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Our attorneys stay on top of changes in legislation, agency regulations, case law, and industry trends—then craft timely legal alerts to keep clients up to date on legal developments important to their business.

February 28, 2023

Rights of a Real Estate Buyer When a Seller Is in Bankruptcy

What happens to the buyer under a contract to purchase real estate when the seller is in bankruptcy? Can the buyer still purchase the property? Can it get its money back? The answers depend on a number of factors.

A contract to sell real estate (real estate contract) is an executory contract governed by Bankruptcy Code Section 365. If the seller is in bankruptcy, the bankruptcy trustee, or the debtor if there is no bankruptcy trustee (in either case, referred to as the trustee in this alert), is in the shoes of the seller and may elect to either assume or reject the contract. This decision is subject to court approval (evaluated based on an easily met “business judgment” standard).  

If the trustee elects to assume a real estate contract, the trustee and the buyer are then obligated to fully perform their respective obligations under the real estate contract. The trustee is often inclined to assume a real estate contract that is the product of arm’s-length negotiations with a non-insider following a reasonable marketing period, provided that the proceeds yield a net benefit to the bankruptcy estate after paying all expenses and claims secured by the real estate.

If the trustee rejects a real estate contract, the trustee has breached the agreement and the purchaser’s only remedy, subject to certain exceptions, is to file a claim with the bankruptcy estate for the money damages that would be available for breach of the real estate contract under applicable state law (rejection damages claim). A rejection damages claim is a general unsecured claim and shares pro rata in the distribution, if any, made to the general unsecured creditors. There are several types of claims that must be paid before general unsecured creditors, and these creditors often only receive a small portion of their claim, if anything. 

Any deposit held in escrow should be recoverable by the purchaser in connection with the entry of the order rejecting the real estate contract. In the event that the purchaser’s deposit or other prepayments towards the purchase price are not held in escrow, under Bankruptcy Code Section 365(j) the purchaser should be granted a lien on the real estate, subject to prior mortgages and other liens, to the extent of the amounts deposited or otherwise prepaid. However, unless there is equity in the property over and above the existing mortgages and liens, the lien would have no value and the claim for return of the deposit or prepayment would be treated as a general unsecured claim. 

Under limited circumstances described in Bankruptcy Code Section 365(i), a purchaser in possession of the real estate under the real estate contract (a purchaser in possession) and current on all payments due may choose either: (i) to treat the real estate contract as terminated or (ii) to perform under the real estate contract. 

If the purchaser in possession elects to treat the contract as terminated, the purchaser in possession is excused from any further performance (i.e., payments), has the right to file a rejection damages claim, and also has enhanced rights to recover any deposits and other payments (as discussed above). 

If the purchaser in possession elects to perform, the trustee remains obligated to deliver a deed to the real estate at the closing. In order to preserve its rights, the purchaser in possession must remain current on all payments under the real estate contract. The trustee’s obligation at closing is limited to delivery of a deed. Notably, there is no requirement that the trustee convey the title to the real estate free and clear of liens, claims, and encumbrances (marketable title). The purchaser in possession’s remedy against the trustee for any breach of the real estate contract, including failure to deliver the marketable title, is limited to offsetting any damages against remaining installment payments. Of course the purchaser in possession, having remained current on the installment payments under the real estate contract, might not have an adequate remedy if there are unsatisfied liens as of the closing. 

This is a very narrow exception with many limitations and pitfalls that must be considered. The requirements of 365(i) must be met strictly. As an example, in one case, the court ruled that the special remedies under 365(i) were not available to a party that was a tenant and purchaser under a rejected real estate contract, where the tenant was occupying the real estate and paying rent only and had not yet started making payments towards the purchase price. Although 365(i) offers more remedies to a purchaser in possession under a rejected real estate contract, these additional remedies are available only in narrow circumstances and other factors in the bankruptcy case could significantly limit the utility of those remedies. At a minimum, a purchaser in possession should consult with counsel as soon as possible to consider and protect its rights and remedies.

The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the author, Nic Ferland, partner, at nferland@barclaydamon.com; Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com; or Janice Grubin or Jeff Dove, co-chairs of the Restructuring, Bankruptcy & Creditors’ Rights Practices Area, at jgrubin@barclaydamon.com and jdove@barclaydamon.com.
 

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