Escrow Funds: If You Aren’t Careful, Your Funds May Become Part of a Bankruptcy Estate

Quinlan v. AFI Services, LLC (In re AFI Services, LLC), 486 B.R. 827 (Bankr. S.D. Tex. 2013) –

The debtor (AFIS) entered into a joint venture agreement with a third party (Quinlan) to acquire an apartment complex pursuant to a purchase agreement between the debtor and the seller.  Under the JV agreement, the debtor was supposed to form a new single purpose entity to acquire the property on behalf of the joint venture, and in return Quinlan deposited $1 million with the title company, as contemplated by a proposed amendment to the purchase agreement that would extend the closing deadline of April 30, 2012 for an additional 60 days.  Although Quinlan wired the money, the amendment was not signed, the deal fell through, and the debtor filed bankruptcy.  Not surprisingly, Quinlan wanted his money back.

The joint venture agreement was signed on April 27, 2012, and contemplated that the amendment extending the closing deadline would be signed contemporaneously.  However, on that same day the seller advised that it still expected the sale to close on April 30, and the amendment was not signed.  The following events occurred on April 30:

  • 10:25 a.m.:  Quinlan wired $1 million to the title company “on behalf of AFIS” with “no further qualifications, limitations, restrictions, or reservations.”
  • 1:22 p.m.:  Seller’s attorney sent an email message to the title company with a copy to the debtor’s corporate attorney asking the title company to “please cause this additional earnest money to be wired back to the sender as soon as possible.”
    • In reciting these facts, the court noted that the purchase agreement and escrow instructions did not provide for email notice, and consequently the title company “did not receive proper notice of this instruction.”
    • The title company did not return the money to Quinlan.
  • 8:34 p.m.:  The debtor filed bankruptcy.

On June 7, the title company asked the debtor’s corporate counsel for instructions regarding the $1 million.  In response, the debtor’s bankruptcy attorney requested that the funds be wired to his firm’s IOLTA trust account, which the title company did.  The funds were then deposited with the bankruptcy court.

On July 11, Quinlan filed an adversary proceeding in the bankruptcy court requesting a declaratory judgment that the bankruptcy estate had no interest and he was the sole owner of the $1 million.  On October 5, he filed a motion for partial summary judgment, and on October 26, the trustee filed a counter motion arguing that the $1 million was an asset of the bankruptcy estate.  After holding hearings in October and November, the court took the matter under advisement and issued an opinion in February 2013.

First, the court found that there was a valid escrow account.  As required by state law, the “escrow agreement” section of the purchase agreement set forth a clear agreement that the funds were to be deposited with a third party (the title company) and the terms and conditions on which funds should be delivered.  Although Quinlan was not a party to the purchase agreement, the court found that the joint venture agreement at least implied acceptance of the escrow terms by Quinlan.

Quinlan’s next argument was that the joint venture agreement failed because of a total failure of consideration.  The debtor was supposed to form a new entity and to assign the purchase agreement to that new entity.  When the amendment extending the closing deadline fell through, it became impossible for the debtor to perform.

While the court agreed with the conclusion that there was a failure of consideration and that the failure gave Quinlan grounds to rescind the JV agreement, it also held that he was required to take some sort of affirmative action to rescind (which could be by formal agreement or by course of conduct) “within a reasonable time.”  According to the court, the first time Quinlan made the rescission argument was in the November hearing, and in the court’s view, waiting ~ 7 months after Quinlan had a basis for rescission and ~ 4 months after litigation began was not within a reasonable time.

Since Quinlan didn’t timely rescind the JV agreement, the court concluded that he was bound by the terms of the escrow agreement and the purchase agreement.  Under those terms, only the debtor as purchaser or the seller could direct the title company to release funds.  Although Quinlan argued that he believed the title company would return the funds to him if the amendment was not signed, that was not consistent with the express terms of the agreement.

After deciding that the terms of the escrow agreement governed disposition of the money, the court then weighed a series of factors including “(1) whether the debtor initiated or agreed to the creation of the escrow account; (2) whether the debtor exercises any control over the escrow account; (3) the incipient source of the escrow account; (4) the nature of funds within the escrow account; (5) the recipient of the escrow accounts remainder funds (if any); (6) the targeted benefit of the escrow account; and (7) the purpose of the escrow account’s creation.”  The only factor that weighed in favor of Quinlan was the source of funds.  Consequently, the court concluded that the $1 million was property of the debtor’s bankruptcy estate.

The court commented that Quinlan could have negotiated modification of the escrow terms before signing the JV agreement or could have timely rescinded the JV agreement for failure of consideration.  Since he did not, he lost.

This case highlights the importance of formalities in dealing with escrows.  Clearly Quinlan’s intent was to deposit the funds contingent on the amendment extending the closing deadline becoming effective.  However, the deposit was not accompanied by any explicit indication of this condition.  This failure, in combination with the court’s refusal to recognize the direction from seller’s counsel because it was done by email instead of by a notice procedure sanctioned under the purchase agreement, was Quinlan’s downfall.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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