Chapter 11 Working Group Proposal #5: Exclusion of Payroll Deductions from Property of the Estate

The filing of a bankruptcy petition creates an estate that is comprised of all legal or equitable interests of the debtor as delineated in 11 U.S.C. § 541(a). The estate encompasses funds held in a debtor’s bank accounts. The estate is not intended to include property that actually is held for another party. [ FN: See , e.g. , Begier v. Internal Revenue Service , 495 U.S. 53 (1990) (prepetition payment of trust fund taxes to IRS from general accounts was not transfer of property of estate).]

Employers frequently hold funds deducted from employees’ paychecks in their general accounts awaiting periodic transfer to third parties. In addition to tax obligations, payroll deduction is a standard means by which employees remit a variety of payments owed to third parties. [ FN: A nonexhaustive list of the kinds of payments routinely made through payroll deductions would include: 401(k) and other retirement and savings program contributions, health insurance premiums (including supplemental benefits such as optical and dental coverage), flexible spending account contributions for dependent care and medical expenses, credit union and other loan repayments, membership or agency union dues, child support and other wage garnishment obligations, and charitable contributions.] Employers with cash flow problems are even more likely to have these withheld monies intermingled with their general funds at the time of the bankruptcy filing rather than in special segregated accounts for transfer in a timely fashion. When an employer acts as a conduit for these payments, the employer’s failure to remit these payments to the appropriate third parties can create serious financial problems for employees who may be brought into default on these various obligations. There is little question that these funds do not constitute the employers’ property, but without clear statutory guidance the funds become "trapped" in the bankruptcy estate.

The Recommendation

The Commission should recommend that Congress amend 11 U.S.C. § 541(b) to clarify that funds deducted from paid wages, held by a debtor/employer, and owed by employees to third parties do not fall within the definition of "property of the estate."

Reason for the Change

Many popular benefit programs are administered through payroll deductions. Some are completely voluntary, whereby the employer acts purely as a conduit, while others are employer-sponsored, where the employer makes its own contribution as well. [ FN: With respect to employer-sponsored benefit plans or employer-matched charitable contributions, this proposal deals only with the employee ’s contribution, and does not address the monies owed by the employer.] Credit union and other loans often are repaid directly through payroll deductions for the convenience of both the employee and the lender. Union dues are paid by the employee through payroll deductions under applicable law. Court-ordered support obligations may have to be paid through payroll deductions, as are other payments made through wage garnishments. In this process, a portion of an employee’s wages are withheld from that employee’s paycheck, held by the employer, and periodically transferred to the appropriate third party. It is typical for the employer to hold the funds in its general operating account rather than in a segregated account in the interim period.

When an employer files for bankruptcy before making the requisite transfers to the relevant third parties, those funds are caught in the debtor’s estate, yielding numerous adverse consequences as employees involuntarily become delinquent in their obligations to the third parties. For example, where employees’ insurance payments do not reach their insurance companies, their insurance coverage is jeopardized. The employees may end up in default on their loans or support obligations as a result of the nonpayment to third-party transferees.

The current laws do not provide adequate options for employees to remedy this situation. It may not be possible for employees to duplicate their payments to the third parties. Even if they could, pursuing reimbursement through the bankruptcy claims process often yields only a small percentage of the duplicated payments when the bankruptcy payouts ultimately are made. Sometimes, the trapped funds are freed through a first-day order authorizing the payment of prepetition wages, although often these orders are limited only to payments owed directly to the employee and not to third-party transferees.

