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United States District Court, S.D. New York

September 1, 2004.

LFD OPERATING, INC., Plaintiff-Appellant,

The opinion of the court was delivered by: SIDNEY STEIN, District Judge


This case arises out of the bankruptcy proceedings of Ames Department Stores, Inc. and Ames Merchandising Corporation (collectively, "Ames") in the United States Bankruptcy Court for the Southern District of New York. In 2001, appellant LFD Operating Inc. ("LFD") commenced an adversary proceeding against Ames to compel Ames to turn over to LFD $8.9 million LFD claimed it was due pursuant to a contract. According to LFD, those funds are the property of LFD, not Ames. In a Memorandum Decision dated March 8, 2002, and the resulting Order and Judgment dated March 19, 2002, Bankruptcy Judge Arthur J. Gonzalez held that the disputed funds were the property of Ames, and that LFD's claims were no different than any unsecured creditor of Ames. See In re Ames Dept. Stores, Inc., 274 B.R. 600 (Bankr. S.D.N.Y. 2002). Ames now appeals from that Order and Judgment. I. BACKGROUND

A. The Ames-LFD Agreement

  The facts underlying this action are more fully set forth in Judge Gonzalez's Memorandum Decision, In re Ames Dept. Store, Inc. ("LFD"), 274 B.R. 600 (S.D.N.Y. Bankr. 2002), and familiarity with that decision is assumed. A brief summary is provided for the purposes of this appeal. LFD is the assignee of a licensing agreement dated November 17, 1987, as amended, originally between Ames and JBI Holding, Inc. ("Baker") for Baker to operate shoe departments in various Ames stores ("Agreement"). LFD, 274 B.R. at 605. Baker subsequently assigned to LFD all of Baker's rights in and to the Agreement, and LFD assumed all of Baker's obligations. Id. at 608.

  By the terms of the Agreement, in return for a licensing fee taken out of the proceeds of LFD's sales, Ames authorized LFD to operate the shoe departments in various Ames stores. LFD furnished, staffed and operated the departments. The sales were then processed through Ames's cashiers and the regular channels of Ames's business. Ames was obligated to turn over the proceeds, minus its share, to LFD on a weekly basis. The amount to be turned over to LFD each week was known as the Net Sales Proceeds. According to the terms of the Agreement, (i) all proceeds from the sale of merchandise of LFD were LFD's property from the time of sale, (ii) Ames was LFD's agent for the purpose of collecting and holding the proceeds, and (iii) Ames was to hold the proceeds in trust for LFD. (See Special Appellant's Appendix 3 at 10-11).*fn1 B. Implementation of the Agreement

  The Bankruptcy Court made the following findings with respect to the actual implementation of the Agreement. Sales of LFD merchandise were received in the same cash registers that received proceeds from Ames's merchandise. Ames identified these sales at the point of sale, and tracked them in a manner that permitted LFD to receive daily transmissions showing its footwear sales in Ames's stores. Ames maintained separate and distinct records of all sales from LFD merchandise. Ames would then use the information in its system to calculate the total proceeds from LFD sales, and calculate the amount that had to be remitted periodically to LFD. LFD, 274 B.R. at 610-11. Ames would produce a weekly statement of LFD's sales for the second preceding week, and would also remit the payment due according to that statement. Id., 247 B.R. at 607. Thus, Ames would remit a payment on a weekly basis to LFD for the sales that took place two weeks before that date. Id.

  Ames did not maintain separate bank accounts for the proceeds from LFD merchandise. Proceeds from LFD sales were deposited along with Ames's other proceeds in bank accounts, and thereafter transferred at Ames's request to certain blocked accounts established by Ames. In March 2001, Ames entered into a credit agreement with a syndicate of banks and financial institutions headed by General Electric Capital Corporation. ("GECC"). The agreement was collateralized by, among other things, Ames's inventory as reflected in a stock ledger inventory report and cash proceeds from all sources. GECC would sweep all funds from the blocked accounts into a concentration account, and apply them according to the terms of the credit agreement. GECC would then advance money to Ames (as requested and within the limits of Ames's available credit) by depositing money into a blocked Disbursement Account, which Ames used to pay all of its operating expenses. Id. at 611-12.

