BROKER RISK MANAGEMENT
WEEKLY PRACTICE TIP
Bankruptcy and Real Estate Transactions
Once a seller files for bankruptcy, or is forced into bankruptcy by creditors, there is an immediate impact on listing agreements and on any pending or contemplated sale transactions. Also, there are special rules for bidding on properties sold through bankruptcy.
1. Bankruptcy Basics
A. TYPES OF BANKRUPTCY: The three most common types of bankruptcy filings include:
(1) Chapter 7 liquidation;
(2) Chapter 11 reorganization, usually for debtors engaged in business, including individuals, partnerships, and corporations; and
(3) Chapter 13 reorganization, for an individual or married couple with regular income.
B. THE TRUSTEE: The Trustee, appointed by the Bankruptcy Court, is a “fiduciary,” with duties to the bankruptcy estate. The Bankruptcy Court, and other “parties in interest” including the creditors, assure that the Trustee is acting in the estate's best interests. Before a trustee can sell estate property, parties in interest must be given notice of the impending sale and an opportunity to comment on it. The Bankruptcy Court will rule as to whether the sale will be allowed. This process, which may be time consuming and an inconvenience to the buyer of real estate, does provide the buyer with certain protections. This is because the Trustee will generally ask the Court to determine that the buyer is a “good faith purchaser,” and thus buyer is protected to some extent from later argument that the sale was not handled properly.
C. THE BANKRUPTCY ESTATE: The bankruptcy “estate” is a fictitious entity consisting generally of all of the debtor's property and debts. The Trustee has a duty to get the best price possible for the debtor's property to maximize the distribution to the debtor's creditors.
D. THE STAY: Generally speaking, once a person or a business files for bankruptcy, all assets belonging to that debtor become property of the bankruptcy estate and subject to the control of the Bankruptcy Court. At the moment a bankruptcy case is filed, an automatic “stay” is imposed. At that point, the owner of the property loses all control of the property and may not legally enter into a listing agreement or a purchase agreement, nor take any steps to enforce any such existing agreements. The stay also suspends any pending or potential foreclosure proceedings.
The court may, in some circumstances, release a property from the “stay.” This can occur, for example, if the property has no equity (recorded debts against the property exceed the potential purchase price) to allow the lien holders (lenders) to continue with a foreclosure.
2. Effect on Listing Agreements
If a broker has a listing agreement on a property at the time that the seller goes into bankruptcy, the automatic stay prevents the broker from pursuing enforcement of the listing agreement. The listing broker should immediately contact the Trustee to seek a retroactive order from the Bankruptcy Court affirming the existing listing contract, or request that the Court authorize his/her employment under a new agreement. This is because generally a real estate broker can only receive compensation from a bankruptcy estate if the Court authorized the employment. Also, other brokers may try to obtain the listing from the Court.
If the listing agreement is not approved in advance by the Court, the court can decline to pay the listing broker any compensation; or treat the commission earned as an unsecured debt, in which case the broker merely becomes an unsecured creditor of the seller at the back of the line, perhaps receiving pennies on the dollar. However, if the listing agreement is approved by the Court, the commission is paid ahead of other creditors of the bankrupt seller.
Because there is no specific compensation or commission limitation imposed on brokers by bankruptcy statutes, the Bankruptcy Court can authorize any reasonable compensation. Brokers seeking a Court-approved listing agreement should consult with the Trustee, or the Bankruptcy Court clerk, to see what is deemed to be reasonable compensation by that Court.
3. Effect on Existing Sale Transactions
The Bankruptcy Court has the right to assume or reject real estate purchase agreements that were pending at the time the bankruptcy was filed. The decision of whether to assume or reject an existing contract is a judgment call on such matters as whether this is an “arms length, market rate” transaction.” Do not expect this to happen quickly. In a Chapter 7 bankruptcy, the representative of the estate must make a decision within sixty days. In Chapter 11 or Chapter 13 cases, the decision does not have to be made until the reorganization plan has been confirmed.
If the representative of the estate rejects a real estate purchase agreement, agents representing buyers should advise their buyer to consult with a bankruptcy attorney as this action may constitute a breach of the contract, resulting in a potential claim for damages against the bankruptcy estate.
4. Effect on New Sale Transactions
If there is no existing sales contract, or the Court has rejected an existing sales contract, a Trustee may provide that any offer on a property in bankruptcy is subject to “overbid”. This means that, when an offer comes in to the Trustee, the Trustee may provide notice to all parties of the offer and seek Court approval of it, but the Trustee will continue to consider higher offers. There are no standard ways that this is done, such as there is in probate overbids, however all overbid terms are subject to Court approval. Both the initial offerer, and any prospective overbidder, must carefully read, and comply with, the proposed overbid terms. In some cases, the Trustee may seek a “backup bid” to be in position if the primary buyer does not complete the sale.
5. As Is, No Warranties
Because the Trustee has little or no knowledge concerning the property, bankruptcy sales are usually “as is, where is”, with no warrantees or guarantees. Trustees usually allow full access to the property by prospective buyers for inspection and appraisal. Most real property sales go through a full escrow, and have title insurance; however, if warranty issues are significant for a buyer, the prospective buyer should be advised to consider the issue carefully before bidding, and perhaps discuss the matter with their legal advisor.
PRACTICE TIPS:
1. This is a brief summary of bankruptcy court procedures. Different bankruptcy court districts have different local rules and practices. Ask the Trustee or court clerk about local rules.
2. Be careful not to give legal advice to your clients. Advice regarding specific details on a particular transaction must be obtained by buyers from their own legal advisor.
3. If you are a listing broker when the seller enters bankruptcy:
A. Immediately contact the Trustee to get the court to either affirm your existing listing agreement, or authorize a new listing agreement.
B. If there is a pending sale, approach the Trustee to ask the court to affirm the existing contract.
4. If you are representing a buyer in escrow at the time the seller enters bankruptcy, you should:
A. Advise your buyer that, if they want to proceed with the sale, they should consult with an attorney familiar with bankruptcy proceedings.
B. Check with the listing broker to determine whether the listing agreement has been approved by the Bankruptcy Court. If listing broker has not done so, strongly suggest that they do that immediately so as to protect both of your commissions.
This Weekly Practice Tip is attorney-client privileged and for the exclusive use of clients of Broker Risk Management and their agents. It may not be reproduced or distributed without the express written consent of Broker Risk Management. The advice and recommendations contained herein are not necessarily indicative of standards of care in the industry, but rather are intended to suggest good risk management practices.
© Copyright Broker Risk Management 2008 05/16/08
