To avoid property held in "escrow" from becoming part of the bankruptcy estate of a depositor, creditors must be aware of state law governing the creation of escrow accounts and pay attention to the logistics of such accounts to ensure they conform with such law.
Introduction
In February, this column discussed a new state law proposed by the Uniform Law Commission, namely the Uniform Special Deposits Act (the "USDA" or the "act"). The act seeks to eliminate inconsistent treatment across states of structures, such as trusts and escrows, intended to insulate deposit account assets from the risk of the depositor's bankruptcy.
A recent New York case, In re Odonata Ltd., 658 B.R. 62 (Bankr. S.D.N.Y. 2024), held that funds deposited in a purported escrow account were in fact not exempt from being considered "property of the estate." This decision articulates better than most the requirements, at least under New York law, for escrow accounts (see the discussion in our column "Trusts, Escrows and Property of the Estate (or Not)," 269 N.Y.L.J. 109 (June 2023)). It also emphasizes the need for a uniform solution for these and similar structures that is workable across state lines. Today, we discuss the Odonata case and the benefits of a uniform statute on these issues.
Factual Background
In re Odonata Ltd. involved a dispute between Odonata Ltd. ("Odonata"), the owner and operator of a hair salon operating under the name "Cowlicks Japan," which leased space from Baja 137 LLC ("Baja"). In 2021, Odonata and Baja engaged in negotiations to modify and extend Baja's lease, which led to a proposed lease amendment. Odonata executed the proposed lease and sent it to Baja for signature, but Baja refused to sign the amendment, citing change in circumstances, and requesting better terms.
Odonata then sued Baja in New York State court, claiming the draft lease amendment was a valid and enforceable contract or, in the alternative, that Baja had engaged in fraud during the negotiations and was therefore liable based on breach of contract, breach of an implied covenant of good faith and fair dealing, fraud and promissory estoppel. Baja counterclaimed to recover unpaid rent and professional fees. Odonata's attorney submitted an affirmation to the trial court stating that rents were being deposited into an "Escrow Account" in the name of "Odonata Ltd. DBA Cowlicks Japan."
The state court dismissed Odonata's contract claims, leaving only its claim for fraud. Odonata appealed the dismissal order to the Appellate Division, seeking a stay of further proceedings at the trial court level. Odonata's attorney again confirmed that Odonata would "continue to deposit certain sums into escrow each month (representing rent/use and occupancy payments) so as to secure Respondent in lieu of a bond or other undertaking." The appellate court granted Odonata's motion on the condition that Odonata continue to deposit the monthly rent into "the escrow account." But the dismissal of the contract claims was affirmed on appeal on June 28, 2022, leaving only the fraud claims.
Then, on July 6, 2022, Odonata filed for chapter 11 in the Southern District of New York (the "Bankruptcy Case"). Thereafter, the state court action was removed to the bankruptcy court. According to Odonata's bankruptcy petition, it had five bank accounts, four of which had zero or minimal balances (for a total of $2,046.95) and the fifth of which, held at Citibank (described as "Citibank (Escrow))," had a balance of $75,000. On the date of the bankruptcy filing, Odonata told Baja that all of Odonata's funds would be moved into a new debtor-in-possession bank account. In response to further questions from Baja's counsel about the "rent you were putting in escrow," on August 16, 2022, Odonata's counsel responded that Odonata "never said it would be escrowed after the bankruptcy filing," that those funds constitute "an asset of the bankruptcy case" and therefore would be deposited into its "operating account."
During the pendency of Odonata's bankruptcy, the Small Business Administration contended that it had a perfected security interest in all of Odonata's assets, including the cash in its bank accounts. In August 2022, Odonata agreed to stipulate that the SBA had a first priority perfected security interest in its "cash and accounts receivable," in exchange for which the bankruptcy court permitted Odonata to use its cash collateral in accordance with an agreed-upon budget. Interestingly, Baja did not object to this motion. Odonata's fraud claims against Baja were subsequently adjudicated in May 2023, after which the bankruptcy judge found that Odonata had failed to prove that Baja acted fraudulently.
