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Whose Cash Is That Cash? Avoiding Constructive Trust Claims in Trucking Finance Transactions
April 1, 2019
Hurricane Florence hit the mid-Atlantic last year, causing terrible damage, sweeping debris inland and, in one instance, landing a large yacht in the yard of an unsuspecting homeowner. At least one famous observer noted the apparent “windfall” to the couple, asking if they were the owners of the boat. Similarly, in the commercial transportation context, the storm of bankruptcy can sweep over a company and transform cash that is apparently safely moored in the company’s deposit accounts into an asset beached in the front yard of unpaid carriers, causing courts and claimants to ask, “Whose cash is that cash?”
Secured lenders often provide financing to commercial trucking or other transportation companies secured by accounts receivable and cash arising from the transportation services those carriers provide. Part of the typical security package lenders rely on is a perfected lien on both the receivables themselves as well as the deposit accounts in which proceeds of receivables are held. When the winds of a bankruptcy filing stop blowing and cash remains in the accounts of a borrower, a lender might understandably assume it is the borrower’s cash, subject to the lender’s lien and right of setoff. It would be a rude awakening for such a lender if, in the aftermath of a bankruptcy filing, the lender found that this cash was not the borrower’s cash at all, but actually cash of third parties, held in trust and deemed outside the estate of the borrower. If this cash is found to be held in trust for another party, not only would it not be the borrower’s cash, but it would be free of the lender’s lien and right of setoff and amounts previously swept by the lender and applied to loan balances might have to be returned. Not a good outcome for the lender.
This unpleasant scenario is precisely the circumstance that could arise when a trucking company contracts with third-party carriers to transport goods of its customers or otherwise engages in what may appear to be brokerage services, thus giving rise to the claim that the company is acting merely as an intermediary or conduit between shipper and carrier and payments to the company are actually received in trust on behalf of carriers (a “constructive trust” claim). When a trucking company conducts part of its business in this manner (contracting with third-party carriers), it steps into a gray zone in which it might be characterized as a transportation broker or third-party logistic provider (“3PL”) against which these claims of “constructive trust” can be more readily made by unpaid carriers. These claims have become more common recently and can have material consequences for secured lenders, but the risks of such claims can be mitigated by taking certain simple precautions in diligence and drafting of documentation governing commercial trucking and similar finance transactions.
When any commercial carrier, broker or 3PL files for bankruptcy, it is likely there are outside carriers who have performed services for the debtor, yet remain unpaid. In a typical commercial context, such unpaid carriers would simply be like any other unpaid trade creditor, holding unsecured claims against the bankruptcy estate, likely to see little or no payment on their claims. However, asserting a constructive trust claim creates the potential for these unsecured carriers to get paid from funds held by or paid to the bankruptcy estate. If successful, payments received by the bankrupt company can be deemed held in trust for carriers and not part of the estate at all (“That cash is not your cash.”) and, consequently, not subject to prior claims of secured parties, other unsecured trade creditors or superpriority administrative expenses claims.1 When a constructive trust arises, unpaid carriers can seek to be paid from cash remaining in the company or the return of amounts paid to other creditors, including secured lenders, deemed held in trust for carriers. Most disturbing for secured lenders, a bank who may have set off or otherwise swept and applied cash collateral can be subject to a claim of conversion and required to pay over such funds to the unpaid carriers. This can be a material issue for a secured lender.
Lenders to trucking companies that have “brokered” customer accounts (accounts arising from contracts in which it engages third parties for carriage) are faced with two approaches to potential constructive trust claims. The lender can either (1) assume a constructive trust exists, reserve against receivables for carrier charges and accept that swept funds may be subject to disgorgement (or segregation by the company) or (2) require contract terms and operational performance by the company that will minimize the potential for a constructive trust being found. Assuming the first approach will be untenable for borrowers seeking working capital based on receivables, the second approach is the most practically relevant for secured lenders.
