A recent decision of the Bankruptcy Court for the Southern District of New York demonstrates the risks to a creditor of permitting the commingling of funds. The court denied claims for subrogation and declaratory relief to LFD Operating Inc., a licensee that sells shoes in Ames Department Stores. It was undisputed that, at the time Ames filed for protection as a debtor under chapter 11 of the Bankruptcy Code, Ames owed LFD net proceeds of US$8.9 million (EUR9.7 million) for sales of LFD merchandise in Ames Stores. The issue facing the court was whether Ames held only bare legal title without any equitable interest in the LFD sales proceeds. In that case, the property would be excluded from Ames's bankruptcy estate, and LFD would be entitled to immediate payment. LFD based its claims for relief on contract, agency, trust, and constructive trust principles. It relied primarily on its contract with Ames, which provides that: Although all proceeds from the sale of LFD merchandise in Ames Stores were to be processed through the regular channels of Ames's business, they were the property of LFD from the time of sale.

Ames would act as LFD's agent and trustee until the proceeds were paid to LFD.

The bankruptcy court concluded that the relationship between Ames and LFD was that of debtor-creditor based on the following facts: Ames commingled the sales proceeds in its depository account and used the funds in an unrestricted manner with LFD's knowledge.

Ames was not the agent of LFD because LFD had no right to, nor did it, control the collection and handling of the funds.

The court noted that when a recipient of funds is not prohibited from commingling the funds with his own monies, a debtor-creditor relationship, not a trust relationship, exists. Based on these facts, the court dismissed all of LFD's claims for relief and held that the funds were property of Ames's bankruptcy estate. The court concluded, therefore, that LFD had no basis to challenge Ames's transfer of the funds to its secured lenders in partial satisfaction of Ames's indebtedness. The decision demonstrates that contractual language purporting to create an agency or trust is insufficient to do so where there is evidence of a contrary understanding and course of behaviour between the parties.