The intersection of state escrow laws and federal bankruptcy laws can create confusion and surprise for contracting parties.
The Problem & Four Examples
The problem creating such confusion and surprise is this. State escrow laws:
- are, typically, defined by the common law;
- lack precise details; and
- are often applied in bankruptcy to the detriment of the party who believes a valid escrow exists.
Here are four examples of the escrow / bankruptcy problem.
- Debtor pays money into an “escrow account” to cover a landlord’s rent, but the bankruptcy court holds, (i) the account containing such money does not qualify for “escrow” status, (ii) such money is property of the bankruptcy estate that Debtor can use, and (iii) Debtor’s dissipation of that money after bankruptcy filing is fine (In re Odonata Ltd, 658 B.R. 62 (Bankr. S.D.N.Y. 2024));
- Debtor owns a hotel; the hotel stops operating, sustains water damage and develops a mold problem; Debtor’s attorney receives $7 million of insurance money to fix the mold problem, which money is held “in escrow” in the attorney’s trust account for that purpose; but the bankruptcy court holds, (i) the trust account arrangement does not qualify for an “escrow” status, and (ii) the $7 million can be used by the Debtor to help fund its bankruptcy case (In re Urban Commons 2 West LLC, 648 B.R. 530 (Bankr. S.D.N.Y. 2023));
- Fifteen years into the term of a land contract, the contracting parties agree to sell the land, but a dispute develops over a $207,116 fund; that fund is deposited with the “Deed Escrow Agent” with the understanding that the dispute would be later-resolved on the merits; then, one party to the contract files bankruptcy, and the bankruptcy court holds, (i) the $207,116 fund is not in a valid “escrow,” and (ii) the fund must be turned over to Debtor as property of its bankruptcy estate (DeFlora Lake Development Associates, Inc. v. Hyde Park (In re Deflora Lake Development Associates, Inc., 628 B.R. 189 (Bankr. S.D.N.Y. 2021)); and
- Subcontractor installs curb and gutter systems for Debtor’s apartment complex; General Contractor owes retainage of $207,130 to Subcontractor; $92,000 of Debtor’s funds are deposited in “escrow” to a trust account of Debtor’s attorney; then Subcontractor accepts payment of the $92,000 in full settlement of its claims under the subcontract; Debtor files bankruptcy >90 days after the $92,000 deposit into trust account but <90 days after payment to Subcontractor; and the bankruptcy court holds, (i) the deposit into trust account is not a valid “escrow,” and (ii) the $92,000 payment is a voidable preference (In re Chesapeake Associates, LP, 141 B.R. 737 (Bankr. D. Kan. 1992)).
A Uniform Law Solution
The Uniform Law Commission offers a newly-minted Uniform Special Deposits Act as a solution to the escrow / bankruptcy problem described above.
The solution is this: a clear and simple means for contracting parties to set aside a fund for a specific purpose.
Summary of the Act
Here is a summary of the Uniform Special Deposits Act.
A deposit of money in a bank account is a special deposit under the Act, if the deposit is made under an account agreement that:
- is for the benefit of at least two beneficiaries;
- is for a specified purpose;
- is subject to a contingency that will determine which beneficiary is to receive the funds; and
- specifies the intention that the account agreement is to be governed by the Act
Upon the happening of the contingency (or if the contingency does not occur), the funds must be paid to the designated beneficiary.
If any party to the account agreement files bankruptcy, the property interest of the bankruptcy estate in the special deposit is only this: the right to receive the deposited money, upon the occurrence (or non-occurrence) of the contingency. Here is the precise language of the Act on this point:
- “Neither a depositor nor a beneficiary has a property interest in a special deposit”; and
- “Any property interest with respect to a special deposit is only in the right to receive payment if the bank is obligated to pay a beneficiary and not in the special deposit itself.”
Further, funds in the special deposit are not subject to garnishment, except to the extent the bank is obligated to pay the special deposit funds to the garnishment debtor upon the occurrence (or non-occurrence) of the contingency.
Moreover, a bank holding the special deposit may not exercise a right of recoupment or set off against funds in that account, unless and until its debtor is entitled to receive those funds upon the occurrence (or non-occurrence) of the contingency.
Conclusion
Here’s a “Thank you” to the Uniform Law Commission for creating this “special deposits” solution to the “escrow” problem described above!
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