The Interline Trust Doctrine
Constructive trust claims rely on a determination that the parties intended that a fiduciary relationship between the parties be formed and that funds paid to the company be held in trust for the benefit of other carriers, even absent express agreement. As background, the concept of a constructive trust arose directly out of a Federal common law doctrine relating to rail carriers who relied on a single bill of lading to cover the transport of freight along rail lines owned by different rail carriers. This “interline trust doctrine” provided that payment to one of the carriers in the interline arrangement was held in trust for the benefit of all the other carriers moving the goods and was not merely an unsecured business debt owed by the carrier receiving payment. The doctrine was first applied to motor carriers (as opposed to rail carriers) in Parker Motor Freight, Inc., 116 F.3d 1137 (6th Cir. 1997) and has been adopted by various courts presented with constructive trust claims of carriers.2
The court in Parker applied the interline trust doctrine to motor carriers who formed an interconnected motor carrier arrangement (similar to rail lines) for the carriage of goods over the national highway system. In the Parker decision, the court concluded that “the common law trust principles embraced in the interline trust doctrine apply equally to a joint network of . . . motor carriers . . . [and] freight charges, when collected by one motor carrier on behalf of another for services that the latter has performed, are held in trust for the latter carrier.” Citing Penn Central Transportation Co., 486 F.2d 519 (3d Cir. 1973). Cases applying this “interline trust doctrine” have summarized the criteria to establish an interline trust as follows:
(1) no provision for the payment of interest by the collecting party;
(2) segregation of monies due to carriers from collecting party’s general funds;
(3) collecting party agrees to apportion payments collected;
(4) the amount the collecting party owes the carrier directly relates to and depends upon the overall charge to the shipper;
(5) collecting party must pay the carrier only if the customer has paid it; and
(6) collecting party pays the other carrier immediately upon settlement of the account, so that there is no “credit accommodation” for untimely payments.
This doctrine arose in the context of “interline” agreements that were part of a custom and practice among rail carriers at the time. It became a doctrine of federal common law applicable to other circumstances outside the rail carrier context where a broker/arranger receives payment on behalf of third-party carriers, whether part of an agreed interline arrangement or not.3 The federal common law rule has been stated that “a trust is imposed when any entity acts as conduit, collecting money from one source and forwarding it to its intended recipient.”4
Beyond situations in which an express trust is created or an interline trust arrangement is clearly intended, the elements of the federal common law rule have been considered along with state law and applied to arrangements between transportation brokers/arranger, freight forwarders and carriers who contract with third parties for carriage services. In particular, when applied to a non-broker motor carrier who contracts with third parties for part of its carrier services, a gray area arises where a lender may not suspect a trust relationship exists, yet just such a trust may be claimed by unpaid carriers.
Today, the issue of whether a constructive trust exists breaks down along essentially two lines of inquiry (although not bright lines):
• Is the arrangement one in which the borrower is acting as a broker/arranger, merely providing a service and earning a commission for connecting shippers with carriers (thus a mere conduit for payments to the carrier); or
• Is the arrangement one of a carrier or freight forwarder who is obligated to the shipper to transport goods but who may contract with third parties for some or all of the carriage services on a basis wholly independent of the contract with the shipper and outside a traditional “interline” arrangement.
The answer to these two questions will depend upon the terms of the contracts under which the parties perform and the practice of the parties in such performance.
As an initial matter, it is helpful to identify whether the company is a traditional transportation broker or not.5 Although titles are not determinative, designation as a broker can implicitly support a view that the company is a mere intermediary or conduit for payments from shipper to carrier and may give rise to regulatory requirements that in themselves support finding an intent to form a constructive trust. Brokers are subject to certain registration and bonding requirements and are required to keep detailed records of customers, carriers, commission received and payments made to carriers6 as well as being required to maintain accounts such that payments and receipts from the brokerage business are segregated from other activities.7 Compliance with these regulations can support elements of a constructive trust claim described below. Note, however, that motor carriers who perform brokerage services as part of their business are not necessarily “brokers” for the purposes of statute and regulations8, but may still be subject to claims that they are acting in a similar capacity and thus subject to a constructive trust claim.
