creation of a lockbox. In July 2000, for example, according to the affidavit of PlasmaNet's general counsel, Edward Curtin, the Debtor was in default of paying hundreds of thousands of dollars to PlasmaNet and was, in PlasmaNet's view, tardy in collecting fees from the advertisers. In order to rectify these problems, the parties entered into a letter agreement, dated August 2, 2000, in which they modified the March 2000 Agreement and provided as follows: (i) PlasmaNet acknowledged receipt of the Debtor's payment of $400,000 "on account of a portion of all amounts payable to us by advertisers which are outstanding more than sixty (60) days"; (ii) with respect to June 2000 and later invoices, it was agreed that the Debtor would pay PlasmaNet "all amounts due us within sixty days of the invoice date, subject to a 10% holdback for bad debts", provided that if an invoice were paid within the 60-day period, "[PlasmaNet's] portion will be remitted immediately"; (iii) the Debtor agreed, upon PlasmaNet's request, and subject to the approval of Fleet Bank, to "cooperate in establishing a lockbox account at Fleet Bank, and to direct all advertisers to make their remittances directly to said account"; and (iv) the Debtor agreed to sign a UCC Form-1 to evidence, in PlasmaNet's words, "our 70% ownership interest in the receivables from our advertisers, in the form annexed to the letter agreement." According to the affidavit of PlasmaNet's general counsel, "Given the substantial payment [the Debtor] had now made, and the insurance policy represented by this expected change in the payment terms under the Agreement, PlasmaNet's need for a lockbox account diminished." (Curtin Aff. ¶ 11.)
Although there is an indication in the record that this UCC Form-1 was signed by the Debtor, the record does not contain a copy of the Form, and PlasmaNet does not rely on it in connection with its motion for summary judgment or contend that it has the rights of a secured creditor with a perfected security interest in the Debtor's property.
In addition to the provisions for the creation of a lockbox account, the agreements between PlasmaNet and the Debtor specifically prohibited the Debtor from commingling "PlasmaNet's funds" from sales of advertisements on PlasmaNet websites with its "own" funds. Both the April, 1999 and the March 2000 agreements provided:
"Notwithstanding anything to the contrary, the Representative [Debtor] shall not commingle the Client's [PlasmaNet's] funds with its own and the Representative [Debtor] hereby agrees that it is not the beneficial owner of any of the proceeds of the Advertising payments beyond its 30% (thirty percent) fee." (April 1999 Agreement at 6; March 2000 Agreement at 5.)
Despite this specific prohibition, over the course of two years, the Debtor collected payments from the advertisers on PlasmaNet-s website, deposited the collected funds into its own general account, and then from time to time remitted the funds, minus commissions, to PlasmaNet. (Nachmias Aff. ¶¶ 8-10.) The Debtor alleges that PlasmaNet was aware of this arrangement, as evidenced by its endorsement and deposit of the checks marked as having come from the Debtor-s general operating accounts at U.S. Trust Company and, later, at Fleet Bank. (Nachmias Aff. ¶¶ 14-17, 22-25.) PlasmaNet's chief financial officer has submitted an affidavit, claiming it "did not know and did not believe it was responsible for knowing whether the Debtor was in fact segregating the appropriate funds". ( See PlasmaNet Memo at 6, n. 4.) But PlasmaNet did know, as detailed in the affidavit submitted by its general counsel, of the Debtor's continued defaults under the Agreement, in its refusal or failure to set up a lockbox, and of the resolution fashioned in August 2000 whereby the Debtor committed, among other things, to pay all amounts billed to advertisers no later than 60 days of invoice whether or not collected, subject to a bad debt reserve, and to pay over immediately all amounts received from advertisers within the 60-day period.
According to the Debtor the total amount remitted to PlasmaNet over the course of two years was very substantial, exceeding over $23,000,000. (Nachmias Aff. ¶ 45.) Nevertheless, PlasmaNet continued to dispute the timeliness of the Debtor's remission of funds and by November 2000, according to Curtin, the Debtor "had again fallen hundreds of thousands of dollars behind in remittances to PlasmaNet, this time claiming that it had the right to hold back remittances because of PlasmaNet's supposed breaches of the Agreement." (Curtin Aff. ¶ 13.) These alleged breaches involved the defaults of PlasmaNet, or its affiliates, when they entered into direct agreements with advertisers in breach of the exclusivity provisions of the March 2000 Agreement. In response to PlasmaNet's pressure, the Debtor remitted $869,677 to PlasmaNet in December 2000, but relations deteriorated to the extent that by letter dated February 13, 2001 the Debtor sent PlasmaNet a notice terminating the Agreement, alleging that PlasmaNet had breached the exclusivity provisions of the contract. PlasmaNet claims this notice was sent within days of the Debtor's final promise to open a lockbox account, and that after termination of the contract the parties did not further discuss the establishment of a lockbox.
