Daily Development for Wednesday, August 25. 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu

BANKRUPTCY; PROPERTY OF THE ESTATE; ESCROWED FUNDS: Because a debtor in bankruptcy does not have greater rights in property than the pre-petition debtor, assets the debtor has placed in escrow pre -petition are not property of the bankruptcy estate.

NTA, LLC v. Concourse Holding Co., LLC (In re NTA, LLC), 204 U.S. App. LEXIS 17420 (1st Cir. August 17, 2004).

The First Circuit affirmed the holdings of the District Court and the Bankruptcy Court, finding that because a debtor in bankruptcy does not have greater rights than the pre-petition debtor, the assets placed in escrow pre-filing, consisting of the LLC membership interests of the debtor entity ("NTA"), which owned 100% of the membership interests in the borrower LLC ("Concourse") and guaranteed payment of the $4.1 million loan from Concourse Holding Company ("Lender") to Concourse, were not property of the bankruptcy estate.

The parties had originally entered into an agreement, in connection with the loan to Concourse, which provided that NTA's membership interests in Concourse would serve as security for NTA's guarantee of the loan. When Concourse defaulted, the parties entered into a Standstill Agreement and an Escrow Agreement. The Standstill Agreement required NTA to deliver an "Assignment of Interest" that was "intended to transfer all right, title and interest in Concourse to [Lender]." According to the court, this provision "effectively required NTA to place its Membership Interests into escrow." The interests were to be released upon the happening of certain "trigger events," including the failure to supply a letter of intent or the failure to close on new financing by April 30, 2003. (According to the court, "the 'Assignment of Interests' operated to transfer title to the Membership Interests.") The escrowed interests were to be released upon the earlier of (1) two business days after writt en notice from Lender that a triggering event had occurred, or (2) July 1, 2003. (The court noted that there was no provision allowing NTA to contest or prevent the distribution of the escrowed Membership Interests during the two-day waiting period.)

On May 16, 2003, Lender gave notice of a "triggering event," i.e., failure to obtain the letter of intent. NTA immediately (surprise!) sought a restraining order, which request was denied by the Illinois state court. NTA then (again, surprise!) filed for bankruptcy Chapter 11 protection just hours before the expiration of the two-day waiting period for releasing the escrowed Membership Interests. NTA then claimed that the Membership Interests were part of its bankruptcy estate. The bankruptcy court denied this request, and ordered a release of the Membership Interests out of the escrow to Lender (which in fact occurred). NTA then appealed to the District Court, which held that NTA's estate had no right to the Membership Interests, and also rejected NTA's argument that it had somehow retained a "right of redemption" with respect to those interests.

The First Circuit affirmed, noting first that state law (in this case, Illinois) applied and that "a bankruptcy estate cannot succeed to a greater interest in property than the debtor held prior to bankruptcy." The court reasoned that, prior to NTA's bankruptcy filing, the Membership Interests served only as security for the loan, but that the subsequent Standstill Agreement entered into by the parties significantly altered the rights of the parties, providing Lender with virtual control over Concourse's business and prohibiting NTA from assigning, selling, or using the Membership Interests without the permission of Lender. According to the court, "In essence, the Standstill Agreement left NTA with only a limited right to the Membership Interests, best described as a contingent right to reclaim the Interests by meeting certain financing requirements." The court ruled that upon execution of the Standstill Agreement and Escrow Agreement and the deposit of the Membership Interest in to escrow, all that remained was NTA's contractual right to "buy back" the Membership Interests and prevent their distribution by meeting the financing contingency. Because this contingency was never met, the court held that NTA (and, therefore, the bankruptcy estate) could no longer exercise the contingent interest (which had expired) and the Membership Interests were not part of the bankruptcy estate. The court noted that had the bankruptcy not intervened, "there would be no dispute that the Membership Interests should be distributed to [Lender]."

