The equitable constructive trust. In Texas, a court acting in equity may impose a constructive trust upon property held by a party to a transaction that belongs to another. The Austin Court of Appeals recently used this remedy to impose a constructive trust upon life insurance proceeds that, under a divorce decree, should have passed to the decedent’s minor children.

Factual background. “Kristi and Hugh divorced in February of 2013. The agreed final decree of divorce required them to each purchase $250,000 in life insurance, designate the other “as beneficiary in trust for the benefit of the children,” and maintain the coverage until both of their children had turned 18.”  Etcheverry v. Lankford, 03-17-00797-CV, 2018 WL 6615624, at *1 (Tex. App.—Austin Dec. 18, 2018, no pet. h.).  Kristi purchased the life insurance as required by the decree.  However, three days before her death she changed the life insurance beneficiaries to Thomas and Etcheverry. Kristi committed suicide in December 2016.

Two months later, Hugh filed suit against Thomas, Etcheverry, and the life insurance company and requested that the trial court impose a constructive trust upon the proceeds for Hugh to hold in trust for the minor children. Thomas agreed to assign his share to Hugh and Etcheverry contested the proceedings.

Court’s holding. The court stated, “Even though “breach of a special trust or fiduciary relationship or actual or constructive fraud is ‘generally’ necessary to support a constructive trust,” the remedy can be imposed in other circumstances where property is “obtained through bad faith or unconscionable acts.”” The Court held that even though Etcheverry had done nothing wrong, the policy against unjust enrichment supported the imposition of a constructive trust upon the life insurance proceeds in favor of the children.  Kristi (the decedent) violated the divorce decree by changing the beneficiaries and Etcheverry would not have received anything but for that violation. Etcheverry v. Lankford, 03-17-00797-CV, 2018 WL 6615624, at *2 (Tex. App.—Austin Dec. 18, 2018, no pet. h.).

Conclusion. The court acting in equity imposed a constructive trust upon the life insurance proceeds in favor of the minor children.

 

 

 

 

 

 

 

 

The constructive trust is a powerful weapon that plaintiffs can use against defendants who have breached their fiduciary duties or committed fraud. In one Texas case, the court of appeals actually affirmed the trial court’s award to the plaintiffs of all the assets in the business owned by the defendant who breached his fiduciary duties and committed fraud. Bright v. Addison, 171 S.W.3d 588, 595 (Tex. App.—Dallas 2005, pet. denied) .

In the Bright case, supra, Plaintiffs sued their attorney, Bright, and his law firm(s) for usurping a business opportunity to manage a casino in Aruba. Plaintiffs also sued the Aruban corporation set up by Bright to manage the casino.  The factual record of the case is limited, but apparently, Plaintiffs were in the casino business and hired Bright to perform legal work related to Plaintiffs’ business operations.  In connection with Bright’s representation of Plaintiffs, he allegedly learned of an opportunity to manage a casino in Aruba and did not disclose this opportunity to Plaintiffs   Instead, Bright took advantage of this opportunity for himself by setting up his own corporation to manage the Aruba casino.

Plaintiffs later learned about Bright’s alleged misdeeds and sued Bright and his law firms for usurping this business opportunity. Plaintiff’s alleged causes of action against Defendants including for breach of fiduciary duty, fraud and tortious interference with a prospective contract. Plaintiffs requested that the trial court impose a constructive trust upon the assets of Bright’s corporation used to manage the Aruba casino, and also requested that the trial court award Plaintiffs lost profits and punitive damages against Defendants.  Plaintiffs prevailed at trial and the Defendants appealed.

The court of appeals held that there was legally and factually sufficient evidence to show that Bright was Plaintiffs’ attorney so that Bright owed Plaintiffs a fiduciary duty of full disclosure.  Bright had a duty to disclose the opportunity to Plaintiffs to manage the Aruba casino and intentionally chose not to disclose this opportunity to them. There was sufficient evidence to uphold the trial court’s determination that Bright breached his fiduciary duty, committed fraud and committed tortious interference.