Subsequent to the termination of the contract, the Debtor continued to collect funds on advertisements previously sold on PlasmaNet's websites. On July 18, 2001 the Debtor filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code (the "Code"). At an early date, PlasmaNet acted to protect its claimed interest in funds held and collected by the Debtor, asserting the rights of a constructive trust beneficiary. On August 27, 2001 this Court "so ordered" a stipulation between the Debtor and PlasmaNet which established a segregated account (the "PlasmaNet Segregated Account"). The Debtor agreed to deposit therein an initial $400,000 plus 70% of all advertising payments received after August 1, 2001, from former advertisers on PlasmaNet's websites, without prejudice. The stipulation expressly provided that it was not to be construed as an admission of liability on the part of either party. (Order Aug. 27, 2001 4.)
The stipulation also provided for the establishment of a Phase2Media account (the "Phase2Media Account"), into which PlasmaNet was required to deposit, without prejudice, 30% of all proceeds received directly from accounts that were acquired as a result of Phase2Media's sales efforts. This obligation related to the Debtor's claim that PlasmaNet owed it roughly $100,000 in unauthorized collections by PlasmaNet from advertisers that were introduced by the Debtor, as well as other amounts relating to adjustments in the minimum commission price. (Nachmias Aff 29.)
DISCUSSION
Standards for Summary Judgment
In a motion for Summary Judgment pursuant to Rule 56 of the Federal Rules of Civil Procedure, made applicable to this adversary proceeding by Bankruptcy Rule 7056, a movant is entitled to relief if it can show that there is no genuine issue as to any material fact at issue in the matter. Lujan v. National Wildlife Federation, 497 U.S. 871, 885 (1990). A movant has the burden to show that "there is an absence of evidence to support the nonmoving party's case." Celotex Corp. v. Catrett, 477 U.S. 317, 325 (1986). In opposing the motion, the nonmoving party "must do more than simply show that there is some metaphysical doubt as to the material facts." Matsushita Electric Industrial Co. v. Zenith Radio Corp., 475 U.S. 574, 586-87 (1986). The nonmoving party "must set forth specific facts showing that there is a genuine issue for trial," indicating those that a reasonable trier of fact could find in its favor. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). In a motion for summary judgment, the inquiry should be whether there are "any genuine factual issues that properly can be resolved only by a finder of fact because they may reasonably be resolved in favor of either party." Id. at 250. The Court is to accept the allegations of the parties without making any judgment as to credibility or giving consideration to the weight of evidence, as those are essentially functions of the fact finder. Id. at 255. "The evidence of the non-movant is to be believed and all justifiable inferences are to be drawn in his favor." Id.
In the present case, the material facts on the constructive trust issue are not contested. For its right to impose a trust over the funds the Debtor collected on its accounts, PlasmaNet relies on the language of its Agreements with the Debtor that provided that the Debtor would not "commingle [PlasmaNet's] funds with its own" and that the Debtor was not "the beneficial owner of any of the proceeds of the Advertising payments beyond its 30% (thirty percent) fee." The Debtor does not dispute the existence of these contractual provisions. With respect to the commingling of funds, PlasmaNet also contends that the Debtor wrongfully, over an extended period of time, failed to set up a lockbox account, despite the contract requirements. The Court will assume that the Debtor's commingling and failure to set up a separate account were willful and constituted a material breach of contract, but this assumption, for the reasons stated below, does not entitle PlasmaNet to summary judgment or defeat the Debtor's cross motion on the constructive trust issue. The Debtor contends that PlasmaNet knew or "must have known" about the commingling of funds, and certainly PlasmaNet made constant demands that a lockbox be established to receive all of the payments from the advertisers. As will appear hereafter, however, PlasmaNet makes no claim that the Debtor lied to it about the commingling of funds, and it is not a necessary predicate to a resolution of these motions in favor of the Debtor that PlasmaNet knew specifically that the Debtor was commingling funds.
Basic Principles of Constructive Trust Law
The basic legal principles applicable to the creation of a constructive trust over property are well established. Under New York law, which both parties agree is applicable, a constructive trust arises against a person who, by fraud (actual or constructive), duress, abuse of confidence or any other form of unconscionable conduct, obtains or holds the legal right to property which in equity and in good conscience he ought not to hold. See Simonds v. Simonds, 45 N.Y.2d 233, 408 N.Y.S.2d 359, 380 N.E.2d 189 (1978); Equity Corp. v. Groves, 294 N.Y. 8, 60 N.E.2d 19 (1945). As stated in `160 of the Restatement of Restitution, a constructive trust should be imposed:
Both the Debtor and PlasmaNet are located in New York and the March 2000 Agreement is governed by New York law. The existence of a constructive trust and other issues as to right to property and property interests are covered, in a bankruptcy case, by applicable state law. See Butner v. United States, 440 U.S. 48, 54-55, 99 S.Ct. 914, 918 (1979)("[C]ongress has generally left the determination of property rights in the assets of a bankrupt's estate to state law."); see also In re Koreag, 961 F.2d 341, 352 (2d Cir. 1992) (where the Court looked to state law in determining whether a constructive trust existed).
"Where a person holding title to property is subject to an equitable duty to convey it to another on the ground that he would be unjustly enriched if he were permitted to retain it." RESTATEMENT (FIRST) OF RESTITUTION' 160, CONSTRUCTIVE TRUST.
