     04-5638-bk
     In Re: Charles Atwood Flanagan




 1                                    UNITED STATES COURT OF APPEALS
 2                                        FOR THE SECOND CIRCUIT
 3
 4                                           _______________
 5
 6                                          August Term, 2006
 7
 8       (Argued September 14, 2006                        Decided: October 9, 2007)
 9
10                          Docket Nos. 04-5638-bk(L), 06-0731-bk(XAP)
11
12                                           _______________
13
14                                    In Re: Charles Atwood Flanagan
15
16                 ***************************************************
17
18                              Cadle Co., D.A.N. Joint Venture, L.P.,
19
20                                                       Appellants-Cross-Appellees,
21
22                                                  v.
23
24                Bonnie C. Mangan, Trustee. Charles Atwood Flanagan,
25                                  John C. Flanagan,
26
27                                                       Appellees-Cross-Appellants,
28
29                                            U.S. Trustee,
30
31                                                             Trustee.
32
33                                           _______________
34
35   Before:
36                                    CARDAMONE, MINER, and STRAUB,
37                                           Circuit Judges.
38
39                                           _______________
40
41        Appellants the Cadle Company and D.A.N. Joint Venture, L.P.
42   appeal from a September 30, 2004 judgment of the United States
43   District Court for the District of Connecticut (Arterton, J.),
44   affirming the July 3, 2003 decisions of the United States
45   Bankruptcy Court for the District of Connecticut (Dabrowski,
46   B.J.), which denied appellants' request for the imposition of a
 1   constructive trust over certain securities. Appellee-Cross-
 2   Appellant Bonnie C. Mangan, trustee, cross-appeals from the same
 3   judgment insofar as it found that a payment of $99,542.87 made by
 4   the debtor Charles Flanagan to appellants was partially protected
 5   from avoidance by the earmarking doctrine.
 6
 7        Affirmed.
 8
 9                            _______________
10
11   EDWARD C. TAIMAN, Jr., Sabia, Taiman, Moskey, Albano & Shea, LLC,
12        Hartford, Connecticut, for Appellants-Cross-Appellees.
13
14   JOSEPH L. RINI, New Haven, Connecticut, for Appellee-Cross-
15        Appellant John C. Flanagan.
16
17   JAMES C. GRAHAM, Pepe & Hazard, LLP, Hartford, Connecticut, for
18        Appellee-Cross-Appellant Bonnie C. Mangan, Trustee.
19
20                            _______________
1    CARDAMONE, Circuit Judge:

2         This appeal arises from two separate but related adversary

3    bankruptcy proceedings that we will describe in a moment.

4    Charles A. Flanagan (debtor) filed a petition under Chapter 11 of

5    the U.S. Bankruptcy Code, 11 U.S.C. § 101 et seq., for bankruptcy

6    relief in the United States Bankruptcy Court for the District of

7    Connecticut (Dabrowski, B.J.) on February 17, 1999.   While

8    debtor-in-possession under Chapter 11, Flanagan instituted the
9    first adversary proceeding (Preference Action) in the bankruptcy

10   court against Cadle Company to avoid and recover for the bankrupt

11   estate a $99,542.87 payment he had made to Cadle Company.

12   Following the conversion of Flanagan's Chapter 11 case to one

13   under Chapter 7, Bonnie C. Mangan was appointed trustee of

14   Flanagan's bankrupt estate and substituted as party plaintiff in

15   the Preference Action.

16        Cadle Company and D.A.N. Joint Venture, L.P. (collectively

17   Cadle Creditors or appellants) then brought a second separate
18   adversary proceeding (Constructive Trust Action) seeking a

19   declaratory judgment and the imposition of a constructive trust

20   over certain securities that Flanagan owned prior to the

21   bankruptcy filing.   In two memorandum decisions issued on May 22,

22   2003, the bankruptcy court denied the equitable relief requested

23   by the Cadle Creditors and ruled the trustee could avoid the

24   payment from Flanagan to Cadle only to the extent of $14,542.87.

25   The bankruptcy court went on to hold that the payment was

26   partially protected from avoidance by the earmarking doctrine.

                                      2
1    Following a motion for reconsideration, the bankruptcy court

2    affirmed its original decisions on July 3, 2003.    Both parties

3    appealed.   The United States District Court for the District of

4    Connecticut (Arterton, J.) affirmed the decisions of the

5    bankruptcy court on September 30, 2004.

6         As Sir Walter Scott observed "Oh, what a tangled web we

7    weave, when first we practise to deceive."     Marmion, Canto VI,

8    Stanza 17 (1808).   Such well describes the circumstances of the
9    debtor's conduct revealed by the record in the appeal before us.

10   Fortunately, these tangled facts were carefully sorted out in the

11   bankruptcy court in its decisions and in the district court's

12   September 30, 2004 decision affirming the judgment of the

13   bankruptcy court.   We now in turn affirm the judgment of the

14   district court.

15                               BACKGROUND

16        The facts of this case were laid out in detail by the

17   district court in Cadle Co. v. Mangan, 316 B.R. 11, 14-17 (D.
18   Conn. 2004).   Nonetheless, for purposes of clarity and analysis,

19   we include a summary of those facts relevant to the disposition

20   of this appeal.

