Bankruptcy Code section 541 establishes what is considered property of the estate. Under section 541(a) of the Bankruptcy Code, with some enumerated exceptions in subsection (b), the estate contains "all legal or equitable interests of the debtor in property" as of the petition date "wherever located and by whomever held."

In addition, as recently reaffirmed by the Fifth Circuit, "Congress enacted § 541(a)(7) to clarify its intention that § 541 be an all-embracing definition and to ensure that property interests created with or by property of the estate are themselves property of the estate."⁴ Notably, "property of the debtor" is not defined in the Bankruptcy Code. Thus, while federal bankruptcy law governs what is property of the estate, a debtor's interest in the property is governed by non-bankruptcy law (generally, state law).⁵

Notwithstanding this broad definition, the bankruptcy estate has limits — in particular, section 541(d) of the Bankruptcy Code provides that property in which a debtor holds "only legal title and not an equitable interest" becomes property of the estate solely to the extent of the debtor's legal title. The Supreme Court commented that section 541(d) demonstrates Congress's intent "to exclude from the estate property of others in which the debtor had some minor interest such as a lien or bare legal title."⁶

Accordingly, "[w]hatever limitations on the debtor's property apply outside of bankruptcy apply inside of bankruptcy as well ... [a] debtor's property does not shrink by happenstance of bankruptcy, but it does not expand, either."⁷

Under New York law, upon funds being delivered to a third-party depositary pursuant to a valid escrow agreement, the grantor relinquishes control over the funds and the funds are delivered to a third party conditioned upon the performance or occurrence of some act or event. The majority of courts hold that "[i]f a valid escrow has been established prior to bankruptcy, and if the escrow is not subject to avoidance as either a preference or a fraudulent transfer, then the pre-bankruptcy transfer of property to the third party escrow agent is deemed to have removed the property from the Debtor's ownership."⁸

Similarly, escrow agents who file for bankruptcy do not have an equitable right to the escrowed funds, which therefore do not become part of their bankruptcy estate. These courts have also held that even funds held in escrow with the possibility to revert back to the debtor in certain circumstances are generally not property of the estate. Rather, "[e]state property is confined to the rights conferred upon the debtor by the escrow agreement, not property rights in the assets escrowed."⁹

In re Atlantic Gulf Communities Corp.¹⁰ is illustrative of how courts generally distinguish between simultaneous, competing rights to escrowed funds. The court acknowledged that several parties had a right to the escrowed funds, but the key inquiry was whether the debtor (which was both the grantor and possible grantee of the funds) had a present right to the escrowed funds.

The court agreed with the "majority of courts" and concluded that because the debtor only had a contingent right to the funds after satisfying a yet-unmet condition, it did not have a present right and the escrow funds were therefore not part of the debtor's estate.

While a minority of cases found that funds held in escrow were property of the bankruptcy estate, they tend to rely on unique facts, such as that a valid escrow agreement was not created or the contingency to return the funds to the debtor had already occurred.¹¹

Similar to escrow accounts, assets held in custody or trust by an intermediary "who lacks beneficial title" are also generally not regarded as property of such entity's bankruptcy estate.¹² This is typically a highly fact-dependent inquiry that depends upon the circumstances of each individual case, including whether a constructive trust may exist under applicable state law.

This issue recently generated significant attention in the pending cryptocurrency chapter 11 cases. Court decisions regarding customers' rights to their digital assets in the recent Celsius, Voyager and BlockFi bankruptcy cases¹³ demonstrate that while digital assets are a relatively nascent financial instrument, courts will apply general principles of contract interpretation to agreement terms when addressing whether a valid custody arrangement exists.

In Celsius Network LLC, the court ruled in December 2022 that digital assets in custody wallets and withhold accounts were not property of the estate under section 541 of the Bankruptcy Code. Celsius acknowledged that ownership and title to those digital assets were determined by "the parties' respective contractual rights," which confirmed their intent for Celsius to only retain custody.