The New York Court of Appeals has declared, "A constructive trust is the formula through which the conscience of equity finds expression. When property has been acquired in such circumstances that the holder of the legal title may not in good conscience retain the beneficial interest, equity converts him into a trustee." Simonds, 45 N.Y.2d at 241, 408 N.Y.S.2d at 363, 380 N.E.2d at 193.
Constructive trust principles apply in bankruptcy, and property that the debtor holds in trust for another entity does not form part of its estate and is not held for the benefit of its creditors. Section 541(b) of the Code excludes from the definition of property of the estate "any power that the debtor may exercise solely for the benefit of an entity other than the debtor", and this includes property held in constructive trust for the benefit of another. United States v. Whiting Pools, Inc., 462 U.S. 198, 205 n. 10, 103 S.Ct. 2309, 2314 n. 10 (1983). As the Second Circuit has stated in two cases involving the application of constructive trust principles in bankruptcy, a constructive trust "confers on the true owner of the property an equitable interest in the property superior to the trustee's." In re Koreag, Controle et Revision, S.A. v. Refco F/X Assoc., Inc. (In re Koreag), 961 F.2d 341, 352 (1992), quoting Sanyo Electric, Inc. v. Howards Appliance Corp. (In re Howards Appliance Corp.), 874 F.2d 88, 93 (2d Cir. 1989), quoting in turn In re General Coffee Corp., 828 F.2d 699, 706 (11th Cir. 1987).
Koreag and Howard's Appliance also establish, for purposes of this case, the following principles. First, the requirements for establishing a constructive trust in a bankruptcy case are, prima facie, the same as in any other case. Koreag sets forth the basic principles as follows: "a party claiming entitlement to a constructive trust 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." Koreag, 961 F.2d at 352, citing Bankers Sec. Life Ins. Soc. v. Shakerdge, 49 N.Y.2d 939, 406 N.E.2d 440, 428 N.Y.S.2d 623 (1980). Second, these requirements are to be applied flexibly. As the Court stated in Koreag, 961 F.2d at 352-53, quoting Simonds, 45 N.Y.2d at 241, although the foregoing "factors provide important guideposts, the constructive trust doctrine is equitable in nature and should not be `rigidiy limited.'" Third, even the absence of one of the four factors listed above will not prevent the court from imposing a constructive trust in an appropriate case. In Koreag, the Court found, in dictum, that a constructive trust would likely be established under the facts of the matter even though the plaintiff had not established a "confidential or fiduciary relationship" between the parties. See also, Counihan v. Allstate Insurance Co., 194 F.3d 357, 361 (2d Cir. 1999) (constructive trust established in non-bankruptcy case despite lack of a fiduciary relationship between plaintiff and defendant).
Nevertheless, as will be further discussed below, in bankruptcy cases, these general principles must take account of the fact that many unpaid creditors can credibly assert that the Debtor has been "unjustly enriched" by being able to retain "its" property without payment.
In bankruptcy cases like this one, the contest is not between a party seeking to retain property and a party wronged, but among equally innocent creditors of the wrongdoer. See Pan Am. World Airways, Inc. v. Shulman Transport Enters., Inc. (In re Shulman Transport Enters., Inc.), 744 F.2d 293 (2d Cir. 1984); Cherno v. Dutch Am. Mercantile Corp. (In re Itemlab, Inc.), 353 F.2d 147. 154 (2d Cir. 1965).
With these principles in mind, the Court will consider, in light of the facts of this case, the two principal factors which are at issue—whether there was a fiduciary relationship between the parties and whether there was unjust enrichment.
The Existence of a Confidential or Fiduciary Relationship
The first element that is usually, but not invariably necessary where a party seeks to establish the existence of a constructive trust is the existence of a confidential or fiduciary relationship. The existence of such a relationship "triggers the equitable considerations leading to the imposition of a constructive trust." Brand v. Brand, 811 F.2d 74, 78 (2d Cir. 1987), citing Sharp v. Kosmalski, 40 N.Y.2d 119, 121, 351 N.E.2d 721, 723, 386 N.Y.S.2d 72, 75 (1976). PlasmaNet argues that the Debtor was its fiduciary, in that the Debtor was an agent entrusted to hold funds for PlasmaNet and, specifically, was barred from commingling these funds with its own. See In re Morales Travel Agency, 667 F.2d 1069, 1071 (1st Cir. 1981); see also In re Ames Dept. Stores, Inc., 274 B.R. 600, 619, 621 (Bankr. S.D.N.Y. 2002); In re Black Geddes, 35 B.R. 830, 837 (Bankr. S.D.N.Y. 1984); Restatement of Agency' 1(1) (1958).