21        Prior to Flanagan's bankruptcy filing of February 17, 1999,

22   the Cadle Creditors obtained several money judgments against

23   Flanagan in federal and state court.     Most significant for our

24   purposes is a judgment obtained by Cadle against Flanagan on

25   March 20, 1997 in the United States District Court for the

26   District of Connecticut (Covello, J.) in the amount of $90,747.87

                                      3
1    (federal judgment).   Among Flanagan's assets at the time of the

2    federal judgment was a 50 percent equity interest in Thompson &

3    Peck, Inc. and Flanagan/Prymus Insurance Group, Inc.

4    (collectively Thompson & Peck), valued in excess of $100,000.

5    Flanagan had possession of the Thompson & Peck stock certificates

6    at the time of the federal judgment in March 1997.   In September

7    1997 he transferred the certificates to Socrates Babacas as

8    security for loans made by Babacas to him in the amount of
9    $85,000 (Babacas loan).

10        Cadle's attempts to locate assets with which to satisfy its

11   federal judgment focused principally upon Flanagan's equity

12   interest in Thompson & Peck.    In March 1998 Cadle subpoenaed

13   Flanagan to appear before Judge Covello for an examination of the

14   debtor and for Flanagan to produce, inter alia, "[a]ll documents

15   and communications related to or evidencing any interest which

16   [Flanagan] may hold in Thompson & Peck, Inc."   Flanagan appeared

17   for the hearing but did not produce any documents that would
18   reveal his interest in Thompson & Peck.   On March 12, 1998 Cadle

19   made a motion for a turnover order commanding Flanagan to "turn

20   over all evidence of . . . ownership and/or other interest in

21   Thompson & Peck . . . including any and all stock certificates in

22   [his] possession, under [his] control and/or available to [him]."

23   The turnover order was granted by the district court on April 13,

24   1998 and upheld on reconsideration.

25        Despite this court order, Flanagan persistently failed to

26   comply with its instructions.   Consequently, on November 16, 1998

                                       4
1    a hearing was held at which Flanagan was ordered to show cause

2    why he should not be held in contempt for his failure to comply

3    with the court's turnover order.       At the conclusion of the

4    hearing, Judge Covello found Flanagan had willfully and

5    intentionally not complied with the turnover order and ordered

6    him committed to the Bureau of Prisons until he complied.         The

7    execution of the contempt order was stayed and a hearing

8    scheduled a week later to allow Flanagan one final opportunity to
9    comply.

10        When Flanagan's father, John Flanagan, learned that his son

11   was facing contempt sanctions, he lent him $100,222.87 for the

12   purpose of satisfying the federal judgment (family loan).         John

13   Flanagan had never loaned money to his son before and did so on

14   this occasion only to prevent Charles Flanagan from being

15   imprisoned and to protect the family's reputation.       The family

16   loan was secured by the debtor's equity interest in Thompson &

17   Peck and Flanagan arranged for Babacas to deliver the stock
18   certificates to his father's home.       Immediately upon receipt of

19   the family loan, Flanagan delivered the funds to his lawyer so

20   that the federal judgment could be satisfied.       On November 20,

21   1998 Flanagan's attorney deposited the funds into the registry of

22   the district court and Cadle received payment on December 3, 1998

23   (Payment).

24        Following Flanagan's bankruptcy and the filing of the

25   Preference Action to avoid and recover the Payment as a

26   preferential transfer under 11 U.S.C. § 547, the Cadle Creditors

                                        5
1    mounted a two-pronged defense.    In the Preference Action and in

2    the Constructive Trust Action instituted by appellants, the Cadle

3    Creditors sought the imposition of a constructive trust over the

4    Thompson & Peck stock for their benefit.    Appellants argued it

5    was solely because of Flanagan's wrongful concealment of his

6    equity interest in Thompson & Peck that they had been unable to

7    execute upon the stock and secure the federal judgment and other

8    judgments they had obtained prior to the 90-day preference
9    period.    Thus, they sought the imposition of a constructive trust

10   over the Thompson & Peck stock to restore them to the secured

11   position they would have occupied absent Flanagan's misconduct.

12   The Cadle Creditors asserted the Payment did not improve their

13   position relative to other creditors (as required by 11 U.S.C.

14   § 547(b)(6)) because, due to their constructive possession of the

15   Thompson & Peck stock, the Cadle Creditors possessed a fully

16   secured lien in the stock prior to the preference period.

17           The second prong of the Cadle Creditors' defense against the
18   Preference Action was their argument that the family loan funds

19   had been earmarked by John Flanagan for the sole and specific

20   purpose of satisfying the federal judgment against his son.

21   Accordingly, they maintained that the family loan funds had never

22   constituted an "interest of the debtor in property" as required

23   by § 547(b).

24           The bankruptcy court resolved the Preference Action and the

25   Constructive Trust Action in two decisions issued on May 22,

26   2003.    Both decisions were upheld on reconsideration and a

                                        6
1    modified opinion was issued in the Preference Action on July 3,

2    2003.    In response to Cadle's constructive trust claim, the

3    bankruptcy court found the imposition of a trust inappropriate in

4    the circumstances.    It noted the Cadle Creditors possessed "only

5    an expectation of the potential fruits of execution [on the

6    stock]," and concluded that a constructive trust should not be

7    imposed to "protect property rights which may or may not have

8    become vested and indefeasible."
9            The bankruptcy court also ruled the Payment was partially

10   protected from avoidance by the earmarking doctrine because the

11   family loan was made for the sole and specific purpose of

12   enabling Flanagan to satisfy the federal judgment.    But the

13   bankruptcy court further held that "even though the transaction

14   fits the earmarking defense insofar as it replaced one creditor

15   (Cadle) with another ([John] Flanagan), the substitution of a

16   secured for an unsecured obligation attenuates that defense

17   because, and to the extent, it caused a diminution to Flanagan's
18   personal estate."    As a consequence, the bankruptcy court entered

19   judgment in favor of the trustee to avoid the transfer but only

20   to the extent of $14,542.87, an amount equal to the difference

21   between the family loan and the Babacas loan whose security

22   interest had been supplanted.