Conversely, the court later ruled in January 2023 that digital assets in yield-earning accounts were property of the estate because the terms of use "unambiguously transfer title and ownership" to Celsius and such assets were therefore distributed pro rata to all creditors.

In Voyager Digital Holdings, Inc., the court held that while Voyager's customer agreements governing their general deposits gave Voyager "all attendant rights of ownership," the for-the-benefit-of (FBO) customer accounts were not property of the estate, based on their respective agreements. The Voyager court explicitly noted that its decision was specific to the facts and "not intended to be a ruling as to the rights that customers might have in cryptocurrency cases generally."

Similarly, in BlockFi Inc., the court entitled customers to the assets in their wallet accounts because the terms of service stated that "title to the cryptocurrency held in your BlockFi Wallet shall at all times remain with you and shall not transfer to BlockFi." While BlockFi customers gained access to their digital assets in custody/wallet accounts within months of the bankruptcy filing, digital assets in other accounts governed by separate terms were deemed property of the estate under BlockFi's confirmed chapter 11 plan.

Relatedly, pursuant to section 363 of the Bankruptcy Code, debtors may sell "property of the estate" free and clear of claims and interests. Necessarily, a threshold determination is whether such assets are in fact property of the bankruptcy estate.¹⁴ If a party can demonstrate that certain assets are not property of the estate, such assets could not be sold free and clear of the creditor's claims and interests.

Two recent Delaware decisions confronted this issue.¹⁵ In DeCurtis Holdings a party sued the debtors prepetition alleging intellectual property infringement, and the jury found against the debtors. Thereafter, DeCurtis filed for bankruptcy and sought to sell all of its assets free and clear of all claims and interests, including those of the counterparty.

The bankruptcy court found that the counterparty had ownership rights in the assets and enjoined DeCurtis from selling such assets free and clear. The court noted that, as a threshold matter, the debtors bear the burden of establishing that the sale assets are "property of the estate."

Similarly, in KDC Agribusiness the debtors sought to sell assets that were subject to a trade secret dispute free and clear of the third party's interests. While the judge "did not see any reason" to prevent the sale, he noted that "competing claims of ownership" cannot be "extinguished in a free and clear sale under section 363." Thus, the court held that any purchaser must "stand in the shoes of the debtors with respect to any such dispute."

These cases demonstrate that a determination of whether assets are property of the estate under section 541 may provide critical protection by precluding the sale of assets under section 363 of the Bankruptcy Code where the debtor's ownership is challenged.

While Congress intentionally created a broad estate under section 541 of the Bankruptcy Code, it is critically limited by section 541(d), which excludes property where the debtor lacks any equitable interest. Understanding whether assets are part of the bankruptcy estate is crucial and may have significant economic implications.

The foregoing are examples where disputes regarding the scope of the bankruptcy estate could provide meaningful protections for parties in interest. Similarly, parties should use extra care when contracting, especially with respect to the terms of custody, escrow, trust or bailment arrangements, to ensure that funds will remain protected and separated from the bankruptcy estate in the event of a bankruptcy filing.

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The opinions expressed in this article are those of the authors and should not necessarily be imputed to the authors' firm and clients.

1 United States v. Whiting Pools, Inc., 462 U.S. 198, 204 (1983). Tellingly, the Second Circuit court noted in Chartschlaa v. Nationwide Mutual Ins. Co., 538 F.3d 116, 122 (2d Cir. 2008) that "[i]t would be hard to imagine language that would be more encompassing" than section 541 because it includes "every conceivable interest of the debtor, future, nonpossessory, contingent, speculative, and derivative."

2 See In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 939 F.3d 340, 349 (1st Cir. 2019) ("That initial compartmentalization [of section 541], in turn, delineates the reach of the automatic stay because the subsections of the automatic-stay provision ... variously apply to 'property of the estate' or, more broadly, to 'property of the debtor.'").

3 Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019).

