Escrows Are Not Safe in Bankruptcy!

Your Escrow Might Not Be Safe in Bankruptcy!

Here's a situation that keeps catching people off guard. You put money into an escrow account, maybe as part of a real estate deal, a construction project, an insurance settlement, or a tenant security deposit. You assume it's safe. It's in escrow, after all. Then the other party files for bankruptcy, and suddenly a bankruptcy trustee is arguing that your money is part of the debtor's estate. It sounds wrong, but it happens far more often than most people realize.

The problem starts with 11 U.S.C. § 541, which defines what constitutes property of the bankruptcy estate. Congress wrote that definition to be extraordinarily broad. It captures "all legal or equitable interests of the debtor in property as of the commencement of the case." That word "all" is doing a lot of work. Courts have consistently interpreted it to sweep in every conceivable interest the debtor holds, no matter how contingent, remote, or seemingly protected by a label like "escrow."

The seminal case on this issue, and the one that still controls the analysis in most federal courts, is In re Missionary Baptist Foundation of America, Inc., 792 F.2d 502 (5th Cir. 1986). That case involved four escrow accounts created in connection with the financing of two nursing homes. The lender, United Savings of Texas, argued that escrowed funds can never be property of the bankruptcy estate. The Fifth Circuit rejected that categorical position and laid out a two-step framework that courts still follow today.

First, the court said, you look at state law to determine what interest the debtor actually holds in the escrowed property. This follows the Supreme Court's instruction in Butner v. United States, 440 U.S. 48 (1979), which established that property interests in bankruptcy are defined by state law. Second, you apply § 541's broad definition to whatever interest state law gives the debtor. In Missionary Baptist, the court found that under Texas escrow law, the debtor retained legal title to the escrowed funds. Equitable title would only pass to the ultimate beneficiary when the escrow conditions were satisfied, and those conditions hadn't been met before the bankruptcy filing. Because the debtor still held a legal interest on the petition date, the funds were property of the estate.

That temporal question, did the debtor still hold an interest in the escrow funds when the bankruptcy case was filed, turns out to be the most important question in almost every escrow dispute in bankruptcy. If the conditions that would have eliminated the debtor's interest were satisfied before the petition date, the funds are excluded. If they weren't, the funds are likely coming into the estate.

Since Missionary Baptist, courts across the country have developed a multi-factor test to determine whether an escrow arrangement creates a genuine trust relationship that keeps funds out of the estate, or whether it's really just a contractual arrangement, or worse, what courts call a "disguised cash collateral arrangement", that falls squarely within § 541. The factors courts examine include who initiated the escrow, what control the debtor exercises over the funds, where the funds came from, who the intended beneficiary is, and what the escrow's purpose is. Of all these factors, control is consistently the most critical. If the debtor can direct the escrow agent to release funds unilaterally or has effective discretion over disbursement, courts will almost certainly treat the funds as estate property.

The case law is full of examples where escrow arrangements that looked solid on paper collapsed in bankruptcy. In In re Vienna Park Properties, 976 F.2d 106 (2d Cir. 1992), a lender took what it called a "lien" on escrow funds but never filed a UCC financing statement to perfect its security interest. When the debtor filed bankruptcy, the trustee used the strong-arm powers under § 544 to avoid the unperfected lien entirely. The lender lost everything, not because the escrow was a bad idea, but because the structure was flawed.

More recently, in In re Urban Commons 2 West LLC, 648 B.R. 530 (Bankr. S.D.N.Y. 2023), approximately $7 million in insurance proceeds for mold remediation was held in the debtor's own attorney's trust account under what the parties called a "Procuration Agreement" requiring unanimous consent for release. The bankruptcy court rejected the escrow characterization because the arrangement lacked defined conditions for disbursement and the debtor retained effective control over the funds. Seven million dollars that a hotel operator thought was safely held in escrow ended up in the bankruptcy estate.