In July 2023, Odonata's case was converted to a chapter 7 proceeding. The chapter 7 trustee eventually agreed to allow a claim in favor of Baja and against Odonata in the amount of $521,010.23, and the Court entered an order granting Baja an unsecured claim in that amount; however, Odonata's estate had no funds at this time, meaning Baja would receive no distribution on such claim.
Then, on October 18, 2023, Baja filed a motion alleging, inter alia, that Odonata wrongfully diverted funds that had been held in escrow for the benefit of Baja. Baja asked the Court to require the replacement of funds withdrawn from the escrow. Baja argued that Odonata had repeatedly referred to the relevant funds as being put in "escrow" and that Baja never gave affirmative written consent to transfer funds out of escrow. Odonata argued that the requirements for the valid formation of an escrow account under New York law were not met.
Decision
At issue before the Court was whether Odonata was the beneficiary of an enforceable and valid escrow account under New York law. The Court began by noting that if a valid escrow is established and funded prior to a bankruptcy filing and not subject to avoidance as a preference or fraudulent transfer, then the pre-bankruptcy transfer of funds to the escrow would remove the property from the bankruptcy estate.
The Court then detailed the requirements for the creation of an enforceable escrow under New York law, which includes (i) a valid escrow agreement, (ii) the identification of a third-party depositary, (iii) the irrevocable delivery of the subject matter of the escrow to the depositary, subject to agreed terms regarding to whom and on what conditions the escrowed property may be released, and (iv) the relinquishment of the property by the party escrowing it.
The Court determined that although the Citibank account was regularly referred to as an "escrow account" by the parties and in papers filed with the state courts, it did not meet the requirements for an enforceable escrow under New York State law. According to the Court, although a formal written escrow agreement is not needed to create a valid escrow account, there must be an agreed delivery of property to a third party and a specification of who the property may be released to and under what conditions the property may be released.
Here, Odonata remained in possession and control of the relevant funds at all times. The Court noted that Baja was aware, or should have been aware based on documents provided or made available, that the "escrow account" was merely an account held by Odonata in its own name (as shown on the bank statements filed in state court). Further, and more importantly, there was never any agreement as to the specific terms and conditions under which the escrowed property was to be held or could be released.
The court found there was no valid escrow account established under New York law, meaning the deposit account rightfully became the property of the bankruptcy estate when Odonata filed for bankruptcy.
Special Deposits Act
Escrow deposits continue to be the source of multiple litigations across the country. As noted above, the Uniform Special Deposits Act is intended to minimize the uncertainties associated with determining whether an arrangement described or intended as an escrow will or will not be sufficient under state law to qualify as one. Specifically, Section 5 of the USDA lays out the following elements of a special deposit under the act: a deposit of funds in a bank under an account agreement for the benefit of at least two beneficiaries (one or more of which may be a depositor), which are denominated in a government-approved medium of exchange, for a permissible purpose that is stated in the account agreement, and where the release of such funds is subject to a contingency. One of the key protective provisions of the USDA, Section 8, addresses the treatment of special deposits in the event of a depositor bankruptcy.
It is unclear whether, had the USDA been in effect in the State of New York at the time Odonata established an "escrow" account for Baja's benefit, the parties would have been aware of or utilized it to create a special deposit. Baja paid little attention to, and was likely unaware of, the requirements under New York law for creation of an escrow, nor did it take action during the pendency of the Bankruptcy Case until 15 months after the filing when the supposedly escrowed cash had been used. However, among the important characteristics of the act are its benefits and therefore intended incentives to banks, and the hope is that following adoption of the USDA, banks will seek to avail themselves of these benefits and, in so doing, promote this feature and make it familiar to the general public. So, when customers like Odonata approach a bank, like Citibank, to open an escrow account, the bank may well volunteer to create it as a special deposit regardless as to whether or not the customer requests one.
Conclusion
As shown by the Odonata case, the establishment of escrow accounts continues to be uncertain territory. The USDA will bring clarity and help reduce these uncertainties. In the meantime, to avoid property held in "escrow" from becoming part of the bankruptcy estate of a depositor, creditors must be aware of state law governing the creation of escrow accounts and pay attention to the logistics of such accounts to ensure they conform with such law. Creditors, like Baja, who do not take pay attention to those requirements, risk losing in their entirety the benefits they believe the escrow arrangements are providing.
Originally published by Law.com.
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