Should Escrow Accounts Funded by the Debtor be Property of the Estate

By: Meagan Mahar

St. John's Law Student

American Bankruptcy Institute Law Review Staff

 

Despite conflicting New York case law, the Delaware Bankruptcy Court in In re Atlantic Gulf Comtys. held that funds in an escrow account are not property of the estate even where the funds were deposited by the debtor.

[1]

  Only the debtor’s contingent right to recover the funds upon satisfying the escrow conditions is considered estate property.

[2]

In Atlantic Gulf, the New York Department of State (“Department”) brought an action to prevent the trustee of a land development corporation from removing funds from an escrow account created by the developer to guarantee construction of water and sewer facilities at its homesites.

[3]

  The state had required the company to establish the escrow in order to sell property to New York residents.

[4]

According to the agreement, the developer was authorized to withdraw the funds when it could provide evidence that water and sewage facilities had been built at each site, which it had not yet done as of the bankruptcy filing.

[5]

The trustee argued that the debtor was entitled to the funds under both New York law and section 541 of the Bankruptcy Code, alleging that the debtor had both a legal and an equitable interest in the account, since it was both the grantor of the account and the recipient of the funds once the condition of building the facilities was met.

[6]

The Department argued that under New York law, the escrow funds were not property of the estate because the property owners also had rights to the fund, which was established for the purpose of constructing facilities to benefit them.

[7]

The Court held that the debtor had only a contingent right to the funds, because it was only entitled to the funds when the condition of constructing the facilities was met.

[8]

  The Court stated, “[t]he filing of a bankruptcy case by the [d]ebtor was not sufficient to divest the lot purchasers of their interest in the escrow.”

[9]

It concluded that “the [e]scrow is not property of the estate, even though the contingent interest that the [d]ebtor has in the [e]scrow is property of the estate.”

[10]

 

Bankruptcy courts in New York have not addressed the issue of the debtor’s interest in funds deposited in an escrow account consistently. A long line of New York cases hold that title remains in the grantor until the condition specified in the escrow agreement is fulfilled.

[11]

However, section 541 of the Bankruptcy Code states that property becomes property of the estate “only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.”

[12]

New York courts have relied on that language to limit the estate’s interest to the debtor’s contingent right to escrowed funds.

[13]

 

This case could have a major impact on the structuring of escrow accounts in the future.  Real estate developers who are currently entering into bankruptcy proceedings may find that they have substantially fewer assets than they imagined if their funds are tied up in escrow accounts.  While this decision protects purchasers, it could make it harder for the developers to reorganize and pay back their creditors.