It is "a firmly established principle that if a recipient of funds is not prohibited from using them as his own and commingling them with his own monies, a debtor-creditor, not a trust relationship exists." Koreag, 961 F.2d at 353, quoting In re Black Geddes, Inc., 35 B.R. at 836. The converse, however, is not established. In In re Morales Travel Agency, 667 F.2d at 1073, discussed below, the Court specifically left open the question whether a provision requiring the segregation of funds, whether met or not, would by itself create a constructive trust for bankruptcy purposes. PlasmaNet has not cited any case for the proposition that a prohibition against commingling inserted in a contract will, ipso facto, result in a trust relationship between the parties or justify the creation of a constructive trust over the relevant funds. In any event, it is clear that the language used in a contract is not determinative of the relationship between the parties for purposes of concluding whether a constructive trust should be established. See In re Shulman Transport Enters., Inc., 744 F.2d at 295; In re Morales Travel Agency, 667 F.2d at 1071. The relationship between the parties arises from the "real character" of their interaction, "rather than by the form the parties have given it." In re Ames, 274 B.R. at 615. It is of particular importance in bankruptcy cases that "substance not give way to form" in determining whether a contractual relationship creates duties in the nature of a trust, as "the relative rights of a bankrupt's creditors are at issue." Shulman, 744 F.2d at 295; see also Ames, 274 B.R. at 615.
In Shulman, the Second Circuit weighed the rights of a secured creditor, Continental Bank, against those of an air carrier, Pan American World Airways ("Pan Am"), in determining their respective rights to the assets of the debtor, Shulman Air Freight. Shulman, a freight forwarder, arranged for the transport of its clients: materials in carriers such as Pan Am and received commissions out of its charges to the shipper. Pan Am contended that it had a constructive trust over the proceeds Shulman received from shippers, relying on a clause in Shulman's contract with its carriers that termed Shulman their "agent." The Second Circuit found that the word "agent" was insufficient to establish the existence of a trust or agency relationship. "A debtor does not become the agent of his creditor simply because he is called an agent," the Court held, finding that Pan Am's lack of control over Shulman's use of the monies, the absence of any provision requiring Shulman to segregate Pan Am's funds, and the "apparent lack of concern on the part of the carriers about how Schulman handled the monies it collected," indicated that the parties were not in an agency relationship. Shulman, 744 F.2d at 295.
The Shulman court relied on a decision of the First Circuit, In re Morales Travel Agency, 667 F.2d at 1071, which held that funds collected by a travel agent from airline ticket sales were not held in trust for the airline, even though the relevant agreement expressly provided that all ticket proceeds were property of the airline. As in Shulman, the Morales court rejected the argument that the contracts terms were dispositive and instead found that the daily dealings between the parties, including the travel agent's practice of turning over the proceeds at regular intervals and not upon demand, indicated a debtor-creditor relationship. Id. at 1072. "If a ritualistic incantation of trust language were deemed conclusive, it would be a simple matter for one creditor, at the expense of others, to circumvent the rules pertaining to the creation of bona fide security interests." Id.
The Ames case drew on Shulman and Morales to find that proceeds collected by the debtor, a retailer, from the sale of Baker shoes in its stores were not held in constructive trust. The contract between the parties provided:
"[a]ll proceeds from the sale of merchandise of Baker to customers . . . shall be the property of Baker from the time of such sale, that Ames shall act as Baker-s agent in the collection and holding of such proceeds, and that Ames shall hold such proceeds in trust for Baker until such time as they are paid over to Baker."
474 B.R. at 608. Notwithstanding these requirements, Ames collected the Baker sales proceeds and commingled them with proceeds from other accounts and used them in an unrestricted manner. The Ames court determined that there was no trust or agency relationship between the parties, contrary to the language of the contract, in that: 1) Ames commingled the sales proceeds; 2) the funds were kept in an account available to Ames's secured creditors; 3) Ames's payments in respect of the shoes came from its general funds account, and thus were not traceable; and (4) under New York law, a fiduciary relationship does not exist where the parties "were acting and contracting at aims-length to a business transaction." Ames, 274 B.R. at 626.
The Debtor as the so-called "Representative" of its "Client" acted in many respects in an agency relationship with PlasmaNet. As an Internet advertising sales and marketing company, the Debtor was an intermediary between the advertisers and its clients, such as PlasmaNet, and had two primary roles: 1) to market and sell advertising space for its clients and 2) to provide an invoicing, collection, and management service for its sales. It solicited business for the client, collected funds, turned over certain funds to the client, and had certain duties toward the client. But a close examination of the record establishes that the relationship that actually existed between the Debtor and PlasmaNet is more appropriately characterized as one of debtor and creditor.
The Debtor was never forbidden to handle the collections from advertisers, notwithstanding the prohibition in the agreements against the "commingling of funds." With respect to commingling, the agreement provided that the Debtor would not `commingle Clients' [PlasmaNet's] funds with its own," and that the Debtor was not "the beneficial owner" of the 70 percent of the advertising payments destined for the client. This gave the Debtor temporary control over all the proceeds from the advertisers, prior to segregating the 70 percent due to PlasmaNet, and at no time did the contract provide PlasmaNet with control over all of the funds received from the advertisers. This would have resulted if a lockbox had been established, but that never took place. A debtor's right to control funds, even briefly, is often significant in determining whether they are protected from other creditors' claims or should be considered property of the estate. Coral Petroleum, Inc. v. Banque Paribas-London, 797 F.2d 1351, 1358 (5th Cir. 1986), reh'g denied, 801 F.2d 393 (5th Cir. 1986).
