Sales transactions typically close only when the two sides are in agreement and satisfied with the benefit they will receive. In some cases, a property owner’s bankruptcy can be a tool to facilitate the transaction by allowing property to transfer free of liens, claims, and interests. However, at other times a bankruptcy – even a bankruptcy that doesn’t involve either the buyer or seller – can create obstacles or interfere with what the buyer and seller intended.
If a bankruptcy is filed before a sale closes, you may find yourself re-negotiating the deal. If the bankruptcy is filed by the other party to the deal, you may find the negotiations now involve a trustee who stepped into the decision making shoes of the debtor. Any property held in escrow may be a particularly appealing target. Whether property in an escrow account established by a debtor pre-petition is property of the debtor’s bankruptcy estate is determined by what rights the debtor holds in the property. Sellers, joint venture partners, and lenders can minimize their risks by carefully structuring the escrow arrangement to, among other things, restrict other parties’ access to the funds, clearly detail the conditions to receive the funds, and terminate the right to receive the funds upon the occurrence of an event of default, as well as incorporating into a joint venture agreement or financing documentation a provision that a bankruptcy estate shall include only the contingent right to receive the funds and not the funds themselves.
After closing, a buyer’s or seller’s bankruptcy would generally have very little effect on the previously closed sale, assuming the sale was for a market-determined price. Payments on a promissory note may be delayed, and the seller or lender may have to work through the court before foreclosing in the event of a default, but otherwise the closed transaction would not be upset.
However, when the purchase payment is provided in whole or in part by a third party who then files a bankruptcy, the seller may have to return the purchase proceeds. A federal court decision addressed this situation. A shopping center was sold and, upon close of escrow, the Seller received $300,000 cash, plus a Seller-financed promissory note. But the cash payment did not come from the buyer; it was wired directly to escrow from an entity owned by the Buyer’s daughter. Shortly after, that entity filed a bankruptcy petition, and the trustee appointed in the bankruptcy case immediately brought an action to recover the deposit from the Seller. The Debtor provided the deposit but received nothing in return for its payment, which is an indication of a fraudulent transfer under bankruptcy and state laws. While the Seller would argue that it acted in good faith and gave up equal value – the property – in exchange for the payment, the court held that this was not an available defense to the Seller because the Seller was the “initial transferee” of the payment from the Debtor: after the payment left the Debtor’s hands, the Seller was the first to have “dominion” over the funds (the ability to manipulate the funds and use them for his own purposes). Neither the Buyer nor escrow agent had dominion over the funds, as escrow was not funded until after all other conditions precedent for the sale had been consummated. This again highlights the importance of structuring escrows and complying with formalities in dealing with escrows.