23           The Preference Action and the Constructive Trust Action were

24   consolidated on appeal to the district court.    On September 30,

25   2004 Judge Arterton of the United States District Court for the

26   District of Connecticut affirmed the decisions of the bankruptcy

                                        7
1    court.   The Cadle Creditors appealed, and the trustee, Bonnie C.

2    Mangan, together with John and Charles Flanagan (appellees)

3    cross-appealed.

4         Meanwhile, the Cadle Creditors instituted two additional

5    proceedings against Charles Flanagan:    (1) a civil RICO action in

6    the United States District Court for the District of Connecticut

7    (Covello, J.) alleging, inter alia, fraud and conspiracy in

8    connection with resisting creditors' collection efforts, and (2)
9    an adversary proceeding in bankruptcy court seeking denial of

10   discharge.    In 2004, the discharge action was withdrawn from the

11   bankruptcy court and consolidated with the RICO action in the

12   district court before Judge Covello.

13        On April 8, 2005 while the instant appeal was pending, the

14   Cadle Creditors and Flanagan entered into a proposed settlement

15   agreement in the consolidated RICO/discharge action.    As part of

16   the proposed settlement, the Cadle Creditors and Flanagan entered

17   into a "Mutual Release of All Claims" (General Release) which
18   stated

19                Upon execution of this Release, both Cadle
20                and Flanagan hereby release each other of and
21                from any and all claims, whether now known or
22                unknown, whether now in existence or arising
23                hereafter, which each has or may have against
24                each other from the beginning of time until
25                the date of the execution of this Release.
26
27   Judge Covello entered an order approving the proposed settlement

28   on May 5, 2005, and dismissing the RICO/discharge action with

29   prejudice.



                                        8
1                                    DISCUSSION

2                                I   Jurisdiction

3            The first issue we address is whether, in light of the

4    General Release, we retain subject matter jurisdiction over that

5    portion of the appeal relating to the Constructive Trust Action.

6    Appellees assert that by executing the General Release the Cadle

7    Creditors relinquished all claims against Flanagan, including

8    claims against Flanagan's bankrupt estate.      The trustee thus
9    reasons the Cadle Creditors have extinguished the basis for the

10   relief sought in the Constructive Trust Action, rendering that

11   portion of the appeal moot.

12           In order for there to be a valid exercise of subject matter

13   jurisdiction, a federal court must have before it an actual

14   controversy at all stages of review, not simply at the time the

15   complaint was filed.     Steffel v. Thompson, 415 U.S. 452, 459 n.10

16   (1974).    In general, if an event occurs while an appeal is

17   pending that renders it impossible for the court to grant any
18   form of effectual relief to plaintiff, the matter becomes moot

19   and subject matter jurisdiction is lost.       Altman v. Bedford Cent.

20   Sch. Dist., 245 F.3d 49, 69 (2d Cir. 2001); see also Church of

21   Scientology of Cal. v. United States, 506 U.S. 9, 12 (1992).

22   However, when an appellant retains an interest in a case so that

23   a favorable outcome could redound in its favor, the case is not

24   moot.     See Firefighters Local Union No. 1784 v. Stotts, 467 U.S.

25   561, 568-72 (1984).



                                         9
1         The crux of the trustee's contention is that the Cadle

2    Creditors' claims against Flanagan's bankrupt estate became

3    unenforceable when they entered into the post-petition settlement

4    agreement with the debtor that included a mutual general release

5    of all claims.   In making this argument, appellees rely on

6    language in § 502(b)(1) of the Bankruptcy Code.   That section

7    states a claim is disallowed in bankruptcy to the extent that it

8    is "unenforceable against the debtor and property of the debtor,
9    under any agreement or applicable law for a reason other than

10   because such claim is contingent or unmatured."   11 U.S.C.

11   § 502(b)(1).   The trustee asserts that § 502(b)(1) should be read

12   to disallow not only claims that are unenforceable against the

13   debtor at the time the bankruptcy petition is filed but also

14   those claims that become unenforceable against the debtor over

15   the course of the bankruptcy and prior to discharge.

16        We think the trustee's interpretation of § 502(b)(1) is an

17   untenable reading of the statutory text because it ignores the
18   provision's context within the Bankruptcy Code.   Section 502(b)

19   instructs the bankruptcy court to "determine the amount of such

20   claim . . . as of the date of the filing of the petition" except

21   to the extent that "such claim is unenforceable against the

22   debtor."   11 U.S.C. § 502(b), (b)(1) (emphasis added).   A plain

23   reading of the statute thus suggests that the bankruptcy court

24   should determine whether a creditor's claim is enforceable

25   against the debtor as of the date the bankruptcy petition was

26   filed.   Were this Court to adopt the trustee's interpretation of

                                     10
1    § 502(b)(1), we would be forced to conclude that all pre-petition

2    unsecured claims are disallowed to the extent they did not

3    represent non-dischargeable debts.     For, as the bankruptcy court

4    aptly noted in In re Strangis, 67 B.R. 243 (Bankr. D. Minn.