The court of appeals also affirmed the trial court’s ruling that a constructive trust should be imposed in favor of Plaintiffs upon all the assets of the Aruban corporation set up by Defendant Bright to manage the Aruba casino. The court of appeals held that breach of fiduciary duty and fraud are grounds for imposing a constructive trust and the trial court did not abuse its discretion in imposing the constructive trust.

Defendants also challenged the trial court’s award of lost profits. Defendants grounds for appeal on this issue included that Plaintiff’s expert CPA was not qualified to testify as to lost profits.  The Court found that the trial court did not abuse its discretion in finding that the CPA who had extensive experience in valuing casinos was qualified to testify.  The court also upheld the trial court’s award of punitive damages against the Defendants.

In conclusion, Texas courts have the authority to award both equitable relief and damages against parties committing breach of fiduciary duty or fraud.  One of the available equitable remedies is the imposition of a constructive trust upon assets that are obtained as a result a breach of fiduciary duty or fraud. As can be seen from the Bright case, this remedy can be harsh and extensive.  Typically, an expert will need to be hired to trace the assets upon which the plaintiff seeks the imposition of the constructive trust as well as to support an award of lost profits. If the expert is qualified, and the plaintiff proves his case, a defendant may lose everything tainted by the breach of fiduciary duty or fraud.

 

Texas Corporate directors and officers owe fiduciary duties of obedience, loyalty and due care to the corporation.  Gearhart Indus., Inc. v. Smith Intern., Inc., 741 F.2d 707, 719 (5th Cir. 1984); Loy v. Harter, 128 S.W.3d 397, 407 (Tex. App.—Texarkana 2004, pet. denied). In this context, directors and officers are probably most often found liable for violating the fiduciary duty of loyalty.

“The duty of loyalty dictates that a corporate officer or director must act in good faith and must not allow his or her personal interest to prevail over the interest of the corporation. The duty of loyalty is described as requiring an extreme measure of candor, unselfishness, and good faith on the part of the officer or director.” Loy v. Harter, supra, p. 407. “An officer or director is considered “interested” if he or she (1) makes a personal profit from a transaction by dealing with the corporation or usurps a corporate opportunity, (2) buys or sells assets of a corporation, (3) transacts business in his or her officer’s or director’s capacity with a second corporation of which he or she is also an officer or director or is significantly financially associated, or (4) transacts corporate business in his or her officer’s or director’s capacity with a family member.” Loy v. Harter, supra, pp. 407–08.

A Texas corporation can make these insider transactions valid by following proper corporate formalities. More specifically, Texas Business Organizations Code § 21.418 sets forth procedures that can be followed to authorize and make this type of transaction valid. In general, these procedures require full disclosure by the interested directors and officers as well as approval of the transaction by the disinterested directors or shareholders. Further, even if this approval is not obtained, the transaction will be deemed valid if it meets the fairness scrutiny of the statute. Additionally, shareholders of a privately held  corporation may  enter into a shareholder agreement governing these transactions (see Tex. Bus. & Org. Code § 21.101. In fact, the Texas Supreme Court in the recent case of Richie v. Rupe, 443 S.W.3d 856, 881 (Tex. 2014) seemed to encourage shareholder agreements.

In conclusion, Texas corporate officers and directors must strictly comply with their fiduciary duties including the duty of loyalty. These issues can be addressed in advance in a manner that will protect the officers and directors from liability and simultaneously benefit the corporation.  This may be done by following applicable  procedures set forth in the Texas Business Organizations Code or through a shareholder agreement. This is why it is important for corporations of all sizes to follow proper corporate formalities.

Introduction. In Texas, officers and directors of a corporation owe fiduciary duties to the corporation. “Three broad duties stem from the fiduciary status of corporate directors; namely, the duties of obedience, loyalty, and due care. Ubelaker at 781–82. The duty of obedience requires a director to avoid committing ultra vires acts, i.e., acts beyond the scope of the powers of a corporation as defined by its charter or the laws of the state of incorporation.” …”The duty of loyalty dictates that a director must act in good faith and must not allow his personal interests to prevail over the interests of the corporation.” …“Under the law of most jurisdictions, the duty of care requires a director to be diligent and prudent in managing the corporation’s affairs.” Gearhart Indus., Inc. v. Smith Intern., Inc., 741 F.2d 707, 720 (5th Cir. 1984). What happens when an officer or director breaches one of these fiduciary duties?