  It was from its Disbursement Account that Ames wired to LFD every Monday the amount of Net Sales Proceeds owed to LFD on a weekly basis (for sale of LFD merchandise during the second preceding calendar week ending the second preceding Saturday). Ames's credit limit under its agreement with GECC was reduced by reserve amounts. One of these reserves was a shoe sale reserve based on the monthly average of past payments made by Ames to LFD. This reserve, however, involved no physical segregation of the proceeds of LFD shoe sales. Id.

  C. Ames's Bankruptcy

  After a significant deterioration in Ames's financial condition, Ames's directors authorized the filing of a Chapter 11 petition on August 12, 2001. The next day, Ames ceased making wire transfers and did not wire to LFD the $2 million in Net Sales Proceeds (reflecting LFD sales from the week ending July 28, 2001) due to it on that date. One week later, Ames filed a Chapter 11 petition under the Bankruptcy Code. In addition to the August 13 payment, Ames has failed to pay LFD the Net Sales Proceeds owed LFD on August 20, August 27, September 3, and September 10, 2001.


  The findings of fact of a bankruptcy court are accepted by the district court on appeal unless they are clearly erroneous, while a bankruptcy court's findings of law are reviewed de novo. In re Manville Forest Prods. Corp., 896 F.2d 1384, 1388 (2d Cir. 1990). "A district court must accept the findings of fact of a bankruptcy court unless the party contesting the findings of fact carries the burden of establishing that the findings are clearly erroneous and that no reasonable person could agree with them." BT/SAP Pool Assocs., L.P. v. Coltex Loop Central Three Partners, L.P., 203 B.R. 527, 531 (S.D.N.Y. 1996), aff'd, 138 F.3d 39 (2d Cir. 1998). "[Q]uestions as to the ambiguity and meaning of the language of a contract" are legal questions, to be reviewed de novo. See Adirondack Transit Lines, Inc. v. United Transport, Union, Local 1582, 305 F.3d 82, 85 (2d Cir. 2002).


  The principal dispute in this action is over the relationship between LFD, Ames and the Net Sales Proceeds. LFD contends that the Net Sales Proceeds are not a mere debt due it from Ames, and that LFD is not a mere creditor with respect to Ames, and therefore it is entitled to immediate payment of the $8.9 million Ames owes it, and does not have to resort to the bankruptcy process. LFD asserts that the Net Sales Proceeds are its property and that Ames held only legal but not equitable title to the proceeds. Pursuant to 11 U.S.C. § 541(d), property in which Ames held legal but not equitable title is exempt from the bankruptcy estate.

  In its motion before the Bankruptcy Court, LFD advanced contract, agency, trust, and constructive trust theories as to why it was entitled to immediate payment of the Net Sales Proceeds, and each theory was rejected by that court. Its contract, agency and trust theories all derive from the language of the Agreement, which states explicitly that the Net Sales Proceeds are the property of LFD, that Ames is LFD's agent with respect to the Net Sales Proceeds, and that the Net Sales Proceeds are held in a trust by Ames for LFD. Judge Gonzalez found the actual relationship between the parties revealed these terms in the Agreement to be conclusory labels, and therefore insufficient to grant LFD rights superior to those of an unsecured creditor.

  LFD now makes the following arguments as to why the Bankruptcy Court's ruling should be overturned. As its principal argument, LFD asserts that the Bankruptcy Court should have simply enforced the formal language of the Agreement, and not looked past the language to inquire into the actual relationship between the parties in determining ownership of the Net Sales Proceeds and the character of the relationship between the parties. As a secondary argument, LFD contends that the actual relationship between the parties was in fact consonant with the terms of the Agreement, and therefore the Bankruptcy Court should not have determined ownership and the character of the relationship in opposition to the Agreement. Finally, LFD disputes the Bankruptcy Court's failure to find a constructive trust and denial of its subrogation claim. As set forth below, this Court finds that the Bankruptcy Court did not err in any of these holdings, and therefore its determination is affirmed.