5    1986), "[a]bsent a finding of nondischargeability, no such

6    unsecured claim is enforceable post-petition against a debtor and

7    property of a debtor."   Id. at 246.

8         The General Release could not have impacted any claims held
9    by or against Flanagan's bankrupt estate for an additional and

10   related reason.   Flanagan simply did not have the authority to

11   settle any claims against the bankrupt estate.    It is well

12   established that once a trustee is appointed, a debtor loses all

13   authority to litigate any claim for or against the estate.     As

14   noted in Collier on Bankruptcy

15                The trustee, as representative of the
16             estate, has the exclusive capacity to sue and
17             be sued on behalf of the estate, and is
18             charged by law with representing the interest
19             of the estate against third parties claiming
20             adversely to it. . . .
21
22                . . . After appointment of a trustee, a
23             debtor no longer has standing to pursue a
24             cause of action that existed at the time the
25             order for relief was entered. Only the
26             trustee has the authority and discretion to
27             prosecute, defend and settle, as appropriate
28             in its judgment, such a cause of action.
29
30   3 Collier on Bankruptcy ¶ 323.03, .03[1], at 323-7 to -9 (Alan N.

31   Resnick et al. eds., rev. 15th ed. 2007); see also 10 Collier on

32   Bankruptcy ¶ 6009.03, at 6009-3 to -6.1.




                                      11
1            Here, not only was the trustee not a party to the General

2    Release, but there is no indication the bankruptcy court was ever

3    presented with a motion to settle, compromise, disallow, or

4    otherwise dismiss the Cadle Creditors' claims.      See Fed. Bankr.

5    R. 9019 ("On motion by the trustee and after notice and a

6    hearing, the court may approve a compromise or settlement."); 10

7    Collier on Bankruptcy ¶ 9019.01, at 9019-2 (noting that any

8    "settlement must be approved by the court").      While Flanagan may
9    have had the authority to settle civil claims that arose against

10   him after his bankruptcy filing, he had no authority to settle

11   claims against the bankrupt estate.

12           Having established that the bases for the relief sought by

13   the Cadle Creditors in the Constructive Trust Action have not

14   been extinguished, and that a favorable result could redound in

15   their favor, we conclude those claims are not moot.     Hence, we

16   retain subject matter jurisdiction to review them.

17                           II   Standard of Review
18           In an appeal from a district court's review of a bankruptcy

19   court's decision, we conduct an independent examination of the

20   bankruptcy court's decision.     Supplee v. Bethlehem Steel Corp.

21   (In re Bethlehem Steel Corp.), 479 F.3d 167, 172 (2d Cir. 2007).

22   The bankruptcy court's factual findings will be upheld unless

23   clearly erroneous, and its legal conclusions are reviewed de

24   novo.    Id.   The ultimate determination of whether or not to

25   impose an equitable remedy -- such as a constructive trust or an

26   equitable lien -- is reviewed for abuse of discretion.      See

                                        12
1    Adelphia Bus. Solutions, Inc. v. Abnos, 482 F.3d 602, 607 (2d

2    Cir. 2007) (bankruptcy court's decision whether to exercise its

3    equitable authority is reviewed only for abuse of discretion);

4    see also Burkhart Grob Luft und Raumfahrt GmbH v. E-Systems,

5    Inc., 257 F.3d 461, 469 (5th Cir. 2001) ("Because a constructive

6    trust is an equitable remedy, the decision whether to impose it

7    is entrusted to the discretion of the district court, and we

8    review the district court's decision only for an abuse of
9    discretion.").    However, legal determinations upon which the

10   dispensation of equitable relief may depend are reviewed de novo.

11   See Superintendent of Ins. v. Ochs (In re First Cent. Fin.

12   Corp.), 377 F.3d 209, 213 (2d Cir. 2004) (reviewing de novo the

13   legal conclusion as to whether a party has been unjustly

14   enriched).

15                   III   General Law on Transfer Avoidance

16        Pursuant to § 547(b) of the Bankruptcy Code, a trustee in

17   bankruptcy may avoid certain transfers if the following criteria
18   are met:

19                (1) the transfer is of an interest of the
20                debtor in property;
21                (2) to or for the benefit of a creditor;
22                (3) on account of an antecedent debt;
23                (4) made while the debtor was insolvent;
24                (5) within 90 days of bankruptcy or within a
25                year of bankruptcy if the creditor was an
26                insider;
27                (6) and the transfer enabled the creditor to
28                receive more than it would have received in a
29                chapter 7 liquidation had the transfer not
30                taken place.




                                        13
1    11 U.S.C. § 547(b).    The burden of proof to establish each of

2    these elements by a preponderance of the evidence rests on the

3    trustee in bankruptcy.    Lawson v. Ford Motor Co. (In re Roblin

4    Indus., Inc.), 78 F.3d 30, 34 (2d Cir. 1996).    The Cadle

5    Creditors do not contest that the Payment was made within 90 days

6    of Flanagan's bankruptcy, while he was insolvent, on account of

7    an antecedent debt, and for the benefit of a creditor.    It is

8    therefore only the first and sixth of these criteria that are at
9    issue in this appeal.

