Commercial Fraud Task Force Committee

ABI Committee News

Recovering Home Owners Deposits in Chapter 11

This article will discuss, in two parts, how real estate developers of projects large and small are experiencing an industry-wide slowdown as mortgage money dries up and construction loans default, and its ramifications on homeowner deposits in chapter 11 cases.

A couple in late middle age asked to speak directly to the bankruptcy judge during a hearing to approve the sale by auction of a retirement home they had under contract. The home was in a large housing project. Construction halted when the debtor ran out of money in the spring. Subsequently, this chapter 11 case and 11 others were filed. The wife told the court about the impact of this business’ failure on their future life together.

The debtor developer had ignored his contract with this couple and other buyers and had used their $100,000 deposit instead of maintaining it in an escrow. When the developer was unable to find new financing to complete over 1,000 new homes and condos, the banks declared more than a dozen projects in default.

Despite efforts to find a new developer, an auction failed to produce anyone willing to accept an assumption of the contracts from the debtors, to build out the projects and to give buyers some hope of moving into the new homes. Like many others, the couple who stood before the court had their deposits taken from an escrow without their knowledge or consent. They had all but lost the slim hope of getting into a new home.

The woman shook with anger as tears rolled down her face. She had borrowed the deposit from the equity in her prior home, then sold the home to prepare to move to the one promised to her and her husband. They were now with no place to live except to move in with an adult child. Except for a small bank account, they had few resources to fall back on after a lifetime of work.

The court had just allowed the debtors to sell many of the projects to the construction lenders for a credit bid under Code §363 and to give the contract purchasers a lien under Code §356(j). The lenders, each soon to be the owner of yet another real estate project securing a nonperforming loan, would pay a sum of money to satisfy the debtor’s claims under Code §506(c) for what was said to be counsel fees and other legitimate costs incurred for the unsuccessful marketing and auction of this couple’s retirement condo and hundreds of others.

This tragedy is repeated in bankruptcy courts throughout the country as residential mortgage lending and construction lending dries up. A number of state law real property and bankruptcy issues arise out of this sadness. Can attorneys for homebuyers who have lost escrowed deposits argue that the deposit must be repaid out of property of the debtor estate before the scheme of distribution under Code §507 is applied? Can the lien under §365(j) attach to the carved-out funds granted under §506(c)?

Is Real Property under Contract Actually Property of the Debtor Estate?

Code §541(d) instructs that if the debtor does not “really” own the property, it never enters the estate. Therefore, by implication, the real property is not eligible to be distributed as Code §507 might otherwise require. Section 541(d) says:

Property of the estate does not include—
Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property, or an interest in such a mortgage, sold by the debtor but as to which the debtor retains legal title to service or supervise the servicing of such mortgage or interest, becomes property of the estate under subsection (a)(1) or (2) of this section only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.

Homebuilder Contracts Are Executory Contracts that Can Be Rejected or Assumed

Real estate developers of projects large and small are experiencing industry-wide slowdowns as mortgage money dries up and construction loans default. The drop in home values fills the headlines. Builders are left with insufficient cash flow to complete homebuyer contracts or even to protect the existing homes under construction from the elements or vandalism. The home construction and land sale contracts are classic examples of executory contracts. They fit Prof. Vern Countryman’s definition as applied by the Supreme Court in many diverse settings including Bildisco. An executory contract is one "on which performance remains due to some extent on both sides." (see National Labor Relations Board v. Bildisco and Bildisco, 465 U.S.513, 522-23 n. 6, 104 S.Ct. 1188,1194 n. 679 L.Ed.2d 482 and other cases.)

Where Does State Law Say Homebuyers Stand before a Bankruptcy Is Filed?

In the ivory tower that is law school, we budding lawyers are told that the signing of a contract to buy land or land and buildings works the judicial magic called equitable conversion. The buyer becomes the “equitable owner” of the real property. The seller is a trustee who holds the property in trust for the buyer. The buyer holds the purchase money in trust for the seller. What about when the seller/builder becomes the debtor? This sounds a lot like what Code §541(d) had in mind.

Equitable conversion is not a mere conjurer’s trick created at the wave of a gavel. In centuries of common law, the doctrine provided meaningful protections for our real estate clients. One protection is the common law vendee’s lien on the real property to be sold and the resultant constructive trust imposed on the seller’s legal title for the benefit of the buyer.

In many states, common law vendee’s liens are said by judges to have been created when the contract is signed. The average contract has mortgage contingencies that provide for the refund of the deposit if the buyer cannot get a mortgage or if the seller/builder cannot deliver good title. State Courts routinely hear actions to compel specific performance and/or of money damages for breach of performance.

But is this historical concept by itself enough to allow a homebuyer’s converted deposit and interest in the real property under contract to escape classification as property of the debtor estate? Certainly, §365 lets the contract be rejected. It is a valuable tool for when the contract is “burdensome” where there is a higher and better offer to be had or where the debtor can not continue to build.

Section 365(a) of the Code, 11 U.S.C. §365, provides:

a) Except as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section, the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor (emphasis added).

Rejection does not mean that the contract never was. Rights and interests do not simply evaporate into thin air.