Various cases have set forth the factors that support a finding that a constructive trust was intended by the parties (i.e., that the company acted as a mere conduit for payments from shipper to carrier and therefor was intended to hold funds in trust for the carrier).9 As a general matter, in determining whether a constructive trust exists, courts have considered the intent of the parties, not only in terms of written agreements, but also in conduct of the parties.10 In absence of express intent to form a trust, the court looked to the facts and circumstances surrounding the transaction and the relationship of the parties, noting that no single factor is determinative and that industry custom as well as agreements between the parties determine whether a trust arrangement was intended.11 These factors can be summarized as follows:
a. Did the company make payments to the carrier from segregated funds (as opposed to payment from its general operating accounts)?
b. Was the company obligated to make payments only if it received payment from the shipper?
c. Did the company remit funds received from shippers immediately to carriers, less its applicable fee or commission?
d. Did the carrier have any direct rights against or privity with the shipper?
To the extent some or all of these questions that are answered in the affirmative, the more likely a constructive trust claim will be successful. If these questions can be answered in the negative, the risk that a constructive trust claim would be successful can be greatly reduced.12 The main determinative factor, where the intent is not otherwise clear, is whether or not the risk of payment from the shipper was born by the company or the carrier. If the company paid the carrier prior to or irrespective of payment by the shipper from its general funds, a constructive trust is much less likely to be found to have been intended.
The most effective approach for lenders to avoid constructive trust claims is to ensure that, if the company has brokered customer contracts (contracts in which it engages third parties for carriage), these brokered contracts are documented and performed so as to minimize the possibility that a constructive trust claim will be successful. From the diligence and documentation standpoint, lenders should do the following:
1. Conduct due diligence with respect to a borrower’s agreements with shippers and carriers and ensure that no language is included creating an express trust or fiduciary relationship and that no interline arrangement is contemplated among the company and carriers.
2. Confirm terms of all contracts with third-party carriers contain the following provisions:
a. Acknowledgment that no trust or interline arrangement is contemplated and no fiduciary or trust relationship exists between the company and carrier;
b. Acknowledgment that the company is solely responsible for payment of fees and charges and other obligations under the applicable carrier contract irrespective of payment by shipper and carrier agrees to look only to the company for such payment; and
c. Carrier shall not have any ability to direct the method or handling by company of payments from shippers and shall not contact the shipper for any reason, including nonpayment, payment disputes, indemnity, insurance or other matters
3. Confirm that (i) all funds received from customers (shippers) in connection with any brokered customer contracts are deposited to a general operating account and held as general funds of the company and not otherwise segregated or identified to a particular carrier contract and (ii) all payments made to carriers are made from general funds.
4. Loan documentation should include an agreement from the company that the company will not:
a. Enter any express trust or interline arrangement with carriers or hold or be required to hold in trust any portion of amounts collected in connection with brokered customer contracts, or have any express trust or fiduciary relationship or fiduciary duty to, any carrier;
b. Segregate from its general funds any amounts collected in respect of brokered customer contracts or make payments to carriers other than from its general funds; and
c. Enter into or amend any existing agreement with carriers that fails to contain the provisions required under item 2 above.
The Last Line of Defense
If control over contractual terms and operational protections fail and a constructive trust is nonetheless found to exist, there are additional lines of defense for lenders based on contesting the equitable foundation of the claim itself or the requirement that funds be turned over.
There has been commentary that constructive trusts in general are disfavored in bankruptcy as “fundamentally at odds with basic principles incorporated in the Bankruptcy Code, such as equality of distribution to creditors”13 A constructive trust found in common law equities may not be found applying the equities of a bankruptcy case. The establishment of the interline trust doctrine may make a general equitable defense less effective, but the equities of a constructive trust claim are always legitimate points of contention.
