Fifth Circuit Holds that a Constructive Trust is a Judicial Remedy Under Texas Law that is not Automatically Created by Contract
In BBX Operating, L.L.C. v. Bank of America, N.A. (In re Connect Transport, L.L.C.), No. 19-11050 (5th Cir. August 11, 2020), the Fifth Circuit Court of Appeals recently upheld the dismissal of a conversion claim as a matter of law, because the plaintiff failed to sufficiently plead ownership of the purportedly converted funds in its complaint, notwithstanding allegations of a constructive trust under Texas law. In doing so, the Court reminded us that a constructive trust under Texas law is a remedy that is not automatically created by contract and does not establish ownership of funds until a court has awarded such remedy.
BBX Operating, L.L.C. (“BBX“), an oil and gas production company, entered into an agreement with Murphy Energy Corporation (“Murphy“) to transport the natural gas produced by BBX to market. Pursuant to this contract, third-party customers paid Murphy for the sale of the natural gas produced by BBX and thereafter Murphy remitted such sale proceeds, minus its marketing and transportation fees, to BBX, which then would distribute such proceeds to its mineral interest owners.
In June 2016, Murphy’s bank (the “Bank“) swept Murphy’s bank account, which, at the time, held net sale proceeds that were required to be remitted to BBX.
In Murphy’s subsequent bankruptcy, BBX initiated an adversary proceeding against the Bank, claiming, among other things, that the Bank had converted net sale proceeds that belonged to BBX. The Bank filed a motion to dismiss this cause of action for failure to state a claim, pursuant to Federal Rule of Civil Procedure 12(b)(6).
To state a claim for conversion under Texas law, a plaintiff must plead four elements:
(1) the plaintiff owned, possessed, or had the right to immediately possess the property; (2) the defendant unlawfully and without authorization assumed and exercised control over the property to the exclusion of, or inconsistent with, the plaintiff’s rights as an owner; (3) the plaintiff demanded the return of the property; and (4) the defendant refused to return the property. Arthur W. Tifford, PA v. Tandem Energy Corp., 562 F.3d 699, 705 (5th Cir. 2009).
Only the first element of conversion–ownership and right to possession–was at issue in Connect Transport. Both the bankruptcy and district courts held that BBX’s mere allegations in its complaint that the funds in question “properly . . . belonged to BBX” and “the equitable owner of the funds was BBX” were insufficient to survive a facial attack. See Smit v. SXSW Holdings, Inc., 903 F.3d 522, 528 (5th Cir. 2018) (“simply pleading the legal status” of ownership “does not alone suffice”).
On appeal, the Fifth Circuit similarly held that such conclusory allegations, which merely “‘parrot the words needed to create a claim,'” do not make ownership plausible enough to survive a facial attack. See Gulf Coast Hotel-Motel Ass’n v. Miss. Gulf Course Ass’n., 658 F.3d 500, 506 (5th Cir. 2011).
Perhaps recognizing this flaw, BBX’s complaint also characterized the funds in question as “trust funds,” that Murphy held for the benefit of BBX. On appeal, BBX attempted to explain this theory of ownership by arguing it was entitled to a constructive trust over the net sale proceeds in Murphy’s account.
But, the Fifth Circuit rejected this contention, finding that BBX misconstrued the nature of a constructive trust under Texas law, which does not allow such trust to be automatically created by contract, but rather recognizes it as “remedy created by the courts to prevent unjust enrichment.” York v. Boatman, 487 S.W.3d 635, 646 (Tex. App.–Texarkana 2016, no pet.). Thus, under Texas law, “[n]o constructive trust exists unless and until a court imposes it as a remedy.” Id. at 647.
Accordingly, the Fifth Circuit held that BBX’s reliance on a constructive trust theory to plead the first element of conversion (ownership) was insufficient and thus this claim was properly dismissed as a matter of law.
Takeaway–the Fifth Circuit’s ruling does not suggest that contractual terms cannot result in a constructive trust in a subsequent judicial proceeding; only that a constructive trust is not automatically created by contract. The problem for the putative owner (BBX) in Connect Transport was that the Bank was not privy to, or bound by, the contractual terms between BBX and Murphy. Had the Bank been bound by such terms, BBX might have been able to plead that the Bank recognized the ownership of the funds vis-a-vis the contract with Murphy. This lesson seems to be one that can easily be rectified in the future by including all third parties, e.g., secured parties, that may have access to funds that are being held in trust by a borrower for the benefit of another person.