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Tuesday, October 20, 2015

An Appellate Court Shows How To Analyze Escrow Accounts in Bankruptcy

One of the recurring frustrations of my practicing years was having to confront a widespread ineptitude among lenders, borrowers and their counsel concerning how to set up an escrow account to protect its contents from being siphoned into the future bankruptcy of the counterparty to the escrow.  Up to and even well after the decision of the Second Circuit in In re Vienna Park Properties, 976 F.2d 106 (2d Cir. 1992), which avoided a lien on a poorly structured escrow account, I frequently encountered lenders and their counsel, whether in-house or outside, who would frequently just throw money into an account at some "escrow agent" and walk away from the closing thinking they had "perfected liens" on the money in the "escrow account" which meant they could just take it upon a default or bankruptcy.   This was a particular problem when said ill-advised lender would come to me in another deal with a term sheet calling for such an arrangement and then be perplexed and suspicious when I would explain to them that their request for a "perfection opinion" from my firm on their "lien" on the money in the escrow account was going to be more harmful to their interests than helpful and the best thing I could do to protect their interests was to restructure the terms of the arrangement.  It was a practical lesson in the lawyering version of "Gresham's Law" (that bad money drives out good) -- in transactional lawyering, it is often the case that, if bad lawyering gets somewhere first, a client sometimes might just as soon prefer not to learn about the risk it's holding in other deals.

So I was gratified to see in Tuesday's Daily Bankruptcy News a New Case squib about a Tenth Circuit case decided Monday that seems to have gotten the analysis of an escrow account in bankruptcy right for a change.  When I clicked on the link to the opinion itself, I saw the opinion is not intended for publication and not to be cited as precedent, and I decided it would be beneficial to write a short post about why it is right so that its analysis, being correct, is better preserved and propagated, which in turn will lead to greater accuracy in future litigation over, and structuring of, these arrangements.

The Tenth Circuit decision is captioned In re Expert South Tulsa LLC, Case No. 15-3000 (10th Cir. Oct 19, 2015); it affirms a reported BAP opinion (522 B.R. 634, which I haven't read).  As succinctly stated in the opinion, one party to the escrow, LTF, bought a piece of land from the other party, debtor Expert South Tulsa.  In the purchase agreement, Expert South Tulsa agreed to make improvements to the land.  In an arrangement that is very common in small business and middle market commercial matters (which is why it's important that courts gets these analyses right), LTF required Expert South Tulsa to put the funds for completion of the improvements into escrow (a more costly mechanism to accomplish the same result would have been a surety bond, although the bonding company might well have required the same arrangement and certainly would have charged a fee for its involvement).  Critically, the opinion reports, Expert South Tulsa "could recover portions of the escrowed funds each time it completed a segment" of the improvements.  Of course, Expert South Tulsa filed chapter 11 before completing much of the work.  LTF initiated an adversary proceeding declaring that the funds in escrow were not part of the bankruptcy estate.  Expert South Tulsa disagreed, seemingly finding the proposition so ludicrously obvious that, the opinion notes, it didn't offer the bankruptcy judge much more than a conclusory snort that, before the money went into escrow, it was in the debtor's pocket, so self-evidently the funds were in the  debtor's estate.

The panel correctly noted that the legal characterization of a debtor's interest in property is strictly one of state law (Butner; Whiting Pools).  And under Oklahoma law, as under the laws I dealt with in my own practice, title to the funds in an escrow account belongs to the escrow agent.  What the principals under an escrow agreement have is a contractual (sometimes called "contingent equitable") right to delivery of the funds upon satisfaction of the conditions specified in the agreement.  That interest, not an interest in the funds themselves, passes to the bankruptcy estate of a party to the agreement that goes into bankruptcy.  That interest, by the way, is a "general intangible" for UCC purposes and a creditor may be wise to file a UCC against that interest to be perfected in the value it represents.  But the lender, or other counterparty to the escrow agreement should not characterize its position as having a "lien" on the escrow account itself, nor on the money in it, or a court may view that as evidence that the arrangement is not a "true escrow" but merely a "disguised cash collateral arrangement" in which case the funds will be deemed property of the bankruptcy estate and the lender will have, at best, a claim for adequate perfection and at worst, an unperfected and avoidable lien on the money in the account, as was the result in Vienna Park.

So, how does one know one has a "true escrow" and not a "disguised cash collateral" setup.  This is where the terms of the escrow agreement are fundamental.  In Expert South Tulsa, they had a true escrow because (a) the conditions for disbursement from the escrow were objective and beyond the discretion of the debtor -- it could receive funds only when it completed a segment of the improvements, an objectively verifiable situation beyond its discretion -- and (b) disbursement from the escrow did not reduce the debtor's obligation to the counterparty to the escrow; rather, it merely repaid the debtor for work previously performed.  So it looked like a "true escrow".

This contrasts with the "escrow account" in Vienna Park where (a) the debtor, through a manager of its choosing, had discretion over spending the funds in the escrow account and (b) the lender took a lien on the funds in the funds in the escrow account and the debtor's "residual" interest in those funds and the "escrow" terminated upon "satisfaction" of the debtor's obligations to the lender.  As the lender had failed to file a UCC financing statement covering those security interests (thinking they were perfected through possession even though the funds were on deposit in a third-party bank and weren't tangible in the first place), their lien was avoided and the funds were free for the estate to use in the chapter 11 case (today, that arrangement could be perfected through a "control agreement" with that third-party bank).  So the two keys to setting up an escrow to be outside a bankruptcy estate are: (1) have disbursement be based on objective criteria and not under the control of the debtor and (2) have disbursement not reduce the debtor's debt.

In the Tenth Circuit case, LTF, the counterparty to the escrow, set it up and documented it just right to keep it out of the bankruptcy estate altogether.  Disbursement was objective and not in the debtor's control and disbursement did not benefit LTF by reducing the debtor's debt to LTF; rather, it benefited the estate.  And those are the two fundamental principles that all good-against-bankruptcy escrow arrangements depend on.  Of course, as the issue is one of state law, in any given specific situation, the relevant state law may prescribe additional bells and whistles to structure the escrow in the optimum manner and practitioners and litigators should inform themselves fully about the escrow law of the relevant state before sallying forth to advise clients or advocate to bankruptcy judges.