10     IV   Transfer Improves Cadle Creditors' Position in Bankruptcy

11                     A.   The Constructive Trust Claim

12          Concerning the sixth criterion required by 11 U.S.C.

13   § 547(b), the Cadle Creditors aver that the Payment did not

14   improve their position in bankruptcy.    They allege that as a

15   result of their constructive possession of the Thompson & Peck

16   stock, they possessed a fully secured lien in the stock.      The

17   imposition of a constructive trust is necessary, they insist, to
18   remedy the harm caused by Flanagan's willful failure to comply

19   with the turnover order, which prevented them from perfecting

20   their judgments more than 90 days prior to the bankruptcy filing.

21   We believe the lower courts' refusal to impose a constructive

22   trust on the Thompson & Peck stock was well founded.

23          The effect of a constructive trust in bankruptcy is

24   profound.   While the bankrupt estate is defined very broadly

25   under § 541(a)(1) of the Bankruptcy Code to include all legal or

26   equitable interests of the debtor, any property that the debtor

                                       14
1    holds in constructive trust for another is excluded from the

2    estate pursuant to § 541(d), which states

 3               Property in which the debtor holds, as of the
 4               commencement of the case, only legal title
 5               and not an equitable interest . . . becomes
 6               property of the estate . . . only to the
 7               extent of the debtor's legal title to such
 8               property, but not to the extent of any
 9               equitable interest in such property that the
10               debtor does not hold.
11
12   11 U.S.C. § 541(a)(1), (d); see also Sanyo Elec., Inc. v.
13   Howard's Appliance Corp. (In re Howard's Appliance Corp.), 874

14   F.2d 88, 93 (2d Cir. 1989).   A constructive trust thus places its

15   beneficiary ahead of other creditors with respect to the trust

16   res.

17          The question of whether the imposition of a constructive

18   trust is appropriate in a particular set of circumstances is

19   governed, in the first instance, by state law.    See id.; see also

20   Butner v. United States, 440 U.S. 48, 54-55 (1979).    The Supreme

21   Court of Connecticut has stated:

22               [A] constructive trust arises contrary to
23               intention and in invitum, against one who, by
24               fraud, actual or constructive, by duress or
25               abuse of confidence, by commission of wrong,
26               or by any form of unconscionable conduct,
27               artifice, concealment, or questionable means,
28               or who in any way against equity and good
29               conscience, either has obtained or holds the
30               legal right to property which he ought not,
31               in equity and good conscience, hold and
32               enjoy.
33
34   Wendell Corp. Tr. v. Thurston, 680 A.2d 1314, 1317 (Conn. 1996).

35   It is uncontested that Flanagan wrongfully concealed evidence of

36   his equity interest in Thompson & Peck.   While such conduct could


                                      15
1    potentially give rise to a constructive trust in other

2    circumstances, it did not do so here because the Cadle Creditors

3    would not be the proper beneficiaries of such a trust.

4         A constructive trust has been imposed most often by

5    Connecticut courts "to restore to the plaintiff property of which

6    he has been unjustly deprived."    Cadle Co. v. Gabel, 794 A.2d

7    1029, 1037 (Conn. App. Ct. 2002) (quoting Restatement (First) of

8    Restitution § 160 cmt. d (1937)); see also Starzec v. Kida, 438
9    A.2d 1157 (Conn. 1981) (affirming imposition of constructive

10   trust for benefit of testator's children where testator gave

11   property to second wife on condition she devise property to his

12   children); Cohen v. Cohen, 438 A.2d 55 (Conn. 1980) (affirming

13   imposition of constructive trust over condominium property where

14   plaintiff conveyed property to son under oral agreement pursuant

15   to which son was to reconvey property back to plaintiff at her

16   request).

17        Here, the Cadle Creditors were never entitled to an
18   ownership interest in the Thompson & Peck stock.    Rather, under

19   Connecticut's post-judgment remedy statute, the turnover order

20   only entitled appellants to gain possession of the stock as the

21   first of several steps in executing a levy upon it.    See Mangan,

22   316 B.R. at 20-21 (describing and applying to the facts of this

23   case Connecticut's post-judgment remedy statute).   As the

24   district court aptly noted:

25               [Appellants'] interests in the stock were
26               subject to a series of contingencies, in
27               which other creditors with secured interests

                                       16
 1                in the stock were entitled to prevent
 2                execution or gain priority status over
 3                Appellants. The distinction here -- that the
 4                turnover order did not entitle Appellants to
 5                own Flanagan's stock, just to gain possession
 6                as an aid to execution of a levy upon it --
 7                is one that Appellants appear to have
 8                blurred.
 9
10   Id. at 21.    Indeed, once the federal judgment had been satisfied

11   by Flanagan with the family loan funds, Cadle lost any

12   expectation interest in the Thompson & Peck stock it might have
13   once had as a result of the district court's turnover order.

14        The Cadle Creditors point out Connecticut courts have in

15   some situations imposed a constructive trust when the plaintiff

16   was not entitled to an ownership interest in the trust property

17   and had not suffered a loss commensurate to the benefit received

18   by the defendant.     See, e.g., Gabel, 794 A.2d at 1039 (allowing

19   for constructive trust over property in favor of plaintiff

20   unsecured creditor because defendant had been unjustly enriched

21   by sham transactions used to shield property from creditors).    In

22   these situations, "the defendant is compelled to surrender the
23   benefit on the ground that he would be unjustly enriched if he

24   were permitted to retain it."     Id. at 1037.

25        However, the argument that Flanagan would be unjustly

26   enriched absent the imposition of a constructive trust is

27   unconvincing when made in the context of a bankruptcy proceeding.