  A. The Bankruptcy Court's Interpretation of the Agreement

  1. The Bankruptcy Court's Decision to Look Beyond the Terms of the Agreement

  Whether contracting parties have established an agency or trust must be determined by the true character of their relationship rather than by the formal language of a contract. Pan Am World Airways, Inc. v. Shulman Transp. Enters., Inc. (In re Shulman Transp. Enters.), 744 F.2d 293, 295 (2d Cir. 1984); In re Morales Travel Agency, 667 F.2d 1069, 1071 (1st Cir. 1981) ("However, talismanic language could not throw a protective mantle over these receipts in the absence of a genuine trust mechanism. Here the relationship remained in practical fact that of debtor-creditor."); see also Carlson Inc. v. Commercial Disc. Corp., 382 F.2d 903, 905 (10th Cir. 1967) (A "trust" is not established by a "trust clause" in a contract); In re Einhorn Vacation Planning Ctr., 59 B.R. 179, 184-185 (Bankr. E.D.N.Y. 1986). Moreover, where the interests of the public and the relative rights of a bankrupt's creditors are at issue, it is particularly important that substance not give way to form. In re Shulman Transp. Enters., Inc., 744 F.2d at 295 (citing Pepper v. Litton, 308 U.S. 295, 304-305 (1939)).

  LFD asserts that an examination past the formal contract language is unwarranted when a creditor's rights are not at stake, and therefore concludes that the Bankruptcy Court should not have looked beyond the contract language because the rights of GECC were not "at stake." LFD contends that whether a bankrupt's creditors have rights at stake is determined by whether the creditor's knowledge was consistent with the terms of the unambiguous contract; only when that knowledge is inconsistent do they have such rights.

  However, courts have not required a finding that the debtor's other creditors have inconsistent knowledge vis-à-vis the consistency of the formal and substantive relationship between creditor and debtor before setting aside formal contract language in examining whether a trust or agency relationship was established. See generally In re Morales Travel Agency, 667 F.2d at 1071. Courts are not required to robotically adopt contractual language and ignore the reality of the substance of the parties' relationship. See In re Shulman Transp. Enters. Inc., 744 F.2d at 295.

  2. Ownership of Net Sales Proceeds

  The Bankruptcy Court held that despite the Agreement's labeling of the Net Sales Proceeds as the property of LFD, they were in fact the property of Ames. LFD, 274 B.R. at 617. LFD provides no evidence to establish that the Bankruptcy Court's findings of fact are clearly erroneous. As a general rule, once funds are deposited in a bank account, the account holder — here Ames — is presumed to have title to and control over those funds. See United States v. $79,000 in Account Number 2168050/6749900, No. 96 CIV. 3493, 1996 WL 648934, at *4 (S.D.N.Y. Nov. 7, 1996). The factual record, far from rebutting that presumption, supports it. The Net Sales Proceeds were deposited with Ames's other receipts into its bank accounts. At no point were the Net Sales Proceeds segregated from the rest of Ames's funds, or precluded from GECC's sweep of Ames's blocked funds. As Judge Gonzalez found, "It is undisputed that Ames used the proceeds from the sale of LFD merchandise to pay Ames's Secured Lenders by placing those funds in the Blocked Accounts." See 274 B.R. at 621. LFD was not paid from a segregated account holding the Net Sales Proceeds, but rather from general disbursement accounts in which Ames commingled funds and from which it paid all of its operating expenses. LFD had no control over the Net Sales Proceeds "once the funds were placed in Ames's cash management system." 274 B.R. at 621.

  Thus, the proceeds from the sale of LFD merchandise was commingled with Ames's funds and placed in the GECC accounts. Accordingly, the Bankruptcy Court was correct to conclude that the parties acted in a manner consistent with the Net Sales Proceeds being the property of Ames, not LFD.

  B. Agency

  The Bankruptcy Court held that "Ames was not the agent of LFD for the collection and remittance of Net Sales Proceeds because LFD has no rights to control Ames's collection and remittance of the handling of the Net Sales Proceeds." LFD, 274 BR at 623. An essential characteristic of an agency relationship is that the agent acts subject to the principal's direction and control. In re Shulman Transp. Enters., 744 F.2d at 295. If an alleged agent's acts concerning a certain subject matter cannot be controlled and directed by the principal, there is no agency relationship with regard to the subject matter. In re Drexel Burnham Lambert Group Inc., 113 B.R. 830, 841-42 (Bankr. S.D.N.Y. 1990).