In any event, whatever the prior relationship of the parties, the August 2, 2000 modification to the March 2000 Agreement largely rendered the "no commingling" and "agency" language of the contract a nullity. By that time PlasmaNet was dissatisfied with the Debtor's collection efforts, and it required the Debtor to pay over PlasmaNet's 70 percent of amounts due from advertisers within 60 days of the invoice date, subject to a 10% holdback for bad debts, whether or not the underlying amount had been collected from the advertisers. In its papers, PlasmaNet calls this provision an "insurance policy" that lessened its need for a lockbox account. It also establishes the debtor-creditor nature of the parties' relationship, as the Debtor was personally liable to make payments to PlasmaNet, whether or not it collected funds from the advertisers. The August 2 modification also provided that if an advertiser paid an invoice within the 60-day period, PlasmaNet's portion "will be remitted immediately." As a practical matter, this provision cancelled out the contractual clause regarding segregation of funds, as PlasmaNet's duty was to pay over funds "immediately."
As part of the "insurance policy" represented by the August 2, 2000 letter agreement, PlasmaNet also required the Debtor to sign a UCC-1, presumably in order to give PlasmaNet a security interest in the receivables to be collected from the advertisers. It also again insisted on the establishment of a lockbox. If all of the requirements for a valid security interest had been complied with, and a lockbox had been created, PlasmaNet would presumably have protected itself, by means of a valid security interest in the receivables and in the collections from the advertisers. PlasmaNet did not take these steps, but its efforts to establish itself as a secured creditor are a further indication that it was not the beneficiary of a trust relationship. A beneficiary of a trust does not need to and does not seek to establish a lockbox or a lien on its trustee's property.
See N.Y. EST. POWERS TRUSTS LAW § 7-2.1(a), "Except as otherwise provided in this article, an express trust vests in the trustee the legal estate, subject only to the execution of the trust, and . . ."; see also SCOTT FRATCHER, THE LAW OF TRUSTS (SCOTT ON TRUSTS), § 128, pg. 338 (4th ed. 1987), "Where a trust is created, the extent of the interest of the beneficiaries depends on the manifestation of intention of the settlor."
"The essential feature of a fiduciary relationship is reliance by one party on the integrity or discretion of another . . . a fiduciary duty generally does not arise out of a contractual relationship between parties where the duties of the parties are dictated by the terms of a contract." Mia Shoes Inc. v. Republic Factors Corp., 1997 WL 525401, No. 96 Civ 7974 (TPG), at *2 (S.D.N.Y. Aug. 21, 1997). There is no indication that PlasmaNet reposed special trust or confidence in the Debtor and allowed it thereby to gain a position of superiority or influence. See Litton Indus. Inc. v. Lehman Bros. Kuhn Loeb Inc., 767 F. Supp, 1220, 1231 (S.D.N.Y. 1991), rev'd on other grounds, 967 F.2d 742 (2d Cir. 1992). PlasmaNet has never alleged that the parties were not comparable in sophistication and did not have comparable bargaining power and ability to contract to their mutual benefit. The transactions were essentially arms-length commercial transactions, and PlasmaNet cannot claim to need the special protection of a court of equity. See In re United Cigar Stores Co. of America, 70 F.2d 313, 315 (2d Cir. 1934); see also Ames, 274 B.R. at 627; In re Braniff Int'l Airlines, Inc., 164 B.R. 820, 825, 827 (Bankr. E.D.N.Y. 1994); In re Drexel Burnham Lambert Group, Inc., et al, 142 B.R. 633 (Bankr. S.D.N.Y. 1992).
As noted above, the absence of a trust or fiduciary relationship is not necessarily fatal to an entity's claim that the debtor must hold property in constructive trust. See Koreag, 961 F.2d at 353-54, citing E.W. Lines v. Bank of Am. Nat'l Trust Sav. Ass'n, 743 F. Supp. 176, 179-80 (S.D.N.Y. 1990); Republic of Philippines v. Marcos, 806 F.2d 344, 355 (2d Cir. 1986), cert. denied, 480 U.S. 942, 107 S.Ct. 1597 (1987). Nevertheless, the fact that the parties had equal bargaining power and were engaged in a commercial contractual relationship that, especially after the August 2, 2000 letter agreement, put them in the position of debtor and creditor; that the putative beneficiary did not rest on its status as such but took steps to protect itself by demanding a security interest in the form of a lockbox and a lien over receivables — all of these factors are relevant in arriving at a final determination as to the claim of PlasmaNet to a constructive trust over the funds at issue.
