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Many companies (call them D for Defendant) require monetary deposits from consumers (C for Claimants), before D undertakes time and effort to order the product. C is an unsecured creditor, and a layman ignorant on trusts law.

But after C pays their deposit, if D goes bankrupt, then C can't recoup their money — because D has little to no assets. Or C ranks so far behind D's secured creditors that C won't be restituted. Or the deposit money is too teensy to warrant paying fees to file a claim, even in Small Claims Court!

  1. How could C have protected and preserved C's deposit money? Could C have instructed D to hold the deposit money on trust, so that C has a proprietary interest or equitable title to the deposit money (Which term is correct here?)? This feels simple. All C needs to do is to write the following in the contract

Company, as trustee, holds customer's deposit money on fixed revocable trust, for the benefit of the customer.

  1. But if every one of D's creditors loaned money to D on trust, then all of D's previous creditors — all beneficiaries of their separate loan monies to D — have priority over C. C ranks behind all of D's previous creditors. Then even if D holds C's deposit on trust, C's proprietary interest or equitable title to C's deposit money would be useless...???

Please don't just answer that D shouldn't buy from companies that require down payments — this is impractical.

This fact pattern has happened 3 times in my family. In my grandpa's case (call him G), D was a medical equipment company. For my aunt A, D = a mattress company. For my mom M, D = a furniture company.

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4 Answers 4

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Business Practices

There are contracts where consumer deposits are required to be held in trust, requirements that mostly, but not entirely, arise under state law in the U.S.

For example, many states require that landlords hold security deposits for residential rental properties in separate trust accounts, and almost all U.S. jurisdictions require that attorneys hold prepayment for legal services in trust for the consumer until the fees are earned.

As another example, in Colorado, if a property owner make a payment to a general contractor for work on real property such as building or renovating a building, the general contractor is required to hold those funds in trust and not make payments to itself from those funds, until all subcontractors and material suppliers on the job have been paid in full and have no lien claims.

In the same vein, many construction contracts, especially for governments acting as consumers, require contractors to be "bonded and insured" meaning that a third-party bond company is responsible for paying claims against the bonded company even if the bonded company is insolvent.

It also isn't unusual in complex commercial transactions between sophisticated big businesses, for the parties to negotiate that certain funds related to a transaction be held in a bankruptcy remote trust, or that the work be done by a "bankruptcy remote entity."

But this is rarely the case when large numbers of consumers enter into small transactions with a big business. As @DaleM rightly notes, a business in a position to impose a contract of adhesion on consumers on a take it or leave it basis, can get away with it, and one simply might want to be wary about doing business with financially insecure businesses, if possible, even though financially secure businesses may charge more.

A common theme is that consumers (maybe business to business or government to business) insist on trust-like or bond-like or insurance-like or collateral-like protections for deposits in transactions where the loss suffered if the security deposit was lost would be a major economic blow to the consumer in light of the consumer's overall financial situation. In contrast, these protections are foregone when the amount of a security deposit is small enough to be merely a survivable nuisance that may happen some small percentage of the time that the consumer engages in such transactions.

This reflects an economic and policy judgment that the trouble of treating small consumer deposits as if they were trust funds isn't worth the transaction cost trouble of doing so.

Priorities Under U.S. Bankruptcy Law

In part to address the imbalance of power in this situation, claims to recover consumer deposits for unperformed goods or services owed by the debtor do have a priority under U.S. bankruptcy laws relative to general unsecured creditors of up to $1,800 per consumer.

Specifically, these are seventh priority claims in bankruptcy pursuant to 11 U.S.C. ¶ 507(a)(7). They are behind claims secured by collateral to the extent of the value of the collateral (priority zero, so to speak), priority one alimony and child support claims, priority two costs of administering the estate, and priority three to six claims which include several kinds of claims that amount to up to about $20,000 of unpaid wages and benefits per employee and about $4,000 of unpaid amounts owed to farmers per farm for their crops. But security deposit claims are ahead of a variety of tax claims, FDIC claims, DUI personal injury claims, and general unsecured creditor claims. They are also ahead of the claims of stockholders.