The First Circuit then analyzed the parties' rights to the Membership Interests under Illinois law, finding that applicable Illinois case law was clear that at the time an escrow is entered into the grantee holds an equitable interest in the escrowed property, even though legal title is not conveyed until a contingent event occurs that entitles the grantee to the escrowed property. The court ruled that because (1) the lower courts had already denied NTA's request for an injunction; (2) the Membership Interests would have been released in a matter of hours had NTA not filed its Chapter 11 petition; and (3) NTA's contingent right to reclaim the Membership Interests had expired, with only the two business day waiting period to lapse, under both Illinois law and federal bankruptcy law the bankruptcy estate "succeeded to only this minimal interest," and the bankruptcy filing could not by itself make the Membership Interests property of the bankruptcy estate in contravention of the Sta ndstill and Escrow Agreements. (The court also cited law from other jurisdictions in support of its conclusion that assets placed in escrow are not part of the bankruptcy estate.)

Finally, the First Circuit dismissed the argument of NTA that the Standstill and Escrow Agreements did not create or preserve a security interest in the Membership Interests. According to the court, "The substantial right to the Membership Interests cannot be described as a mere security interest for [the lender's] loans to Concourse." The court noted that the parties were sophisticated businessmen, and that if they had intended the Standstill and Escrow Agreements to create a security interest (as in the original loan documents), they surely would have inserted language sufficient to accomplish that result.

Reporter’s Comment 1: This certainly is not a surprising result from an equitable standpoint. Courts aren't fond of the "tricks" utilized by borrowers at the last possible moment to avoid liability for debts that they are unable or unwilling to pay. It has been (and unfortunately, remains) common for borrowers to file bankruptcy petitions on the very eve of foreclosure, or, as in this case, hours before the expiration of the two-day "waiting period" set forth in the Standstill Agreement for release of the escrowed Membership Interests. But this case does highlight the dangers of giving "waiting" or grace periods of more than one day before documents can be released from escrow. Such time periods are most often for the benefit of the escrowee (often a title company), because of the logistics and administrative burden of immediately paying out escrowed funds (which may be in a separate account) or delivering escrowed documents. But such time periods are inevitably used (nefariousl
y) by a grantor, when seeking to avoid the results of the escrow contingency, to desperately attempt to get a "friendly" court to enjoin the release of the escrowed funds or documents.

Reporter’s Comment 2: The resolution of the issue of whether property that is the subject of an escrow is part of the bankruptcy estate may not be quite as clear-cut as the First Circuit would like us to believe. For example, in connection with a deed placed in escrow as part of a mortgage workout, the mortgagor, as debtor in possession, or a trustee appointed for the bankruptcy estate, may argue that the automatic stay, which arises by operation of law under § 362(a) of the Bankruptcy Code ("Code"), applies as of the filing date of the bankruptcy petition and prohibits the delivery of the deed and any other escrowed documents. See In re Stockschlaeder & McDonald, Esqs. v. Kittay (In re Stockbridge Funding Corp.), 145 B.R. 797, 811 (Bankr. S.D.N.Y. 1992) (holding that release of escrowed assignments prior to occurrence of stipulated conditions violated bankruptcy automatic stay). Even if the escrowed documents have been delivered out of escrow to the mortgagee prior to the mortga gor's bankruptcy, t he mortgagor or the bankruptcy trustee may seek to avoid the transfer as a fraudulent conveyance, a preference, or an unperfected lien subject to the "strong arm" powers of the trustee under section 544 of the Code. Section 544 vests a bankruptcy trustee with the rights of a hypothetical lien creditor whose lien was perfected at the time of the filing of the bankruptcy petition. If another creditor who claims a lien against the applicable property has not properly perfected its lien as of the date of the filing of the bankruptcy petition, the trustee or the debtor in possession can avoid that creditor's lien and that creditor then becomes merely a general creditor of the estate.

