90 Second Lesson: When a Seller of Real Property Files for Bankruptcy Before Closing

Question:

Sven, of St. Paul, related to us this sad but musical tale, which pertains to purchasing real estate where the seller goes bankrupt before closing:

You see, she and I entered into a written contract to buy a piece of land with a small house on it — all of which she owned free and clear — near St. Paul for $500,000. I had already paid one-half of the purchase price, and besides paid recent water and electric bills (to be settled separately at closing), and was ready to pay the rest of the purchase price at closing. But she scooted! Couldn’t find her in Davenport, but did find a notice of her filing a chapter 7 bankruptcy case in the U.S. Bankruptcy Court for the District of Minnesota in my mailbox when I got back home.

Am I going to get the land? Or at least my money back?

Answer:

Our reply began by noting the remarkable similarity between part of Sven’s tale and the lyrics to Johnny Cash’s Sun label hit, “Big River,” on which he was backed by the Tennessee Two.

I met her accidentally in St. Paul, Minnesota
And it tore me up every time I heard her drawl, Southern drawl
Then I heard my dream was back Downstream cavortin’ in Davenport
And I followed you, Big River, when you called.

What are The Purchaser’s Rights Under an Executory Contract?

We continued:

You should get your money back, for the most part. The property is now in the custody of the chapter 7 trustee. The sales contract is an executory contract because material obligations remain on each side: you to pay the balance, and she to convey title to you. The trustee could theoretically assume the contract, accept your final payment, and close. More likely, the trustee would conclude that they could reject the sales contract, sell the property, and distribute to unsecured creditors any amount realized beyond the estate’s obligations to you.

And what are the estate’s obligations to you? Usually, the non-debtor party to a rejected executory contract receives an unsecured claim in the amount of rejection damages under the contract (i.e., the amounts not paid), with special rules putting a ceiling on the rejection damages of lessors under unexpired leases. The upshot is that rejection claims are paid like other unsecured claims, usually an amount far less than the face amount of the claims.

But how to calculate your damages? And weren’t you expecting more than cash, but rather an unencumbered ownership interest in land? Why should you get only an unsecured claim, like a seller of saddles or other trade creditors?

The Code heard your plea (in a way). Section 365(j) governs the rights of purchasers of real property who were never in possession of the real property (or who could have been but elected not to be in possession). This section provides that such purchasers have a lien on the real property to secure recovery of any portion of the purchase price that they had already paid. The purchaser’s claim for other damages caused by the rejection of the executory contract is an unsecured claim against the estate (as it would be if section 365(j) did not exist).

So, the real property would be sold either in bankruptcy (more likely) or outside of bankruptcy after you successfully move to lift the automatic stay. You would receive the first $250,000 of net proceeds, and the trustee would get the rest — to be distributed to unsecured creditors. And you would be one of the unsecured creditors with a claim for rejection damages with respect to amounts you advanced outside the sale contract to pay water and electric charges on the real property.

Section 365(i) covers the situation where the purchaser is in possession of the real property and the seller enters bankruptcy. But we’ll await the query of another lonely cowboy to discuss that one.

We think you’ll also like:

1. Not Necessarily Free and Clear: Purchasing Real Estate Property in a Section 363 Sale
2. Personal Property Appraisals 101
3. 90-Second Lesson: Personal Chapter 7 Bankruptcy Petition, Are Single-Member LLC Assets Safe from the Trustee?

[Editors’ Note: This 90 Second Lesson is based, in substantial part, in material reprinted from Commercial Bankruptcy Litigation 2d and Strategic Alternatives For and Against Distressed Businesses, with permission of Thomson Reuters. For more information about these publications, please visit www.legalsolutions.com. For more on contract assumption and rejection, in all its glory, see chapter 8 of Commercial Bankruptcy Litigation (Jonathan P. Friedland, Elizabeth B Vandesteeg & Christopher M. Cahill, eds., 2d Ed. 2024).

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. The Nuts & Bolts of a 363 Motion
2. Representing the Commercial Landlord
3. The Intersection of Bankruptcy and….Tax Law

This is an updated version of an article originally published on August 23, 2019.]

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