August 8, 2021
Authored by: Brian Walsh
In a recent post, I discussed three situations in which a debtor in bankruptcy might find itself dispossessed of assets that appeared to be property of the bankruptcy estate. This article expands on that general idea and presents a compendium of situations in which creditors or circumstances may deprive a debtor of assets or their value.
- Adverse possession. Adverse possession is technically an application of the statute of limitations, discussed more generally below. In re Colarusso, 295 B.R. 166, 173 (B.A.P. 1st Cir. 2003). The expiration of the statutory period to recover possession, as extended by 11 U.S.C. § 108(a), may shift ownership and control of real property from the bankruptcy estate to others. Reported decisions often arise in the context of a debtor’s efforts to sell property free and clear of the interest of the adverse possessor. See, e.g., In re Catholic Bishop of Northern Alaska, 509 B.R. 229 (Bankr. D. Alaska 2014) (involving caretaker’s claim to 320-acre property and hot springs).
- Bankruptcy of another. A debtor’s account receivable may be subject to discharge in the account debtor’s bankruptcy case. Or a debtor’s contractual counterparty may reject the contract in its own case. See In re Noranda Aluminum, Inc., 549 B.R. 725, 729 (Bankr. E.D. Mo. 2016) (authorizing debtor to reject contract even though counterparty pursued assumption in its bankruptcy case).
- Casualty. Debtors are not immune from fires, floods, storms, and other destructive forces. In ordinary circumstances, insurance proceeds should replace the value of the damaged or destroyed asset. See In re Scholl, 605 B.R. 163, 178-79 (Bankr. S.D. Ohio 2019) (rejecting Chapter 13 debtors’ attempt to retain $194,000 in insurance proceeds while paying 3% dividend to unsecured creditors).
- Condemnation. A debtor that owns or controls unsafe premises can’t count on the automatic stay to stall regulatory proceedings or demolition of the property. See In re Javens, 107 F.3d 359, 370 (6th Cir. 1997) (upholding bankruptcy court’s determination that city could demolish apartment building and houses owned by debtor).
- Conditional gift. In Kansas, if the debtor has an engagement ring on the petition date but the wedding is called off post-petition, the ring is no longer property of the estate. In re Heck, 355 B.R. 813, 823 (Bankr. D. Kan. 2006). Results may vary in other states or with other types of conditional gifts.
“This will always be property of your bankruptcy estate.”
- Constructive trust. See my prior post on issues relating to constructive trusts in bankruptcy.
- Eminent domain. The courts disagree whether and in what circumstances a government agency may exercise the power of eminent domain without seeking relief from the automatic stay. Compare In re Royal, 137 F. App’x 537 (4th Cir. 2005) (taking of groundwater was not exercise of police and regulatory power), with In re Bevelle, 348 B.R. 812, 816 (Bankr. N.D. Ala. 2006) (taking of land to build new courthouse was not stayed). But regardless of the procedural hurdles, any debtor may find itself with a pot of cash instead of the property it was planning to use to restructure its affairs.
- Escheat. See my prior post on issues relating to escheat in bankruptcy.
- Exceptions to automatic stay. The Bankruptcy Code expressly permits creditors and regulators to take certain actions that may deprive debtors of assets. For example, the HUD secretary may pursue foreclosure of certain multifamily mortgages, see 11 U.S.C. § 362(b)(8); a state may revoke the license of an educational institution, see § 362(b)(15); a creditor may close out a swap agreement, see id. § 362(b)(17); and a landlord may evict a tenant for property endangerment or use of controlled substances, see id. § 362(b)(23).
- Expiration of deadline. Certain property interests, such as options and rights of redemption, are subject to contractual or statutory expiration dates. See In re Northington, 876 F.3d 1302, 1315 (11th Cir. 2017) (debtor’s interest in pawned vehicle was extinguished under state law when he failed to redeem it by post-petition deadline). The courts do not always agree whether these types of deadlines are subject to the 60-day extension provided in 11 U.S.C. § 108(b). See In re 1075 S Yukon, LLC, 590 B.R. 527, 537 (Bankr. D. Colo. 2018) (holding that purchase option was not subject to extension and discussing contrary authority).