As a practical matter, when you are doing business with a business entity rather than a sole proprietor, there are no child support or alimony claims, and most businesses that have lots of transactions with retail consumers don't buy crops directly from farmers, so consumer deposit claims actually have a very high priority in bankruptcy and are usually repaid in full except in the very most catastrophic business collapses under U.S. law. So, while it isn't quite as good as holding those funds in trust, the bankruptcy priority comes close from the perspective of providing a practical benefit to every day small consumers doing business with large firms that go bankrupt.

Canada Compared

Superficially, at least, it appears that Canada does not have a similar priority for consumer security deposit claims in bankruptcy, although it could be that this arises in some back door manner invisible to practitioners unfamiliar with it under court interpretations of Section 70 of the Canadian Bankruptcy and Insolvency Act (BIA) which governs creditor priorities in bankruptcy in Canada.

For example, the consumers may have an implied in law security interest in those funds of which I am not aware. It may also be that there are specific kinds of transaction in which deposits do have to be held in trust, just as there are in the U.S., even if that isn't true as a general rule.

Finally, if one pays by credit card, it is often possible to reverse a charge like this one, pushing the risk of bankruptcy loss from the consumer buying with a credit card to the bank issuing the credit card, particularly if action is taken promptly.

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  • Thanks. can you please elaborate your last para.? what do you mean by "reserve a charge like this one"? do Mom and Pop stores do this? Are you referring to a credit card Guarantee, not a deposit?
    – as ts
    Mar 26 at 7:23
  • Credit card companies frequently reverse payments made via credit card when the consumer complaints that the goods or services paid for were not provided. I am not referring to a credit card guarantee, but to a payment of a deposit made by credit card.
    – ohwilleke
    Mar 27 at 23:14
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If D is willing to accept money on trust, sure

However, D is probably unwilling to hold money on trust for C and will tell them to fornicate off.

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I am not a trust lawyer, but I did study trust law many years ago. Trusts lawyers here — don't hesitate to correct me, or improve this answer.

I spot 3 issues with your purported trust.

  1. Your purported trust is a sham trust, because the deposit money is actually consideration for forming the sales contract. The deposit money is not the subject matter of a trust.

  2. Even if your trust isn't a sham, this purported trust is void for uncertainty — because, if not to form the sales contract, its purpose is unclear.

In other words, you intend C to be the Settlor but non-Trustee, so that C has the discretion and power to reclaim C's deposit money at any time. Clearly you don't intend D to be the ultimate beneficiary. But then these intentions of yours, and this arrangement, merely further support my points 1 and/or 2 above.

  1. Even if your trust is valid, D's clearly the ultimate beneficiary. So if D goes bankrupt, D shall continue to enjoy the equitable interest.
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  • For the most part, these concerns are unfounded. It is perfectly possible to hold deposit funds in a valid trust for a consumer until the business earns the right to claim them. It simply isn't done for reasons of economic negotiating power unless there is a legal requirement to do otherwise in most cases.
    – ohwilleke
    Mar 24 at 1:51
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Just to add to what's already been posted:

But if every one of D's creditors loaned money to D on trust [...]

I don't think that would make sense. If the money is held on trust, it's supposed to be held. But in normal cases when D borrows money, they don't want to have to hold it, they want to be able to spend it on stuff they can use to make more money. So loans they take out to buy equipment, buildings, inventory, etc, couldn't be "loaned on trust" as that would defeat the whole purpose. Thus if C could get D to hold the deposit in trust, they should indeed be ahead of other creditors in a bankruptcy.

On the other hand:

This feels simple. All C needs to do is to write the following in the contract

Sure, and while they're at it, they can write in "D also agrees to deliver to C, at no extra charge, one pony". D will most likely decline to sign any such contract, or will demand some other significant concession in exchange. D probably likes having the ability to spend the deposit money that C puts up, and C's business alone wouldn't be worth the trouble of having their lawyers set up appropriate structures to hold funds in trust.

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