The Code specifies that the rejection of an executory contract that had not been assumed constitutes a breach of that contract. The breach relates back to the date immediately preceding the filing of a petition in bankruptcy. 11 U.S.C. §365(g)(1). Consequently, claims arising after filing, such as those resulting from the rejection of an executory contract, must also be presented through the normal administration process by which claims are estimated and classified. See 11 U.S.C. §502(g); In re Hoe & Co. Inc., 508 F.2d 1126, 1132 (CA2 1974); Workman v. Harrison, 282 F.2d 693, 699 (CA10 1960) (emphasis added).

Deposits for the purchase of homes are secured by a lien “on the interest of the debtor in such property” when the contract is rejected under §365(j). This section of the Bankruptcy Code provides that:

A purchaser that treats an executory contract as terminated under subsection (i) of this section, or a party whose executory contract to purchase real property from the debtor is rejected and under which such party is not in possession, has a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid.

The lien under 365(j) for the refund of the purchase price is created by Congress in an effort to protect buyers. While similar to the common law vendee’s lien in some respects, it is not a judicial creation.

Is the Lien under §365(J) a Meaningful Protection?

The rejection and the lien under §365(j) must relate back to the day the case was filed. Matter of Continental Airlines, 146 B.R. 520 (Bankr D. Del 1997), In re South Motor Co. of Dade County, 161 B.R. 532 (Bankr S.D. Fla. 1993); United Food and Commercial Workers Union Local 328 AFL-CIO v. Almac’s Inn 90 F.3d 1 (1st Cir. Rh. I. 1996), American Flint Glass Workers Union v. Anchor Resolution Corp., 197 F.3d 76 (3d Cir. Del. 1999). The “relation back” of the §365(j) lien to the day before the filing of the bankruptcy proceeding is not a meaningful protection when the real property is fully “liened up.”

The statutory lien under §365(j) arising upon rejection, but considered to be created the day before the date of filing, is junior in time and priority to any lien predating its judicial creation. The bankruptcy court in Aetna v. Dvorak, 176 B.R. 160, 163 (Bankr. N. D. Ill. 1994), examined carefully the legislative history and case law predating the enactment of §365(j) and found no special treatment beyond a lien on the debtor’s interest. Judge Moran wrote:

Section 365(j) does not specify what priority the lien it creates should receive. It says only that the vendee is entitled to "a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid." 11 U.S.C. §365(j). The absence of any reference to lien priority in the plain language is our first clue that Congress did not intend to give holders of §365(j) liens any special treatment other than to create the lien in the first place.

The §365(j) lien is usually worthless in light of the senior construction mortgage’s accrued interest and other loan charges. But is there a way of interpreting §365(j)’s text to give a frustrated homebuyer a lien on the sales proceeds post-363 sale or on the carved- out funds from the secured lender’s credit bid?

Most projects are subject to a construction mortgage. There is limited or no equity held by the debtor estate for the §365(j) lien to attach to. Most home construction projects are heavily financed. Scrutinizing the wholly encumbered “interest of the debtor in such property,” counsel will be hard-pressed to find any value for the lien to attach to except for the proceeds of a 363 sale or consideration for a credit bid. Damages from the contract that result from the rejection of an executory contract must be administered through bankruptcy and receive the priority provided general unsecured creditors. See 11 U.S.C. §§502(g), 507. Chapter 11 debtors with home construction projects stalled for lack of cash are faced with unhappy choices: selling what may be an unprofitable contract or rejecting the contract and selling the land and uncompleted homes to someone else, surrendering the collateral to the disappointed lenders or permitting foreclosure to run its course.

Certainly, the priorities of the Code provide for an orderly and lawful distribution of estate property among many deserving classes. One Circuit opinion suggests that the scheme of distribution is like the Woody Allen joke in the movie Annie Hall, about a crummy restaurant. “Not only is the food terrible, but the portions are small.” See In re Omegas Group Inc., 16 F.3d 1443 (C.A.6 (Ky.) 1994).

But what about the homebuyers’ deposit? Can creditors, even those with administrative priority claims, eat a meal that state courts say belongs to someone else?

We all understand that trustees and debtors-in-possession are new entities with a new bundle of rights. These rights allow the recovery of property from third parties who have done nothing wrong. The targeted property must once have been an asset of the pre-petition debtor. Courts hear actions to set aside fraudulent conveyances and to recover preferential transfers in order to even out the distribution to claimants of the same priority. Those creditors with lesser priorities receive nothing until those claimants senior in priority are paid in full. Reclamation claims under §546(c)(3) let debtors retain goods received without payment in return for §503(b)(9) status and administrative treatment for goods (but not services) received within the 20 days before a debtor files for bankruptcy. The estate, in effect, gets something for nothing—or, more correctly, what will probably be an unsatisfied unsecured claim at the end of the case. Experienced businesspeople understand these risks as a cost of doing business. But what about when they become homebuyers?

We all need a place to go home to at the end of the day. Not so for disappointed homebuyers, who have little to protect themselves from an escrow that is emptied and the funds used by the pre-petition debtor without authorization.

This is the first installment of a two-part article discussing real estate developers of projects large and small who are experiencing an industry-wide slowdown as mortgage money dries up and construction loans default and the ramifications on homeowners’ deposits in chapter 11 cases. Part II on “Can The Bankruptcy System Condone a Grown-up Game of “Steal the Old Lady’s Bundle?” will be in our May eNewsletter.