- Expiration of lease, license, patent, or contract. The automatic stay “does not toll the mere running of time under a contract.” Moody v. Amoco Oil Co., 734 F.2d 1200, 1213 (7th Cir. 1984). Thus, nothing prevents a contract or a lease from expiring post-petition by its own terms. See In re Nashville White Trucks, Inc., 5 B.R. 112, 117 (Bankr. M.D. Tenn. 1980) (franchise agreement expired 19 days after bankruptcy filing); In re Crabb, 48 B.R. 165, 167 (Bankr. D. Mass. 1985) (lease expired post-petition, before debtor attempted to exercise option to extend).
- Foreclosure or termination of superior interest. If the debtor holds a junior mortgage on property, foreclosure by the senior lienholder may eliminate the debtor’s interest. See In re Three Strokes L.P., 397 B.R. 804, 808 (Bankr. N.D. Tex. 2008) (discussing cases with different views of applicability of automatic stay). Similarly, termination of a lease may result in the termination of the debtor’s interest as sublessee. See In re 48th Street Steakhouse, Inc., 835 F.2d 427, 431 (2d Cir. 1987).
- Forfeiture. See my prior post on issues relating to forfeiture in bankruptcy.
- Hot goods. The Fair Labor Standards Act prohibits the sale in interstate commerce of goods produced by workers who have not been paid the minimum wage, aka “hot goods.” 29 U.S.C. § 215(a)(1). A debtor’s inventory may thus be effectively worthless unless and until it locates the funds necessary to compensate the workers who manufactured it. See Brock v. Rusco Industries, Inc., 842 F.2d 270, 274 (11th Cir. 1988).
- Legislation or regulation. A debtor’s products may quickly become worthless if legislative or regulatory bodies take action to restrict or prohibit their sale. See, e.g., R.B. Jarts, Inc. v. Richardson, 438 F.2d 846 (2d Cir. 1971) (challenging regulation that would have banned sale of plaintiff’s lawn darts within one day). And assets that are marketable outside of bankruptcy may become worthless because of the court’s obligation to uphold federal law. See In re Johnson, 532 B.R. 53, 58-59 (Bankr. W.D. Mich. 2015) (ordering debtor to destroy marijuana plants and inventory as a condition of restructuring debts in Chapter 13).
- Obsolescence or spoilage. Inventory has no value if nobody wants to buy it or if it’s not in a condition to be sold. See In re Diplomat Electronics Corp., 82 B.R. 688, 690 (Bankr. S.D.N.Y. 1988) (granting stay relief to lender and noting that “much of this type of ‘high-tech’ inventory becomes quickly obsolete either because of technological advances or because of the shelf life of the electronic components”).
- Statute of limitations. Section 108(a) of the Bankruptcy Code may extend the debtor’s or trustee’s statute of limitations until two years after the order for relief. But once the deadline passes, the estate’s cause of action is worthless. See In re Coin Phones, Inc., 153 B.R. 135, 142 (Bankr. S.D.N.Y. 1993) (dismissing time-barred, multi-million-dollar warranty claim involving “cocots”).
- Theft or similar behavior by others. Anyone can be a victim of an opportunistic crime. See In re Grimm & Rothwell, Inc., 108 B.R. 186, 190 (Bankr. S.D. Ohio 1989) (declining to surcharge landlord for value of estate property stolen from warehouse). Unfortunately, the assets of bankruptcy estates occasionally prove tempting to the fiduciaries who are supposed to manage them. Some estates are particularly unlucky. See In re Mushroom Transportation Co., 227 B.R. 244, 247 (Bankr. E.D. Pa. 1998) (discussing theft of estate funds by counsel to Chapter 11 debtors, which was followed by embezzlement of additional funds by trustee elected under 11 U.S.C. § 702).
- Void title. If the debtor never validly owned an asset in the first place, the bankruptcy estate will not own it either. See In re Newpower, 233 F.3d 922, 931 (6th Cir. 2000) (debtor’s title to $382,000 that he embezzled was void, and funds were not estate property); In re Shelton, 593 B.R. 755, 764 (Bankr. N.D. Ohio 2018) (because state law prohibited debtor from using power of attorney to transfer her mother’s real property to herself, her title was void and estate had no interest in property).
 Aficionados may be aware that lawn darts were not actually banned in the United States until 1988, and so this is not, strictly speaking, an example of products quickly becoming worthless.