28   See First Cent., 377 F.3d at 218 ("[W]e believe it important to

29   carefully note the difference between constructive trust claims

30   arising in bankruptcy as opposed to those that do not . . . .").


                                       17
1    It has been observed that the "equities of bankruptcy are not the

2    equities of the common law."     XL/Datacomp, Inc. v. Wilson (In re

3    Omegas Group, Inc.), 16 F.3d 1443, 1452 (6th Cir. 1994).       This is

4    particularly true in the context of constructive trust law.      As

5    discussed above, the effect of a constructive trust in bankruptcy

6    is to take the property out of the debtor's estate and to place

7    the constructive trust claimant ahead of other creditors with

8    respect to the trust res.    11 U.S.C. § 541(a)(1), (d); Howard's
9    Appliance, 874 F.2d at 93.     It is therefore not the debtor who

10   generally bears the burden of a constructive trust in bankruptcy,

11   but the debtor's general creditors.    This type of privileging of

12   one unsecured claim over another clearly thwarts the principle of

13   ratable distribution underlying the Bankruptcy Code.    As a

14   consequence bankruptcy courts have been reluctant, absent a

15   compelling reason, to impose a constructive trust on the property

16   in the estate.   See First Cent., 377 F.3d at 217-18 (collecting

17   cases); Haber Oil Co. v. Swinehart (In re Haber Oil Co.), 12 F.3d
18   426, 436 (5th Cir. 1994); Omegas Group, 16 F.3d at 1452

19   ("Constructive trusts are anathema to the equities of bankruptcy

20   since they take from the estate, and thus directly from competing

21   creditors, not from the offending debtor.").

22        The Cadle Creditors make no argument as to why Flanagan's

23   bankrupt estate or, more to the point, Flanagan's general

24   creditors, would be unjustly enriched by the estate's continued

25   ownership interest in the Thompson & Peck stock.    Accordingly, we



                                       18
1    affirm the bankruptcy court's refusal to impose a constructive

2    trust on the stock.

3                  B.   Availability of an Equitable Lien

4         In the alternative, the Cadle Creditors declare that an

5    equitable lien should be imposed on the Thompson & Peck stock to

6    the extent of their claims.   This point was not raised before the

7    bankruptcy court, but appears to have been prompted by language

8    in the district court's opinion.     In noting that the appellants
9    were not claiming they rightfully owned the stock, but only that

10   they were entitled to reach the stock as security for their

11   claims, the district court observed that an "equitable remedy

12   that would give Cadle a perfected lienholder status might be best

13   described as an 'equitable lien.'"     Mangan, 316 B.R. at 22.    The

14   district court then went on to dismiss the possibility of

15   imposing an equitable lien because it concluded that "an

16   equitable lien, even if enforceable, would not relate back" to

17   before the preference period.   Id. at 23.
18        We generally will not consider arguments raised for the

19   first time on appeal.   Universal Church v. Geltzer, 463 F.3d 218,

20   228 (2d Cir. 2006).   We do, however, retain discretion to

21   consider an argument not presented to the trial court in order to

22   prevent a manifest injustice or where the argument presents a

23   question of law and additional factfinding is unnecessary.       Id.

24   Because the district court considered the equitable lien issue

25   and because the imposition of an equitable lien on the facts of



                                     19
1    this case raises only a question of law, we briefly consider the

2    matter.

3         Connecticut law recognizes the equitable lien remedy.       See,

4    e.g., Hansel v. Hartford-Conn. Trust Co., 49 A.2d 666, 673 (Conn.

5    1946); Bassett v. City Bank & Trust Co. (In re Judd), 165 A. 557,

6    561-62 (Conn. 1933).   The equitable remedy was aptly described by

7    the Connecticut Supreme Court in Hansel

 8             An equitable lien creates merely a charge
 9             upon the property and when the person
10             entitled to it is not in possession of that
11             property, he has no right to obtain
12             possession from another unless by virtue of
13             some authority to do so expressly granted to
14             him; his remedy to enforce the lien is by a
15             proceeding in equity to bring about its sale
16             and the application of the proceeds to the
17             satisfaction of the obligation secured, or,
18             in some other manner, by order of the court,
19             to make the property available for the
20             discharge of that debt.
21
22   Hansel, 49 A.2d at 673.

23        Equitable liens arise in a variety of circumstances.    For

24   example, an equitable lien may arise by express or implied-in-
25   fact agreement of the parties.   See, e.g., Bassett, 165 A. at

26   561; see also Dan B. Dobbs, 1 Law of Remedies § 4.3(3), at 601

27   (2d ed. 1993).   Most often, however, equitable liens are imposed

28   to prevent unjust enrichment.    See Dep't of the Army v. Blue Fox,

29   Inc., 525 U.S. 255, 262-63 (1999).    In this sense, equitable

30   liens and constructive trusts share the same substantive basis;

31   both are remedies in equity to redress unjust enrichment.    See

32   Dobbs, supra, § 4.3(3), at 601 ("The [equitable] lien is imposed



                                      20
1    for reasons that, in principle, are the same as those that

2    warrant the constructive trust . . . .").

3         The traditional distinction between a constructive trust and

4    an equitable lien is that the beneficiary of a constructive trust

5    receives complete title to the asset whereas the holder of an

6    equitable lien receives only a lien on the asset through which it

7    may satisfy a money claim.     See Airwork Corp. v. Markair Express,

8    Inc. (In re Markair, Inc.), 172 B.R. 638, 643 (B.A.P. 9th Cir.
9    1994); Dobbs, supra, § 4.3(3), at 601.    Yet, in some states --

10   including Connecticut -- there is little practical difference

11   between the two remedies because courts have held that a

12   constructive trust beneficiary does not necessarily obtain a

13   right to possess the trust property, but may only receive a lien

14   on the property equal to the amount of the plaintiff's claim.

