Contributed by Danielle Donovan
At the most basic level, bankruptcy is all about property. Going out on a limb here, we’d say that it’s a good idea to have a sense of what is and what is not your property before filing for bankruptcy. Of course, this is easier said than done in some cases and can be subject to dispute, as demonstrated by In re Expert South Tulsa, LLC, a recent decision from the Tenth Circuit. In that case, the court, not surprisingly, held that consistent with Oklahoma law, funds that a debtor puts in escrow prepetition are not property of the estate prior to the conditions to release the funds being met; rather, it is only the debtor’s contingent interest in the funds that is considered property of the estate.
LTF purchased from the debtor an undeveloped commercial site where LTF planned to operate a health club. Part of the deal struck by the parties was that the debtor would make certain improvements to the site. To guarantee that the debtor would hold up its end of the bargain, the debtor placed funds in escrow with a third party. Under the parties’ agreement, the debtor’s work was divided into segments. Each time the debtor completed a segment, the debtor could recover a portion of the escrow funds. The debtor, however, filed for bankruptcy before finishing the improvements…any of them.
LTF filed an adversary proceeding seeking a declaration that the escrow funds were not property of the debtor’s estate. Both the bankruptcy court and the bankruptcy appellate panel ruled in LTF’s favor.
The question to be answered by the Tenth Circuit was a simple one given the facts of the case: what was the scope of the debtor’s interest in the escrow funds at the time of the bankruptcy filing?
Without reciting for you the definition of “property of the estate” under section 541(a) of the Bankruptcy Code, we will remind you that it is broad enough to suggest that even a debtor’s nonpossessory and contingent property interests constitute property of the estate. The existence and scope of a debtor’s interest in property typically are defined by state law. In this case, Oklahoma law governed. Here, the debtor argued that the funds were legally and equitably property of the debtor’s estate at its inception. The Tenth Circuit rejected this argument outright, finding that Oklahoma precedent would not support a finding that the debtor retained an unqualified interest in the escrow funds.
Before wrapping up the opinion, the Tenth Circuit was kind enough to clarify a few points:
(1) The opinion should not be read to suggest that a debtor escrowing funds in Oklahoma (or in any state, if we had to guess) could not have a contingent equitable interest in the funds, a cause of action to secure the release of the funds, or even legal title to the funds. And, further, all of these interests could belong to a debtor’s estate upon a bankruptcy filing under the appropriate circumstances;
(2) There is not a uniform federal rule that precludes the possibility that escrow funds can ever belong to a debtor’s estate upon a bankruptcy filing; and
(3) In holding that the escrow funds in this case were not fully, legally, and equitably property of the debtor’s estate at inception, the Tenth Circuit was not suggesting that the funds could not become part of the debtor’s estate at a later time.
We think the takeaway here is this: although the definition of “property of the estate” is an expansive one, in cases like Expert South Tulsa, the key is delineating the proprietary nature of the debtor’s interest. Is it a right to possession contingent upon certain conditions precedent? Or, is it a current right of possession? Both interests constitute property of the estate, but only the latter could make escrow funds property of a bankruptcy estate at the commencement of a case.
A wise person once said, “don’t count your chickens escrows before they hatch.”
Danielle Donovan is an Associate at Weil Gotshal & Manges, LLP in New York.