Debtor argues that PlasmaNet was aware of the Debtor-s commingling, by its receipt of disbursements from the Debtor-s general account and the parties' failure to open a lockbox account, which at least after the second agreement PlasmaNet was required to initiate. As noted above, this decision assumes PlasmaNet did not know and took no action to find out whether the Debtor was commingling funds. PlasmaNet argues that the existence of an anti-waiver clause in its agreement preserves its right to claim that it did not have any actual knowledge of the commingling. This argument, in any event, misses the point; it is not what the contract says, but what the parties do that will determine the existence of a fiduciary relationship in a bankruptcy case.
Unjust Enrichment
The single most important factor to a finding that a constructive trust exists is unjust enrichment. The New York courts mandate "a showing that property is held under circumstances that render unconscionable and inequitable the continued holding of the property and that the remedy is essential to prevent unjust enrichment." Counihan, 194 F.3d at 361-62; see also Ames, 274 B.R. at 626. The party against whom the constructive trust is sought need not have performed a wrongful or unconscionable act. Koreag, 961 F.2d at 354; Tekinsight.Com, Inc. v. Stylesite Marketing, Inc. (In re Stylesite Marketing, Inc.), 253 B.R. 503, 508-09 (Bankr. S.D.N.Y. 2000). It is necessary, however, that the property be held by the party "under such circumstances that in equity and good conscience he ought not retain it." In re Koreag, 961 F.2d at 354; Miller v. Schloss, 218 N.Y. 400, 113 N.E. 337, 339 (1916); Stylesite, 253 B.R. at 508-09. "Unjust enrichment results when a person retains a benefit which, under the circumstances of the transfer and considering the relationship of the parties, it would be inequitable to retain." Counihan, 194 F.3d at 361-62.
In a bankruptcy case, in considering whether equity demands the creation of a constructive trust to prevent unjust enrichment, it is necessary to take into account that the contest is not between the transferee of funds and alleged beneficiary of the constructive trust, but between the debtor's other creditors and the putative beneficiary. "The principle that equality is equity" is the spirit of the bankruptcy law., Cunningham v. Brown, 265 U.S. 1, 13 (1924); In re Corrozella Richardson, 247 B.R. 595, 602 (B.A.P.2d Cir. 2000). As the Sixth Circuit stated in XL/Datacomp, Inc. v. Wilson (In re Omegas Group, Inc.), 16 F.3d 1443, 1451 (6th Cir. 1994), "A constructive trust is fundamentally at odds with the general goals of the Bankruptcy Code." The Fifth Circuit recently wrote:
The remedy of a constructive trust is . . . a potent one in bankruptcy because it gives the successful claimant "priority over the defendant's unsecured creditors to the extent of the property subject to the trust. As a result, creditors of the bankrupt debtor have every incentive to argue that their unsecured claims are eligible under state law for the remedy of a constructive trust. Because the constructive trust doctrine can wreak such havoc with the priority system ordained by the Bankruptcy Code, bankruptcy courts are generally reluctant to impose constructive trusts without a substantial reason to do so.'
Southmark Corp. v. Grosz (In re Southmark Corp.), 49 F.3d 1111, 1119 (5th Cir. 1995), quoting its prior opinion in In re Haber Oil Co., 12F.3d 426, 436 (5th Cir. 1994). See also In re U.S. Financial, Inc., 648 F.2d 515, 521 (9th Cir. 1980) (permitting creditor to "rescind and reclaim" would render absolute priority rule "meaningless"); In re Itemlab, Inc., 353 F.2d at 154; In re Morales, 667 F.2d at 1071-72; In re First Century Financial Corp. 269 B.R. 481, 500 (Bankr. E.D.N.Y. 2001) (if constructive trust is recognized, creditor can "leapfrog" over other creditors); In re Black Geddes, 35 B.R. at 836 ("imposition of a constructive trust must include a consideration of the relative equitities between a proposed trust beneficiary and other creditors."); Ames 274 B.R. at 626; Cf. SEC v. Credit Bancorp, Ltd., 297 F.3d 127, 139 (2d Cir. 2002). Thus, in considering whether there would be "unjust enrichment" and whether it would be "unconscionable and inequitable" for the Debtor's estate to retain the funds at issue here, it is necessary to consider the fact that the party at fault, the Debtor, is out of business. The funds at issue will either be awarded to PlasmaNet or shared by PlasmaNet and the Debtor's other creditors, who are as innocent as PlasmaNet of any wrongdoing or breach of contract.
The Debtor had approximately 60 other clients for which it performed essentially the same services it performed for PlasmaNet. In examining the precise nature of the Debtor's wrongs, on which the creation of a constructive trust would be premised, it is significant that the Debtor breached its duty to and contracts with many of these clients, as well as PlasmaNet, by failing to pay over their respective entitlements from advertising revenues. Although it appears that none of these other clients was as careful as PlasmaNet, and none inserted a clause in its contract requiring segregation of certain of the funds collected, it cannot be said that these other clients of the Debtor, as well as other creditors, would be unjustly enriched if they were permitted to share in the PlasmaNet collections. The only difference between the Debtor's breach of contract with PlasmaNet and its breach of contract with the other clients is the breach of the contractual clause requiring segregation of funds. This was not a separate wrong to PlasmaNet of such magnitude that it would be "unconscionable and inequitable" for the Debtor's other, less clever clients to share in the funds. See McKey v. Paradise, 299 U.S. 119, 57 S.Ct. 124 (1936) (holding that that mere failure to pay debts is not a circumstance in which equity will fasten a constructive trust upon property); In re Itemlab, Inc., 353 F.2d at 154 ("Breach of a contract concerning payment of a debt furnishes no basis for the finding of a constructive trust."); Amendola v. Bayer, 907 F.2d 760, 763 (7th Cir. 1990) (finding that a breach of an agreement, without other wrongful activity, is insufficient to justify the imposition of a constructive trust); In re Stylesite, 253 B.R. at 509 (party enriched by virtue of its breach of a contract is not unjustly enriched).