15   See Wendell 680 A.2d at 1320 ("To say that the . . . property is

16   subject to a constructive trust in Wendell's favor is not to say

17   that Wendell owns the property.    On the contrary, it is to say
18   only that Wendell may seek satisfaction of its debt, and no more,

19   out of that property . . . .").    Thus, in Connecticut, the right

20   to recover under a constructive trust is limited in a similar way

21   as it would be under an equitable lien theory.

22        The Cadle Creditor's contention that they should receive an

23   equitable lien on the stock fails for the same reason as their

24   constructive trust argument.    Both the equitable lien and

25   constructive trust remedies are equitable devices to prevent

26   unjust enrichment.   But, as discussed above, appellants have

                                       21
1    failed to demonstrate how Flanagan's bankrupt estate would be

2    unjustly enriched by its continued ownership interest in the

3    Thompson & Peck stock.     Because no equitable lien arises in these

4    circumstances, we need not review the district court's conclusion

5    that, even if an equitable lien did arise, it would not relate

6    back to a time before the preference period.

7                           V   Earmarking Doctrine

8         In order for a transfer to be avoidable by a trustee in
9    bankruptcy, it must be of "an interest of the debtor in

10   property."   11 U.S.C. § 547(b).    The requirement that the

11   transfer be of an interest of the debtor in property is not

12   defined in the Bankruptcy Code and has therefore been left to the

13   courts to interpret.   In so doing, courts have crafted a doctrine

14   that has come to be known as the earmarking doctrine.

15        The earmarking doctrine applies "where a third party lends

16   money to the debtor for the specific purpose of paying a selected

17   creditor."   Glinka v. Bank of Vt. (In re Kelton Motors, Inc.), 97
18   F.3d 22, 28 (2d Cir. 1996).    In such situations, the loan funds

19   are said to be "earmarked" and the payment is held not to

20   constitute a voidable preference.       McCuskey v. Nat'l Bank of

21   Waterloo (In re Bohlen Enters.), 859 F.2d 561, 565 (8th Cir.

22   1988).

23        Early applications of the earmarking doctrine concerned

24   situations in which the debtor's obligation was secured by a

25   guarantor.   See id.   Where the guarantor paid the creditor on

26   behalf of a debtor, the courts rejected the proposition that the

                                        22
1    payment could be avoided by the trustee.   Id.   The rationale for

2    such an outcome was that the property transferred belonged to the

3    guarantor and thus the transfer of that property in no way

4    diminished the debtor's estate.    See Nat'l Bank of Newport, N.Y.

5    v. Nat'l Herkimer County Bank, 225 U.S. 178, 185 (1912) ("Neither

6    directly nor indirectly was this payment to the bank made by the

7    [debtor], and the property of [the debtor] was not thereby

8    depleted.").   It is likely that courts were also mindful that the
9    opposite result would have the inequitable effect of forcing the

10   guarantor to pay the same obligation twice.    See McCuskey, 859

11   F.2d at 565.

12        Today, the earmarking doctrine has been extended beyond the

13   guarantor context and several courts have held that it applies

14   whenever a third party provides funds to the debtor for the

15   express purpose of enabling the debtor to pay a specified

16   creditor, that is substituting a new creditor for an old

17   creditor.   See Glinka, 97 F.3d at 28; Adams v. Anderson (In re
18   Superior Stamp & Coin Co.), 223 F.3d 1004, 1008 (9th Cir. 2000);

19   Buckley v. Jeld-Wen, Inc. (In re Interior Wood Prods. Co.), 986

20   F.2d 228, 231 (8th Cir. 1993); In re Smith, 966 F.2d 1527, 1533

21   (7th Cir. 1992); Mandross v. Peoples Banking Co. (In re Hartley),

22   825 F.2d 1067, 1070 (6th Cir. 1987); Coral Petrol., Inc. v.

23   Banque Paribas-London, 797 F.2d 1351, 1356 (5th Cir. 1986).     But

24   see Manchester v. First Bank & Trust Co. (In re Moses), 256 B.R.

25   641, 646-49 (B.A.P. 10th Cir. 2000) (stating that the earmarking

26   doctrine should not be extended beyond guarantor situations);

                                       23
1    McCuskey, 859 F.2d at 566 (expressing doubt as to whether

2    earmarking doctrine should be extended beyond guarantor

3    situations but ultimately adopting test that allows for

4    application of earmarking doctrine outside that limited context).

5         Several formulations have been developed to determine

6    whether the earmarking doctrine applies in a particular case.

7    See Manchester, 256 B.R. at 649-50 (discussing various approaches

8    to application of earmarking doctrine).   An oft cited approach is
9    that adopted by the Eighth Circuit in McCuskey.     McCuskey held

10   that in order for a transaction to qualify under the earmarking

11   doctrine, three requirements must be satisfied:    "(1) the

12   existence of an agreement between the new lender and the debtor

13   that the new funds will be used to pay a specified antecedent

14   debt, (2) performance of that agreement according to its terms,

15   and (3) the transaction viewed as a whole (including the transfer

16   in of the new funds and the transfer out to the old creditor)

17   does not result in any diminution of the estate."    859 F.2d at
18   566; see also Kaler v. Cmty. First Nat'l Bank (In re Heitkamp),

19   137 F.3d 1087, 1088-89 (8th Cir. 1998) (applying McCuskey

20   formulation).   Other courts have focused primarily on whether the

21   debtor lacked control over the funds supplied by the new

22   creditor.   See, e.g., Hansen v. MacDonald Meat Co. (In re Kemp

23   Pac. Fisheries, Inc.), 16 F.3d 313, 316 (9th Cir. 1994); Coral,

24   797 F.2d at 1358.

