Resale Profit Participation: Beware – Payments May Be Avoidable as Preferences

Kane v. Coulson (In re Price), 575 B.R. 461 (Bankr. D. Haw. 2017) –

A chapter 7 trustee sought to recover as a preference the transfer of proceeds from a sale of the debtor’s real estate under a profit sharing agreement. The matter involved a third party’s contingent rights to a portion of the profits from a resale of the property and the effect of an escrow of the sale proceeds.

The debtor and a third party (Coulson) both wanted to buy the same property. To resolve their competition the parties entered into an agreement that (1) required Coulson to terminate his purchase agreement so the debtor and his wife could buy the property (2) in exchange for their agreement to pay 50% of the net proceeds if the property was resold within 20 years.

Although the agreement was not recorded at that time, Coulson later recorded an Affidavit of Adverse Claim with a copy of the agreement attached. The debtor and his wife sued Coulson for declaratory relief relating to his claim, and Coulson counterclaimed for specific performance and damages.

While this case was pending the property was sold, netting ~$122,500 in sale proceeds. The parties agreed to put the money in escrow to be held until (1) the parties issued joint instructions, (2) a court issued an order directing the escrow holder to release the funds, or (3) a specified date.

Coulson moved for summary judgment and obtained a court order determining that he was entitled to recover ~$363,000. Subsequently the court entered a final judgment in the amount of ~$424,000 and directed that the funds held in escrow be paid to Coulson in partial satisfaction of the judgment. For some reason, the funds were not immediately released, and an amended final judgment was issued a couple of months later. At that time the funds were released to Coulson, and a week later the debtor filed bankruptcy.

The chapter 7 trustee sought to recover the funds from Coulson as a preference. Under section 547 of the Bankruptcy Code a trustee can avoid a transfer (1) to or for the benefit of a creditor, (2) for or on account of an antecedent debt, (3) made while the debtor was insolvent, (4) made within 90 days before the bankruptcy filing, (5) that allows the creditor to receive more than it would receive in a chapter 7 liquidation assuming the transfer had not been made.

There was no dispute with respect to the first two criteria. As for the third element regarding insolvency, a debtor is presumed to be insolvent during the 90 days prior to bankruptcy. Since Coulson did not present evidence regarding the financial condition of the debtor, the third and fourth criteria boiled down to whether the transfer was made within 90 days prior to bankruptcy. The fifth element turned on whether Coulson’s claim to the funds was considered secured or unsecured.

Coulson advanced several arguments about the timing of the transfer. First, he argued that the relevant transfer occurred either when the parties entered into the agreement or when he recorded the affidavit. (Both events occurred many years before the bankruptcy filing.) However, the court disagreed.

Under section 547 a transfer of this type takes place when it takes effect between the parties if it is perfected within 30 days, and if not when perfection occurred. For this purpose, a transfer is perfected “when a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee.” So, the question was whether Coulson obtained a lien relating to his contingent right to receive a portion of the resale proceeds it would defeat a judicial lien.

Under the court’s analysis, a lien arises by statute, by contract, or if required by equity. Here no statute gave Coulson a lien. As for a contractual basis, the agreement gave Coulson only a contingent, time-limited right to payment, and did not grant any lien or other interest in property. The affidavit was signed only by Coulson, so could not function as a grant of an interest in property by the debtor and his wife. As for equity, under applicable law an agreement to pay a debt out of a particular fund was not sufficient to create a lien. Thus, the agreement and affidavit were not relevant to determining the date the escrowed funds were transferred to Coulson.

Next, Coulson argued that the transfer occurred when the funds were placed in escrow. However, all the escrow did was preserve the status quo. It did not change the rights of the parties and the debtor and his wife still had an interest in the funds.

Finally, Coulson argued that the transfer occurred when the court issued its initial order determining that he was owed $363,000 (which occurred more than 90 days prior to bankruptcy). However, this order was not sufficient to cut off the debtor’s rights to the escrowed funds. Under the escrow instructions, funds were to be released only if there were joint instructions from the parties or there was a court order directing release of the funds.

Thus, the earliest that it could be argued that a transfer had been made was on the date the court issued its first order directing release of the funds. However, this order was issued within 90 days prior to bankruptcy. Consequently, the third and fourth criteria were met since the transfer was made within 90 days prior to bankruptcy and the debtor was presumed to be insolvent.

That left only the question of whether the money released to Coulson from escrow was more than he would receive in a chapter 7 liquidation assuming he is not received the escrow funds. If he had a lien on the escrow funds, he would have received them in a liquidation. However, the court had already determined that Coulson did not have a lien, and as an unsecured creditor he received more than he would have in a chapter 7.

Consequently, the court determined that the transfer of the escrowed funds to Coulson could be avoided as a preference under section 547.

Even if the parties had effectively encumbered the debtor’s title and right to receive sale proceeds so that Coulson’s claim would be senior to a judicial lien, the arrangement might not have been enforceable. Recently there has been significant controversy surrounding private transfer fee covenants. Typically, this involves a covenant created in connection with the sale of property that imposes a transfer fee payable to the seller upon any subsequent resale of the property. That scenario involves considerations distinct from the circumstances of this case. However, state legislation designed to prohibit private transfer fee covenants may be broad enough to cover other arrangements such as this.

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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