This conclusion is bolstered by the fact that PlasmaNet could have protected itself by perfecting a security interest in the Debtor's property and establishing a lockbox, or by terminating the contract if the Debtor refused to perform and open a lockbox account. A lockbox and a filed security interest in receivables would also have provided notice to the Debtor's other creditors of PlasmaNet's interest in the subject property. It would also have permitted a tracing of the property as to which PlasmaNet claims an equitable interest. PlasmaNet's failure to obtain a security interest that would have provided it with protection and would have given notice to the Debtor's other creditors of its rights further weakens PlasmaNet's claim that it is equitably entitled to superior rights. As the Second Circuit said in In re Itemlab, Inc., 353 F.2d at 155, a creditor who fails to obtain a valid security interest cannot, by asserting the rights of a beneficiary of a constructive trust or equitable lien, transform its unsecured position into a "preferred secured obligation. The adoption of such a construction of the law would be completely destructive of the intent and purpose of the recording act and cannot be seriously entertained." The Court continued:
failing to set up a lockbox account, and by failing to make any efforts to police the requirement of segregation of funds, PlasmaNet also made it virtually impossible to trace the funds in which it claims an interest. In re Corrozzella Richardson, 247 B.R. at 602. PlasmaNet argues that most of the funds at issue can be traced into the Debtor's cash account. In view of the Court's conclusion that a constructive trust was not established, it is not necessary to determine this issue. Commingling, however, makes tracing difficult, and a matter of chance.
PlasmaNet would not have had any rights as a secured party against the Debtor, after its bankruptcy filing, if the Debtor had segregated 70 percent of the funds collected from the relevant advertisers in an account under the Debtor's control, unless a lockbox had been created. As a debtor in possession, the Debtor has all of the rights of a trustee, which includes the status of judicial lien creditor and bona fide purchaser for value. 11 U.S.C. § 544(a), 1107(a). Under New York law, prior to the adoption of the amendments to UCC Article 9 effective July 1, 2001, a creditor had to have control over a deposit account or have possession of an indispensable instrument providing it with control in order to assert a viable lien or pledge over funds in a deposit account. Miller v. Wells Fargo Bank Intl. Corp., 540 F.2d 548 (2d Cir. 1976). Under current law, Article 9 of the revised UCC governs, but the key factor is still control over the deposit account. See N.Y. UCC 9-314, 9-312(b), 9-102(a)(29), 9-104. The establishment of a lockbox account at PlasmaNet's bank would apparently have given PlasmaNet the degree of control over the funds at issue to maintain a valid security interest against the intervening powers of a bankruptcy trustee. Similarly, if PlasmaNet had perfected its interest and taken the other steps necessary to obtain a valid lien over receivables, PlasmaNet would presumably have had a valid security interest in receivables and, for a time at least, in their proceeds. See UCC 9-306(4) (Revised UCC 9-203(f), 9-315(c)). Although PlasmaNet evidently knew what had to be done, it never enforced its contractual rights.
"Dutch American [the creditor] would be barred from equitable relief because of the basic principle that he who seeks equity must do equity. By its failure and neglect to file or record any instrument giving notice of its claim of an equitable interest in the chattels, Dutch American enabled Blanmill and Itemlab [the debtor and its principal] to mislead 18th Avenue Land Corp. [a substantial unsecured creditor]." 353 F.2d at 155.
Although there is nothing in this record to indicate that the Debtor misled third parties, PlasmaNet could have protected itself and could have given notice to third parties of its rights, but it did not.
There are cases that hold that the action of a debtor in fraudulently preventing a secured party from perfecting its lien or continuing such perfection may give rise to a constructive trust or equitable lien and accord the secured party the rights it would have had absent the fraud. See, e.g., In re Howard's Appliance Corp., 874 F.2d at 93 (debtor failed to inform creditor that property had been moved out of State and thereby prevented creditor from re-filing under the UCC). Here, however, PlasmaNet was aware that the Debtor had refused or failed to open a lockbox account, and it accepted alternative performance.