25        We have long recognized the earmarking doctrine, though our

26   early cases did not refer to it by that name.     See, e.g., Smyth

                                     24
1    v. Kaufman (In re J.B. Koplik & Co.), 114 F.2d 40, 42-43 (2d Cir.

2    1940); Grubb v. Gen. Contract Purchase Corp., 94 F.2d 70, 72-73

3    (2d Cir. 1938) (L. Hand, J.).    We have held that where a debtor

4    receives funds subject to a clear obligation to use that money to

5    pay off a preexisting debt, and the funds are in fact used for

6    that purpose, those funds do not become part of the estate and

7    the transfer cannot be avoided in bankruptcy.    See Grubb, 94 F.2d

8    at 73.   However, we have been equally clear that where a new
9    creditor provides funds to the debtor with no specific

10   requirement as to their use, the funds do become part of the

11   estate and any transfer of the funds out of the estate is

12   potentially subject to trustee's avoidance powers.     See Smyth,

13   114 F.2d at 42 (finding that transfer could be avoided where

14   "nothing indicat[ed] that [the new creditor] loaned this $500 on

15   condition that it should be applied to this particular

16   creditor.").   This result does not change even where the new

17   creditor knows, but does not require, that the new loan funds
18   will be used to pay off a preexisting debt.     See id.

19        In this case, the bankruptcy court found that Flanagan's

20   father provided the family loan for the specific purpose of

21   paying the federal judgment.    There was no doubt that the

22   debtor's father made such funds available "for the sole purpose

23   of purging Flanagan's contempt before Judge Covello through

24   satisfaction of the underlying Judgment."    This factual finding

25   is not clearly erroneous and we accept it on this appeal.



                                      25
1         The trustee does not seriously dispute that the family loan

2    was made for the purpose of allowing Flanagan to pay the federal

3    judgment.   She insists, however, that the earmarking defense does

4    not apply because Flanagan obtained possession of the funds

5    temporarily.   The fact that Flanagan temporarily had possession

6    of the family loan funds does not necessarily demonstrate that

7    Flanagan had control of them.   The proper application of the

8    earmarking doctrine depends not on whether the debtor temporarily
9    obtains possession of new loan funds, but instead on whether the

10   debtor is obligated to use those funds to pay an antecedent debt.

11   See 5 Collier on Bankruptcy ¶ 547.03[2], at 547-24 ("The

12   [earmarking] rule is the same regardless of whether the proceeds

13   of the loan are transferred directly by the lender to the

14   creditor or are paid to the debtor with the understanding that

15   they will be paid to the creditor in satisfaction of his claim

16   . . . ."); see also Superior Stamp, 223 F.3d at 1009.   Compare

17   Grubb, 94 F.2d at 73 with Smyth, 114 F.2d at 42.   Flanagan's
18   receipt of the family loan funds was specifically conditioned

19   upon his use of those funds to pay the federal judgment, and he

20   never obtained control of the funds in the sense of being able to

21   control how they were ultimately distributed.   The earmarking

22   doctrine therefore potentially applies to protect the Payment

23   from avoidance.

24        There is, nonetheless, an important limitation on the

25   earmarking doctrine.   The doctrine will only protect a transfer

26   from avoidance to the extent it did not diminish the debtor's

                                     26
1    estate.   Glinka, 97 F.3d at 28.    Where a debtor replaces an

2    unsecured obligation with a secured obligation, the payment is

3    voidable to the extent of the collateral transferred by the

4    debtor.   Id. ("[T]o the extent that the debtor offered its own

5    property as collateral for the [loan], the debtor transferred an

6    interest in its property and therefore the earmarking defense is

7    not available."); see also Mandross, 825 F.2d at 1071.     In the

8    case at hand, Flanagan satisfied the unsecured obligation of the
9    federal judgment by taking on the secured obligation of the

10   family loan.   However, the bankruptcy court also found that the

11   lien obtained by the debtor's father in the Thompson & Peck stock

12   supplanted Babacas's lien in the stock.    As a consequence, the

13   bankruptcy court concluded the net diminution of the estate was

14   equal to the difference between the Babacas loan ($85,000) and

15   the Payment ($99,542.87), or the extent to which John Flanagan

16   encumbered previously unencumbered property of the debtor estate

17   to enable the Payment.
18        The trustee disputes the bankruptcy court's finding that the

19   family loan lien supplanted, rather than merely subordinated,

20   Babacas's lien.   We believe the bankruptcy court's finding that

21   the Babacas lien was supplanted by the family loan lien finds

22   support in the record and is not clearly erroneous.

23   Consequently, we conclude that the Payment can be avoided by the

24   trustee, but only in the amount of $14,542.87.




                                        27
1                              CONCLUSION

2        Accordingly, for the foregoing reasons, the judgment of the

3   district court is affirmed and appellees' motion to dismiss for

4   lack of subject matter jurisdiction is denied.




                                   28