A similar argument focuses on the general equitable requirement that there be some element of unjust enrichment in order to establish a constructive trust. This may include a defense that (i) the recipient bank made additional funds available to the estate in reliance on payments received from the company’s accounts, (ii) trust claims are subordinate to claims of secured creditors and/or (iii) that the lender was a bona fide purchaser without notice of the beneficial claim.14 If the lender who is being asked to disgorge “constructive trust” funds took those funds as a bona fide purchaser without notice, as a general matter of trust law, the trust claims are defeated and no recovery from the lenders will occur.15 Courts have held lenders to a standard of knowledge of the trust arrangement itself or knowledge sufficient to warrant inquiry.16
The forgoing notwithstanding, constructive trust claims are highly fact- specific and subject to interpretation of federal common law and applicable state law that can vary from jurisdiction to jurisdiction. Given the uncertainty of a fact-specific analysis and the general knowledge that may be imputed to a lender given customary due diligence, reliance on equitable defenses or bona fide purchaser status is little comfort for most lenders. The best means of assuring a constructive trust claim fails (and everyone agrees “That cash is your cash”) is to ensure that documentation terms and business practices are in place that (i) prohibit express trust relationships or traditional interline arrangements and (ii) prevent the company from operating as a “mere-conduit” for payments, but instead ensure the company takes on the primary and exclusive obligation to pay its carriers from its own funds. TSL
1 Matter of Kennedy & Cohen, Inc. 612 F.2d 963 1980; Bankruptcy Code §541(d)
2 Third and the Sixth Circuits have held that the interline trust doctrine exists as a matter of federal common law. See Parker Motor Freight, Inc. v. Fifth Third Bank, 116 F.3d 1137 (6th Cir. 1997); Ann Arbor R.R. Co. v. Comm. of Interline R.R. (In re: Ann Arbor R.R. Co.), 623 F.2d 480 (6th Cir. 1980); In re: Penn Central Trans. Co., 486 F.2d 519 (3d Cir. 1973). The Seventh and Ninth Circuits have rejected the doctrine as a matter of federal common law, Union Pac. R.R. Co. v. Moritz (In re Iowa Railroad Co.), 840 F.2d 535, 538 (7th Cir. 1988); In re Consolidated Freightways, 443 F.3d 1160 (9th Cir. 2006), however, claims in those jurisdictions have relied on applicable state law and traditional common law trust doctrines to find constructive trusts.
3 Transportation Revenue Management v. Freight Peddlers, Inc. 2000 WL 33399885; In re Columbia Gas Systems, Inc., 997 F.2d 1039 (3rd Cir. 1993)
4 Transportation Revenue Management v. Freight Peddlers, Inc. 2000 WL 33399885 p.4
5 The term “broker” in the transportation regulatory context is defined in 49 U.S.C. §13102(2):
(2) Broker. –
The term “broker” means a person, other than a motor carrier [emphasis added] or an employee or agent of a motor carrier, that as a principal or agent sells, offers for sale, negotiates for, or holds itself out by solicitation, advertisement, or otherwise as selling, providing, or arranging for, transportation by motor carrier for compensation.
6 See 49 C.F.R. §371.3
7 See 49 C.F.R. §371.13
8 See 49 C.F.R. §370.1
9 Parker Motor Freight, Inc., 116 F.3d 1137 (6th Cir. 1997), Penn Central Transportation Co., 486 F.2d 519 (3d Cir. 1973), Transportation Revenue Management v. Freight Peddlers, Inc. 2000 WL 33399885 p. 6.
10 Penn Central Transportation Co., 486 F.2d 519 (3d Cir. 1973)
11 In Re Muma, 322 B.R. 541, 556-557 (Bankr. D. Del. 2005)
12 See Delta Pride Catfish, Inc. v. Marine Midland Business Loans, 767 F.Supp. 951 (E.D. Ark. 1991) which found funds not held in trust where (i) company was not found to be a statutory “broker”, (ii) did not segregate funds, (iii) paid the carrier prior to receipt of payment from shipper or (iv) otherwise bore the risk that the shipper would fail to pay. Note this case was based on an agency claim rather than a claim under federal common law constructive trust theory.
13 XL/Datacomp, Inc. v. Wilson (In re Omegas Group Inc.), 16 F.3d 1443 (6th Cir. 1994). “The equities of bankruptcy are not the equities of the common law,” concluding that property subject to a claim of constructive trust is excluded from the bankruptcy estate only if such a trust has been imposed by a court “in a separate proceeding prepetition.” Constructive trusts, “are anathema to the equities of bankruptcy since they take from the estate, and thus directly from competing creditors, not from the offending debtor.”
14 Delta Pride, 767 F.Supp. at 963
15 Delta Pride, 767 F.Supp. at 963
16 Parker, p. 1141-1142