In its opinion in LTF Real Estate Company, INc. v. Expert South Tulsa, LLC (In re Expert South Tulsa), 2014 WL 6845675 (10thCir. BAP 2014), the Tenth Circuit Bankruptcy Appellate Panel agreed with the majority rule that funds placed in escrow pre-petition by the debtor, and which the debtor may obtain only through performance as required by the escrow agreement, are not property of the debtor’s bankruptcy estate.  Instead, only the debtor’s right to the escrow funds pursuant to the escrow agreement is property of the estate.

In Expert South Tulsa, the debtor agreed to sell real property to LTF Real Estate Company, with the debtor to construct at its cost improvements to the property.  The debtor escrowed 120% of the estimated cost to construct the improvements, for a total of $1,226,400, as required by the agreement.  The agreement entitled the debtor to receive disbursements from the escrow upon completion of certain milestones in the construction process.   The agreement further provided that LTF could use the funds to complete any of the improvements if the debtor failed to do so.  The debtor failed to complete any of the construction milestones before an involuntary bankruptcy petition was filed against it.  LTF filed an adversary proceeding seeking declaratory judgment that the funds in escrow were not property of the bankruptcy estate and were instead available to LTF to complete the improvements to the property.  The debtor disagreed and contended that, since it supplied the escrow funds and had completed some of the improvements, the funds were property of its bankruptcy estate. 

The BAP granted summary judgment to LTF, finding the escrow funds were not property of the bankruptcy estate.  The court began its analysis with § 541(a)(1), which defines the term “property of the estate” as “all legal or equitable interests of the debtor in property as of the commencement of the case,” “wherever located and by whomever held.”  The court then noted, however, that while § 541(a)(1) is construed broadly, it is not without limits, and the estate succeeds only to the same property interest the debtor possessed at the time the case is commenced.  The court cited the well-known principle that federal law determines the extent to which a debtor’s property interests are property of the estate, while state law defines the debtor’s interest in property.

In this case, governing Oklahoma law provided that an entity’s interest in escrowed funds is limited where the entity places the funds in escrow for a specific purpose and that purpose has not been achieved when the case is filed.  In this instance, the agreement was clear that the debtor was entitled to disbursements from the escrow only on meeting certain construction milestones, none of which it met.  As a result, the court concluded that, while the debtor’s rights under the contract were property of its estate, it did not have an present right to a disbursement of the funds from the escrow when the case was commence, and therefore the funds themselves were not property of the bankruptcy estate.  The court was persuaded by the reasoning of the court in In re Palm Beach Heights Dev. & Sales Corp., 52 B.R. 181 (Bankr. S.D. Fla. 1985), which held, in connection with an escrow funded by a debtor to pay for road and drainage improvements under which disbursements to the debtor were contingent on completion of improvements: “any claim, contingency of chose in action against the trust fund is the property of the estate, but the fund itself is not.  The debtor may not have any part of said fund until such time as the debtor establishes that all prior claims in the fund have been paid and that a residuum remains to which it is entitled.”  Palm Beach, 52 B.R. at 183.  Likewise, the BAP ruled that the debtor’s estate included its rights under the escrow agreement to the funds at such point as the construction milestones were met, but that the funds themselves in the escrow were not property of the estate.