In In re DeFlora Lake Development Associates, Inc., 628 B.R. 189 (Bankr. S.D.N.Y. 2021), about $207,000 was deposited with a deed escrow agent with instructions to hold the funds "until there was an agreement or determination by a Court as to where it would go." The court found that condition was too vague to create a true escrow. The funds went to the estate. And in In re Odonata Ltd., 658 B.R. 62 (Bankr. S.D.N.Y. 2024), funds labeled as a rent escrow were held not to qualify for escrow treatment at all, the court allowed the debtor to use and even dissipate the funds.

Tenant security deposits present their own special risk. When a landlord files bankruptcy, a tenant's security deposit is in serious jeopardy unless state law or the lease requires the landlord to segregate the deposit in a separate trust account. If the deposit was commingled with the landlord's operating funds, which happens far more often than it should, the tenant is likely an unsecured creditor with little hope of recovery. Going the other direction, when a tenant files bankruptcy, courts uniformly hold that security deposits held by the landlord are property of the tenant's estate, meaning the landlord cannot apply them post-petition without obtaining relief from the automatic stay.

The cryptocurrency world has generated its own version of this problem. In In re Celsius Network LLC, 2023 WL 34106 (Bankr. S.D.N.Y. 2023), the court distinguished between "Earn Accounts", where the crypto platform had unrestricted use of deposited assets, making them estate property, and "Custody" accounts where assets were properly segregated. The lesson is the same regardless of whether you're dealing with dollars or digital assets: actual segregation and clear contractual terms are what matter, not the label on the account.

There is good news on the legislative front. The Uniform Law Commission approved the Uniform Special Deposits Act at its 2023 Annual Meeting, and it offers the first comprehensive statutory solution to this problem. The Act creates a mechanism for parties to designate a bank account as a "special deposit" that is, by statute, excluded from the bankruptcy estate. The key provision declares that neither the depositor nor any beneficiary has a property interest in the special deposit itself. Because § 541 only captures the debtor's legal or equitable interests, and the Act eliminates any such interest in the deposit, the funds become effectively bankruptcy-remote.

To qualify under the Act, the deposit must be for the benefit of at least two beneficiaries, denominated in money, serve a permissible purpose such as a commercial or regulatory objective, and be subject to a contingency that triggers the bank's obligation to pay a specific beneficiary. The account agreement must specify that the Act governs. As of early 2026, four states have enacted the USDA: Colorado, Delaware, Oklahoma, and Washington. New York has pending legislation with strong support from the New York City Bar Association. But even in adopting states, the Act only applies if the parties opt in, it doesn't automatically protect existing escrow arrangements.

For anyone who can't rely on the Uniform Special Deposits Act, which is most of the country right now, the existing case law provides a clear set of principles for structuring escrow arrangements that will survive a bankruptcy challenge. Use an independent third-party escrow agent, not the debtor's attorney or an affiliated entity. Define objective, verifiable conditions for disbursement that don't depend on the debtor's discretion, completion of construction milestones verified by independent inspectors, passage of a specific time period, or receipt of third-party certifications. Eliminate the debtor's control entirely. Segregate the funds in a clearly designated account. Never characterize the arrangement as a lien on the escrow account, which creates perfection requirements that can be exploited under § 544 if not met.

The escrow agreement itself should explicitly state that the debtor's interest is limited to a contingent contractual right to receive funds upon satisfaction of the escrow conditions, not an ownership interest in the funds themselves. The agreement should be executed well in advance of any potential bankruptcy filing to avoid preference exposure under § 547's 90-day lookback period.

The bottom line is this: calling something an escrow does not make it bankruptcy-proof. The label means nothing if the substance doesn't hold up. Courts look at who controls the funds, whether the disbursement conditions are objective, whether the funds are segregated, and whether the debtor's interest was truly eliminated before the petition date. If you're relying on an escrow to protect significant funds in any transaction, make sure the arrangement is structured to pass that analysis, because if the other party files bankruptcy, the trustee's attorney is going to test every element of it.