Lawrence v. Commonwealth of Ky. Transportation Cabinet (In re Shelbyville Road Shoppes, LLC), 775 F.3d 789 (6th Cir. 2015) –

A chapter 7 trustee sought return of a “good faith” deposit made prior to bankruptcy in connection with a proposed purchase of real estate.  The bankruptcy court found against the trustee, as did the district court.  So the trustee appealed to the 6th Circuit.

A buyer made a good faith deposit ~$960,000 (20% of the ~$4.8 M purchase price) pursuant to its purchase agreement with a state agency.  The buyer subsequently assigned the purchase agreement to the debtor.  Two days before the deadline for closing, the debtor filed bankruptcy.  The trustee did not assume the purchase agreement, so it was deemed rejected.  Notwithstanding the rejection, the trustee moved for summary judgment seeking turnover of the deposit under Section 542 of the Bankruptcy Code.

Under the purchase agreement the good faith deposit was “to be held in a special deposit trust fund” by a state agency pending the closing.  Upon delivery of the deed, the balance of the purchase price was due and payable.  The agreement further provided that if the debtor failed to close, the deposit would be forfeited to the seller as liquidated damages.

Under the 6th Circuit’s analysis, the debtor had no right to possess or use the deposit prior to or as of the bankruptcy filing, and thus the deposit was not part of the bankruptcy estate.  It noted that a majority of lower courts have held that a trustee cannot compel turnover of funds if a debtor does not have a present right to the funds at the time of filing.

According to the court, the debtor did not have a stand alone interest in the deposit.  Rather “the debtor’s sole property interest was in the Agreement, not the deposit.”  Upon payment of the balance of the purchase price, the debtor was entitled to own the property and it had a “limited, conditional interest in a credit of the deposit towards the balance” of the price.

Since the court did not find any circumstances that would have entitled the debtor to a refund of the deposit prior to the bankruptcy filing, the court reiterated that the deposit was not property of the estate.  This was distinguished from circumstances where the debtor had a right to return of the deposit upon the occurrence of specified conditions.

The court acknowledged that this does not require the debtor to have an immediately enforceable interest in order to bring the deposit into the bankruptcy estate.  Courts have permitted turnover actions based on “future and non-possessory interest[s] maintained by a debtor in property held by another.”  However, the court distinguished this case from circumstances where the future right was “sufficiently rooted in the pre-bankruptcy past” to permit inclusion in the estate.

The trustee also argued that the deemed rejection of the purchase agreement relieved performance by both parties, which the trustee contended eliminated the forfeiture clause so that the deposit should be returned to the debtor.  In response, the court distinguished between future performance, such as payment of the balance of the purchase price and delivery of a deed, from already completed actions such as making the deposit.  In other words, the state agency had a stand-alone interest in the deposit as a result of completed acts that was not reversed by the deemed rejection.

The trustee further argued that the debtor had an equitable interest in the deposit.  Under state law, if a seller is unable to deliver good title through no fault of its own, it may still be required to return the deposit to the buyer.  However, the court found that this argument was based on evaluating the parties’ positions at different points in time – i.e. the trustee argued that the debtor was performing as of the commencement of the bankruptcy, but postulated that the seller failed to deliver title post-petition.  When both parties were evaluated at the same point in time, the result was that (1) at the time the petition was filed both parties were performing, and (2) after the filing it was the debtor, not the selling state agency, that was in default.

Trying yet another approach, the trustee contended that the deposit was held in escrow.  However, the debtor made the deposit with a state agency.  The selling agency and the agency holding the deposit were not separate parties, so in essence the debtor delivered the deposit to the seller.  Under applicable state law delivery must be made to a third party in order to establish an escrow.  If delivery is made to the seller instead, it is considered an absolute delivery, with title immediately passing to the seller.

In addition, the purchase agreement did not set out the terms of an escrow:  there was nothing that established a condition before the agency was entitled to the deposit, and nothing that gave the debtor a right to any refund.

In a last ditch attempt, the trustee argued that the sale was a contract for deed.  However, under a contract for deed the purchaser acquires an immediate right of possession, which was not the case here.

Consequently, the 6th Circuit affirmed the lower court decisions denying the trustee request for turnover of the deposit.

The status of a deposit can be elusive.  The 6th Circuit’s finding that the debtor did not have anyinterest in the deposit as of the petition date seems counterintuitive.

Although the purchase agreement apparently did not say so, if the seller had failed to deliver title at closing as required under the purchase agreement, it seems implausible that it would have been allowed to retain the good faith deposit.  And if there are circumstances under which the debtor would have been entitled to return of the deposit, it would seem that it had a contingent interest in the deposit as of the bankruptcy filing.

On the other hand, since the agreement was deemed rejected as of the filing date, that means that the debtor was in default and would not have been entitled to return of the deposit under the agreement.  So, the result is not surprising, perhaps just some of the reasoning.