Texas Supreme Court opinion. In the recent Texas Supreme Court case of Longview Energy Co. v. Huff Energy Fund LP, 533 S.W.3d 866, 868 (Tex. 2017), reh’g denied (Dec. 8, 2017), reh’g denied (Jan. 26, 2018), the court addressed the evidence required to support the remedies allowed for breach of corporate fiduciary duties. These remedies include the imposition of a constructive trust upon assets wrongfully acquired and disgorgement of ill-gotten gains.

In this case, Longview Energy Corporation sued two of its directors and entities associated with them after discovering one of the associated entities, Riley-Huff, purchased mineral leases in an area where Longview had been investigating the possibility of buying leases.  The jury found that the directors breached their fiduciary duties owed to Longview by usurping a corporate opportunity and by competing with the corporation without disclosure. The trial court rendered judgment awarding Longview $95.5 million, imposing a constructive trust in Longview’s favor on substantially all Riley-Huff’s Eagle Ford acreage leases and associated properties, together with future production from the leases; and ordering Riley-Huff to transfer the leases and properties to Longview. Unfortunately, for Longview, the court of appeals reversed the judgment and the Texas Supreme Court affirmed the reversal.

Background. Longview, an oil and gas exploration company, was looking into investment opportunities in the Eagle Ford. In 2010, Longview held a board meeting to discuss the results of its investigation. The proposal before the board involved investing up to $40 million to lease 7,000 acres for drilling. The proposal did not identify or target specific acreage or leases in the large blobs of land considered. Longview decided against investing, at least in part, because of alleged misrepresentations and factual omissions by two of Longview’s board of directors.

These two directors had formed Riley-Huff in the preceding year to locate and fund oil and gas investments including in Eagle Ford. This had not been disclosed to Longview. Just 3 days before the 2010 Longview board meeting, Riley-Huff agreed to purchase Eagle Ford leases from Wyldfire which was one of the lease brokers Longview consulted in developing the proposal. Riley-Huff eventually acquired mineral leases to approximately 50,000 Eagle Ford acres, some of which were within the blobs on maps Longview’s board had considered.

The jury found that the two Defendant directors breached their fiduciary duties owed to Longview by taking a corporate opportunity and by engaging in competition with Longview without the approval of its board of directors. The trial court rendered judgment awarding Longview $95.5 million; imposing a constructive trust in Longview’s favor on substantially all Riley-Huff’s Eagle Ford acreage leases and associated properties, together with future production from the leases; and ordering Riley-Huff to transfer the leases and properties to Longview.

Court’s holding. The Texas Supreme Court affirmed the reversal of the trial court’s judgment because Longview failed to prove that the leases in issue were acquired by Riley-Huff as a result of the Defendants’ breach of fiduciary duties. There was no evidence that the leases in question were leases that Longview intended to acquire.  There was only evidence that these leases were encompassed within the large blobs of land considered by Longview as part of the investment proposal.  Thus, the evidence was not specific enough to support the court’s imposition of a constructive trust upon these leases, award of $95 million in lost profits or award of other remedies.

Conclusion. The lessons learned from this case are that corporate officers and directors owe strict fiduciary duties to the corporation and must be open and honest with the corporation about any competing ventures in which the directors and officers have invested or intend to invest.  Otherwise, they may have to account to the corporation for these investments.  Further, it is important for a plaintiff suing for breach of fiduciary duty to hire competent financial experts to trace the specific assets that a plaintiff alleges were wrongfully acquired as a result of a defendant’s breach.  Can you imagine investing large amounts of money and time into a lawsuit, being awarded a judgment for almost $100 million in damages and then later having the judgment reversed?