A further factor that detracts from PlasmaNet's appeal to equity for a priority over other creditors is the absence of a fraud claim. PlasmaNet's claim against the Debtor is that it breached its commitment to segregate funds; PlasmaNet's papers admit it never asked the Debtor about its compliance with the clause requiring segregation of funds. Although PlasmaNet implies that the Debtor is guilty of misconduct amounting to fraud, where a claim of misrepresentation is based on an alleged breach of contractual duties, the plaintiff does not have a viable fraud claim absent proof of a misrepresentation that is collateral or extraneous to the terms of the agreement. Bridgestone/Firestone, Inc. v. Recovery Credit Services, Inc., 98 F.3d 13, 20 (2d Cir. 1996); McKernin v. Fancy Farmer Candy Shops, Inc., 176 A.D.2d 233, 234, 574 N.Y.S.2d 58, 59 (2d Dept. 1991). There is no such allegation here.
Only a handful of cases have considered whether to impose a constructive trust in connection with the bankruptcy of an agent who has allegedly diverted funds entrusted by a principal. In Shulman, Morales and Ames, discussed above, the courts characterized the relationship between the parties as that of debtor and creditor, and denied the application principally on that analysis. Black Geddes applied the same analysis; it put substantial weight on a comparison of the position of the creditor seeking constructive trust treatment with the other creditors, and it found that the creation of a constructive trust could not be justified under the competing principle of equality of treatment provided for in the Bankruptcy Code. 35 B.R. at 836. The few cases in which a constructive trust has been imposed involve unique claims of individual creditors who (unlike PlasmaNet) could credibly assert a special legal interest different from that of other creditors in a discrete and relatively limited portion of the debtor's property. See In re Construction General, Inc., 737 F.2d 416 (4th Cir. 1984) (debtor required to pay over to owner one-half of the proceeds of a note collected prior to bankruptcy but withheld; court found that under local law the trustee's rights would be inferior to the ownership claim of the creditor); see also In re Specialized Installers, 12 B.R. 546 (Bankr. D. Colo. 1981) (creditor paid debt of debtor and expected reimbursement the same day; little analysis); In re Treiling, 21 B.R. 943 (Bankr. E.D.N.Y. 1984) (dictum; claimants had deposited earnest money with broker); In re Martin Fein Co., 34 B.R. 333 (Bankr. S.D.N.Y. 1983) and 43 B.R. 623 (Bankr. S.D.N.Y. 1984) (deposit of proceeds of auction sales with bankrupt auctioneering firm). None of those cases involves facts similar to those present here. The cases cited by PlasmaNet, in its papers, also bear no relationship to the facts at bar.
A 1989 article, attempting to find a common denominator among the cases as of that date, concludes that the common thread through the winning cases is the relative uniqueness of the creditor's claim compared to those of other general unsecured creditors. See Davis, Equitable Liens and Constructive Trusts in Bankruptcy: Judicial Values and the Limits of Bankruptcy Distribution Policy, 41 FLA. L.REV. 1 (1989). There the author writes:
"[A]n explicit agreement prohibiting an agent from treating the funds as his own will strengthen a claimant's clause. But the more telling characteristic seems to be the relative uniqueness of the claim. All claimants whose agents in a three-party transaction become bankrupt are entitled to sympathy. But the general creditors are entitled to sympathy, too. Only if a claimant's circumstances are relatively unusual is a court able to distinguish the equitable claim form those of the great mass of general claims." 41 Fla. L. Rev, at 52-53.
PlasmaNet cites Clancy v. Goldberg, 183 B.R. 672 (Bankr. N.D.N.Y. 1995), where homeowners sought recovery of payments made to a debtor-contractor prior to completion of a home improvement project. The Court determined that the New York Lien Law applied and that the advance payments were held in escrow. Similarly, PlasmaNet cites In re Mishkin, 138 B.R. 410 (Bankr. S.D.N.Y. 1992), a case where plaintiff-investors sought funds the debtor stole for his own use, for the proposition that "the investors' funds were tendered to the general partner on a fiduciary basis, and they are not part of the bankrupt estate." In fact, the Court did not base its ruling on the existence of a fiduciary duty, but rather that the debtor, as an individual, had no property rights in stolen funds. In In re Vermont Real Estate Investment Trust, 25 B.R. 813 (Bankr. D. Vt. 1982), an investor was held entitled to recover proceeds he invested in a real estate investment trust after it suspended securities transactions, since the funds were not part of the estate.
In conclusion, PlasmaNet's complaint rests on the proposition that it can assert a constructive trust over funds by virtue of a clause requiring the Debtor to segregate 70 percent of the funds received from certain advertisers. For all of the reasons stated above, the Debtor's breach of this contractual requirement of the contract is insufficient, in equity or good conscience, to cause this Court to prefer PlasmaNet over all the other creditors of the Debtor who were also unpaid when the Debtor filed its Chapter 11 petition.
Conclusion
PlasmaNet's motion for summary judgment is denied, and the Debtor's motion on the constructive trust issue is granted. The Debtor has not moved for summary judgment on its counterclaim for commissions which it alleges were wrongfully withheld by PlasmaNet, and there has been insufficient information submitted by PlasmaNet to enable the Court to determine the viability of the Debtor's claim.
The Debtor is directed to settle an order on five days' notice dismissing PlasmaNet's constructive trust claims and scheduling a pretrial conference to consider further proceedings on its counterclaim.