Other efforts by employees in the bankruptcy process to free the funds and have them paid to third party transferees have not always been successful. Courts may require that the employees establish the existence of a trust, a task that is especially difficult when funds are not kept in a segregated account and often cannot be traced sufficiently to satisfy the strict requirements of trust law. ERISA plan contributions are more likely to be recoverable due to regulations that deem employee contributions to be ERISA plan assets, and thus are excluded from the employer’s bankruptcy estate. [ FN: See In re College Bound Inc. , 172 B.R. 399 (Bankr. S.D. Fla. 1994) (tracing requirement does not apply because funds are deemed to be assets of ERISA plan under express statutory trust).] However, the lack of traceability can be fatal to the collection of non-ERISA benefit plans and other types of third-party payments. [ FN: See In re Columbia Packing Co. , 35 B.R. 447 (Bankr. D. Mass. 1983) (employees unable to direct debtor to remit withheld funds to third party transferees because "general cash account is property of the estate. No separate trust fund was created for these employee payroll deductions ").] Moreover, some courts have held that aconstructive trust cannot be imposed without proving fraudulent conduct or wrongdoing. [ FN: See In re Lee Way Holding Co. , 113 B.R. 410 (Bankr. S.D. Ohio, 1990) (avoiding postpetition transfer of union dues to union owed from prepetition wage deduction).] Proving the existence of an express trust is an even more insurmountable undertaking, requiring a showing of intent of the parties, among other factors. [ FN: Id. , at 412.]

Much confusion and inconsistency could be eliminated through a statutory amendment that would make clear that withheld funds are not property of the estate. The change would obviate the need to employ the cumbersome and ill-fitting trust analysis. This clarification would be consistent with both bankruptcy and nonbankruptcy policy. The policies and purpose behind the creation of a broad bankruptcy estate would not be undermined by such an amendment that reinforces the basic tenets of what properly belongs in the debtor’s estate. Moreover, bankruptcy policy does not favor attempts to allocate disproportionate losses to nonadjusting creditors; to a large extent, employees are involuntary, nonadjusting creditors who will not be able to amortize the loss over time and often do not even know they have entered a debtor-creditor relationship when they agree to have funds withheld from their paychecks.

The clarification also would be consistent with other social policies favoring savings plans, insurance, support obligations, and the like. The clarification would maximize the safety of the wage deduction mechanism for insurance payments and retirement fund payments, which many would agree is in the best interest of everyone.

In addition to furthering bankruptcy and nonbankruptcy policy, this proposal also has an important jurisprudential effect because it would eliminate the need to expand the constructive trust doctrine. In general, constructive trusts offer a remedy that is best used sparingly, but one that often is sought even if it is not readily applicable. When parties successfully convince a court to impose a constructive trust, perhaps even "automatically" in the context of the first-day order, the court may have achieved an outcome that is socially defensible, but at the cost of generally weakening the doctrinal concept of the constructive trust. This has troubling implications in other contexts, where a flexible application of the constructive trust doctrine may not be nearly as desirable. Codifying the wage deduction exclusion will enable courts to "do the right thing" without stretching the trust doctrine in ways that will have negative repercussions in other situations.

It is important to note the issues that would not be implicated by this proposal. This proposal has no effect on an employer’s independent obligation to contribute to employee benefit funds or on a claim arising from nonpayment of that obligation. In addition, the recommendationonly affects deductions from wages that actually have been paid "on the books." The clarification would not enable an employee to obtain a priority repayment of a portion of her wages if the employer has suspended all wage payments. The goal is to obtain equality among employees, such that those who chose to make direct payments are not better off than those who used their employer as a conduit for payments. Thus, because the clarification only would affect amounts withheld from wages that already have been paid, this recommendation would have no direct implications for the wage priority claim provision. [ FN: 11 U.S.C. §507(a)(3), (4).] It merely would establish that the withheld funds are not property of the estate at all.

Competing Considerations

One might argue that the suggested provision is special purpose legislation that would further complicate the interpretation and application of section 541. However, many people who have discussed this issue have agreed that trapped funds withheld by the employer, which acts merely as a conduit, truly are not property of the estate, akin to withheld taxes. Thus, while this might constitute special interest legislation in the literal sense, it is wholly consistent with the notion of property of the estate and is not a carve-out or special exception.

Although this proposal does not alter what constitutes a priority wage claim, it could be argued that the wrongful withholding of these monies also should give rise to a priority fraud claim in certain situations, i.e., when the employer has spent the withheld money and has no wherewithal to remit payment to third party transferees. However, in a situation where the employer/debtor is cash starved, it is unlikely that even priority claimants will get repaid at all, thus obtaining an additional priority claim is likely to be a hollow victory.