The bankruptcy court must first determine if the escrowed property is part of the estate. Section 541 of the Code defines property of the estate to include all legal or equitable interests of the debtor in property as of the commencement of the bankruptcy case. In order to determine the debtor's interest in the escrowed property or account, the bankruptcy court must look to state law. See Butner v. United States, 440 U.S. 48, 55 (1979); In re Lee Road Partners, Ltd., 155 B.R. 55 (Bankr. E.D.N.Y. 1993); Nobleman v. Am. Sav. Bank, 508 U.S. 324, 328 (1993). The issue of when an actual transfer of the escrowed property has occurred, under § 101(54) of the Code, is also a matter of state law. Section 101(54) defines "transfer" as "every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor's equity of redemp tion." Some courts hold that title to the escrowed property is transferred at the inception of the escrow. See, e.g., In re Newcomb, 744 F.2d 621, 626 (8th Cir. 1984) (holding that an "unavoidable . . . transfer occurred when the escrow was created"); Forest Hills Construction Co. v. City of Florissant, 562 S.W.2d 322, 325 (Mo. 1978) (ultimate grantee entitled to dividends from interest earned by escrow account prior to occurrence of stipulated condition); Musso v. New York State Higher Education Services Corp. (In re Royal Business School, Inc.), 157 B.R. 932, 940 (Bankr. E.D.N.Y. 1993) ("when considering preference actions, the predominant rule is that a subsequent judgment or release of escrow monies does not deprive the estate of anything of value since the debtor reserves only a contingent right to the escrowed funds"); Arrow Mill Development Corp. v. Shoprite of Clinton (In re Arrow Mill Development Corp.), 185 B.R. 190, 198 (Bankr. D.N.J. 1995 (escrow account was property o f creditor and not property of debtor's estate); Cedar Rapids Meats, Inc. v. Hager (In re Cedar Rapids Meats, Inc.), 121 B.R. 562, 567-68 (Bankr. N.D. Iowa 1990) (escrow fund was not part of debtor's bankruptcy estate); Dickerson v. Central Florida Radiation Oncology Group, 225 B.R. 241, 245 (M.D. Fla. 1998) (escrow account was not property of estate because condition precedent to release of escrowed funds occurred before filing of petition).

Other courts, however, hold that title is transferred only when the condition of the escrow is met. See, e.g., Wilson v. United Sav. Bank of Texas (In re Missionary Baptist Foundation of America, Inc.), 792 F.2d 502, 506 (5th Cir. 1986) (holding that escrow funds are property of estate); Gassen v. Universal Building Materials, Inc. (In re Berkley Multi-Units, Inc.), 69 B.R. 638, 642 (Bankr. M.D. Fla. 1987) (same); In re Flannery, 51 B.R. 697, 700 (Bankr. S.D. Ohio 1985) (finding that escrow was part of estate because debtors held "a legal or equitable interest" in escrow); Makoroff v. Allegheny Graphics, Inc. (In re Allegheny Label Inc.), 128 B.R. 947, 952 (Bankr. W.D. Penn. 1991) (ruling that sum of money placed into escrow was part of debtor's bankruptcy estate); Mason v. Benjamin Banneker Plaza, Inc. (In re Mason), 69 B.R. 876, 883 (Bankr. E.D. Pa. 1987) (holding that payments into court escrow account were property of bankruptcy estate, and that transfer occurred on date of ac tual remittance of funds for purpose of determining existence of avoidable transfer).

Still other courts further hold that upon fulfillment of the escrow condition, the vesting of legal title relates back to the creation of the escrow when equitable considerations mandate such a result. See, e.g., Donnelly v. Robinson, 406 S.W.2d 595, 598 (Mo. 1966) (transfer of real property by life tenant and remaindermen via escrow related back to creation of escrow).

Editor’s Comment: Had the interest placed in escrow been real estate, then there is no question that property would still have been the property of the debtor. Secured lenders cannot take property of the debtor to satisfy the loan without a foreclosure. A standstill agreement giving the debtor a contingent interest in the security at some future time, depending upon the debtor’s performance of certain elements of a loan agreement, can be nothing more than a mortgage, and the ownership of the security, again, can’t transfer without a foreclosure.

Sale agreements, with or without escrows, may be viewed as creating equitable ownership in the vendee under the concept of equitable conversion. But, if this were real estate, the court would not view the escrow established in this case as pursuant to a sale agreement.
In other contexts, Jack Murray has gathered what authority he could for the proposition that a contingent deed tendered as part of a work out agreement is a valid deed in lieu of foreclosure, even though the borrower will get the property back upon avoidance of the contingency, which is satisfaction of elements of the loan agreement. The editor has always strongly disagreed that this represents the general common law view of this situation. A contingent deed in lieu has been viewed traditionally as an equitable mortgage.

Jack might argue further that this escrow arrangement was the equivalent of a deed in lieu of foreclosure, and that consequently this case is relevant support for his contention concerning contingent deeds in lieu. But, again, the editor stresses the difference between real property rules and personal property rules.

The reporter for this item was Jack Murray of First American Title Insurance Company, Chicago office.

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