4 In re S. Coast Supply Co., 94 F.4th 376, 382 (5th Cir. 2024).

5 Butner v. United States, 440 U.S. 48, 55 (1979) ("Property interests are created and defined by state law."); see also In re TelexFree, LLC, 941 F.3d 576, 584 (1st Cir. 2019) ("Ordinarily, state law creates and defines the underlying property interests, but federal bankruptcy law determines whether those interests are 'property of the estate.'") (citations omitted).

6 Whiting Pools, Inc., 462 U.S. at 205 n.10; see also In re Ursa Operating Co., LLC, , *3 (3d Cir. Jan. 25, 2024) ("The code contemplates [in § 541(d)] that a debtor in bankruptcy may be holding property that equitably belongs to another and provides that such property should not be disbursed to creditors along with the debtor's own.").

7 Mission Prod. Holdings, 139 S. Ct. at 1663 (internal citations omitted).

8 In re Odonata Ltd., , *7 (Bankr. S.D.N.Y. Feb. 22, 2024); see also, e.g., Davis v. Cox, 356 F.3d 76, 93-94 (1st Cir. 2004) (finding funds held in escrow do not become part of the estate); In re Urban Commons 2 West LLC, 648 B.R. 530, 537-38 (Bankr. S.D.N.Y. 2023) ("As the Collier treatise states, 'most courts have held that assets in escrow are not property of the estate.'"); In re Dreier LLP, 527 B.R. 126, 134 (S.D.N.Y. 2014) (same); In re Royal Bus. Sch., Inc., 157 B.R. 932, 940-41 (Bankr. E.D.N.Y. 1993) (same); In re O.P.M. Leasing Servs., 46 B.R. 661, 667 (Bankr. S.D.N.Y. 1985) (finding escrowed funds were not property of the estate, even if "the grantor retains a contingent right to repossess the property if the specified condition does not occur ... ").

9 In re Urban Commons 2 West LLC, 648 B.R. at 537-38.

10 369 B.R. 156 (Bankr. D. Del. 2007).

11 See 5 COLLIER ON BANKRUPTCY ¶ 541.09[2] (16th ed. 2023) ("Five cases are among those sometimes cited for the proposition that funds held in escrow are property of the estate. On close analysis, however, these cases do not differ significantly from the majority approach [that escrow funds are not property of the estate]."). See also In re Odonata Ltd., , *10 ("I hold that there was no valid escrow agreement in effect when the Debtor filed for bankruptcy and therefore that the funds were property of Odonata's estate.").

12 In re Joliet-Will Cnty. Cmty. Action Agency, 847 F.2d 430, 432 (7th Cir. 1988); see also In re LAN Tamers, Inc., 329 F.3d 204, 210 (1st Cir. 2004); Westmoreland Hum. Opportunities, Inc. v. Walsh, 246 F.3d 233, 251 (3d Cir. 2001).

13 In re Celsius Network LLC, 647 B.R. 631, 651 (Bankr. S.D.N.Y. 2023); In re Voyager Digital Holdings, Inc., No. 22-10943 (MEW), (Bankr. S.D.N.Y. Aug. 5, 2022); In re BlockFi Inc., Case No. 22-19361 (MBK) (Bankr. D.N.J. May 17, 2023), Docket No. 923.

14 See, e.g., Darby v. Zimmerman (In re Popp), 323 B.R. 260, 266 (B.A.P. 9th Cir. 2005) ("Section 363(b) … requires that the estate demonstrate that the property it proposes to sell is 'property of the estate.'"); In re Whitehall Jewelers Holdings, Inc., , at *4 (Bankr. D. Del. July 28, 2008) ("A bankruptcy court may not allow the sale of property as 'property of the estate' without first determining whether the property is property of the estate.").

15 In re DeCurtis Holdings LLC, (Bankr. D. Del. Aug. 9, 2023) and In re KDC Agribusiness LLC, Case No. 23-10786 (CTG) (Bankr. D. Del. Nov. 13, 2023), Docket No. 464.