The separate assets of 31 Catholic churches, schools, cemeteries and other charities held in a pooled investment account of the Catholic Diocese of Wilmington (DE) are available to pay the debts of the Diocese in bankruptcy, according to the bankruptcy court in Delaware.  The Diocese held the funds in trust for the benefit of the organizations, but could not meet the burden of specifically tracing the funds, the Court said.  The entire fund (with one exception for a group with a different arrangement) was therefore available for the general creditors of the Diocese.  (In Re:  Catholic Diocese of Wilmington, Bkrptcy Ct., D. DE, Chapt. 11 No. 09-13560, 6/18/10.)

The Diocese had held the funds with a single custodian in pooled investments for many years, and both the Diocese and the organizations thought that they could deposit or withdraw their own funds at any time.  On December 31, 2009, shortly after the Diocese filed for bankruptcy protection, the total value of the fund was about $120 million, including about $45 million invested by and allocated to the Diocese, $45 million from the Catholic Diocese Foundation, a totally separate corporation, and the balance from the other charities.  The unsecured creditors’ committee claimed the entire pool.

Both the Diocese and the affiliates had always believed that all funds within the pool were the property of the individual investors.  Each treated its funds in the pool as an asset on its financial statements, and their independent auditors repeatedly reported the funds in the pool as assets.  The Diocese listed the funds other than its own as “assets held for affiliates” on its balance sheet.

The Investment Committee of the Finance Council of the Diocese recommended 12 different investment managers for separate portfolios, including a cash management account and 11 investment types.  Some of the investors selected the portfolios in which their funds were invested, but the majority of participants delegated that responsibility to the Diocese.  The Diocese maintained approximately 180 separate “accounts” to track the investments of each organization to the penny.  The overall account was held solely in the name of the Diocese.

When an affiliate made or withdrew an investment, the Diocese did not put the money in or withdraw the money from the pooled investment account.  Instead, the Diocese put the money in or withdrew money from its ordinary business operations account and only made an accounting entry in the pooled account.  If, for example, a parish church made a $50,000 investment into the pooled investment account, the Diocese put the money in its business operations account and made an entry in the pooled account increasing the funds in the parish account and reducing the funds in the Diocese account at the pooled investment account.  No money actually changed in the pooled investment account, and the total value of the pooled account did not increase.

Similarly with a withdrawal, the Diocese paid the affiliate with funds from its business operations account and not the pooled investment fund.  The Diocese reduced the amount allocated to the withdrawing investor and increased the amount allocated to the Diocese.  No funds moved in the investment account.

The creditors’ committee sought a declaratory judgment that there was no trust relationship between the Diocese and the investors, and that if there were, the Diocese was unable to trace the funds so that they were all available for the creditors.  The Diocese and the affiliates opposed.

Although there was no written trust agreement between the Diocese and the investing organizations, the Court concluded that the arrangement created a “resulting trust” under state law.  It said a resulting trust is “one implied by law from the supposed intentions of the parties and the nature of the particular transaction.”  It arises when a person transfers property to another “under circumstances that raise an inference that the person does not intend the person taking or holding the property to have the beneficial interest in the property.”

Here, the Court said, the relationship was “akin to that between an investor and a broker,” with the broker investing the funds on behalf of the investors.  The parties intended that the funds would remain their property and treated the funds as their own.  The evidence was sufficient to establish the resulting trust.

Having established the trust, however, the affiliates had to be able to identify and trace the funds if they had been commingled with non-trust funds, the Court ruled.  Because the Diocese deposited and withdrew the investments from its own operating account, and not directly in or from the pooled account, and because the accounting sub-funds allocating assets to the investors were not actual separate accounts, the Diocese had commingled the finds with its own. 

“The accounting system may serve to divvy out the pieces of the pie,” the Court said, “but the pieces are all in one dish.  Thus, the [affiliates] must identify and trace their piece of pie.”

To see if the funds could be traced, the Court applied the “lowest intermediate balance test” (“LIBT”), which has its roots in general trust law.  It rejected a more liberal “nexus” test adopted by the U.S. Supreme Court in another situation, saying the nexus test did not apply in this case.

LIBT is grounded on the “fiction that, when faced with the need to withdraw funds from a commingled account, the trustee withdraws non-trust funds first, thus maintaining as much of the trust’s funds as possible….  If the amount on deposit in the commingled fund has at all times equaled or exceeded the amount of the trust, the trust’s funds will be returned in their full amount. Conversely, if the commingled fund has been depleted entirely, the trust is considered lost.  Finally, if the commingled fund has been reduced below the level of the trust fund but not depleted, the claimant is entitled to the lowest intermediate balance in the account.  In no case is the trust permitted to be replenish by the deposits made subsequent to the lowest intermediate balance.”  The Court called this “an elegant common law solution to this problem.” 

The affiliates argued that the trust portion of the pooled account was always greater than their portion of the pool.  “This argument,” the Court said, “ignores the fact that the trust funds were deposited and withdrawn from the operating account and not the [pooled account].  Thus, [the affiliates] must identify and trace the trust funds (i) to and from the operating account and (ii) between the operating account and the [pooled account].  This is what they cannot [do].  The [affiliates] did not present any evidence to trace the funds in this manner because no such evidence exists.  As such, they simply cannot meet their burden.”

The Court protected the funds of one of the affiliates.  In that case, the affiliate had a written trust agreement with the Diocese and made its only deposit directly into the pooled account.  The balance in the pooled account “never remotely came close to dipping below the amount invested” by the affiliate.

YOU NEED TO KNOW

This is a horrendous result for the affiliates who, if the result stands, don’t lose everything, but are left as general creditors of the Diocese along with all of the others.  Clearly, the organizations never expected to be in that position. 

The silver lining of the case is the lesson for others: create a specific agreement with each organization and transfer all funds directly into and out of the pooled fund.  Don’t commingle assets with non-trust funds.