  The Bankruptcy Court's finding that LFD did not have control over the collection and handling of the Net Sales Proceeds by Ames is completely supported by the factual record. Ames's commingling of the Net Sales Proceeds, placement of the Net Sales Proceeds in the swept blocked accounts, and payment of LFD from general accounts are just as determinative on the issue of agency; none of these facts is consistent with LFD having control over Ames's handling of the proceeds. Further, the court found that the available evidence concerning which party bore the risk of loss on bounced check and credit transactions also was consistent with there being no agency relationship between the parties. Accordingly, this Court finds the Bankruptcy court did not err in finding no agency relationship between the parties.

  C. Express Trust

  The Bankruptcy Court also determined that no trust relationship existed between LFD and Ames. LFD, 274 BR at 625. As noted above, the court made a finding that Ames commingled the Net Sales Proceeds with other funds as a regular practice. In addition, Ames used the funds between settlement dates for purposes other than paying LFD, and then made payments to LFD out of general funds provided by GECC. Plaintiff has provided no evidence to demonstrate such findings are in clear error.

  "It is well established that if a recipient of funds is not prohibited from using the funds as his own and the recipient is not prohibited from commingling the funds with his own monies, a debtor-creditor, not a trust, relationship exists." Dampskibsselskabet Af 1912 Aktieselskab v. Black & Geddes, Inc., 35 B.R. 830, 836 (Bankr. S.D.N.Y. 1984) (citations omitted); see also In re Penn Central Transp. Co., 328 F.Supp. 1278 (E.D.Pa. 1971); 4A Collier on Bankruptcy (15th Ed.) P 541.13 at 541-67. Accordingly, the Bankruptcy Court correctly held that the actual relationship between Ames and LFD was a debtor-creditor relationship, not a trust relationship.

  D. Constructive Trust

  The Bankruptcy Court also held LFD's constructive trust arguments were without merit. In New York, a party seeking to establish entitlement to a constructive trust must demonstrate four elements: (i) a confidential or fiduciary relationship; (ii) a promise, express or implied; (iii) a transfer made in reliance on that promise; and (iv) unjust enrichment. Koreag, Controle et Revision S.A., v. Refco F/X Assocs., Inc. (In re Koreag), 961 F.2d 341, 352 (2d Cir. 1992).

  The Bankruptcy Court held that not only was there no fiduciary relationship between Ames and LFD, but also there had been neither conversion nor unjust enrichment. The bankruptcy judge was correct. As set forth above, Judge Gonzalez found that the parties' course of dealing established a creditor-debtor relationship. The mere failure to pay a debt cannot support a constructive trust. See e.g., Mahon v. Stowers, 416 U.S. 100, 105 (1974); McKey v. Paradise, 299 U.S. 119 (1936); Thunderbird Motor Freight Lines, Inc. v. Penn-Dixie Steel Corp. (In re Penn-Dixie Steel Corp.), 6 B.R. 817 (Bankr. S.D.N.Y. 1980). This rule naturally applies to leased department store arrangements such as the one in this case. Monnig's Dept. Stores, 929 F.2d 197, 201-03 (5th Cir. 1991). Appellant cannot turn to the conclusory labels of the Agreement in an effort to construe the relationship between the parties in a manner sufficient to establish a constructive trust.

  E. Subrogation

  Having concluded that the Net Sales Proceeds are not LFD's property, and that no agency or trust relationship exists, the bankruptcy court did not err in denying LFD's claim for subrogation.


  For the reasons set forth above, this Court finds that the Bankruptcy Court did not err by finding (1) that the proceeds from the sale of LFD's merchandise are not LFD's property, (2) that no trust or agency relationship existed between the parties, (3) LFD was not entitled to a constructive trust relationship, and (4) LFD was not entitled to its claim for subrogation. The Bankruptcy Court properly dismissed LFD's complaint for declaratory relief. Accordingly, the Order and Judgment of the Bankruptcy Court is affirmed.


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