In today's troubled real estate market across the nation, this is a question many of your buyers may have already asked you. If so, did you give them the right advice? This was the question posed to Mr. Don R. Hancock, a lawyer with over 35 years real estate law experience here in Austin, Texas, and partner in Hancock & McGill, L.L.P., attorneys at law (excuse the LONG answer - he IS a lawyer, remember - but worth reading to the end.) State laws may vary, so be sure and check with your local attorney before reciting his answer verbatim, but this is something we as REALTORS need to know! Even though our RE market in Austin is healthier than most across the nation, a new home builder here and a few custom home builders have already filed for bankrupcy protection.

He actually broke the question down into three parts relating to the bankruptcy of a home builder: First, can a buyer rely upon a contract with a builder after bankruptcy? Second, what happens to funds paid to a builder in bankruptcy? Third, should a buyer consider contracting with a builder in bankruptcy?

"For our purposes, there are two categories of business bankruptcies: a Chapter 7 bankruptcy and a Chapter 11 bankruptcy. Under a Chapter 7 bankruptcy, the builder is out of business and the bankruptcy purpose is essentially to distribute remaining assets to claimants. Under a Chapter 11 bankruptcy, the builder is attempting to re-organize, stay in business and continue to build and sell homes. I will limit the discussion to Chapter 11 bankruptcies.

Can a buyer or homeowner rely upon the contract he has with a builder, if the builder files for protection under Chapter 11?The answer is a qualified "NO!" The builder, as part of the bankruptcy process, can reject the contract without the consent of the buyer. However, the builder cannot unilaterally modify the terms of the contract. It is an all or nothing proposition. The builder can either honor the contract as written or terminate it. If both the builder and the buyer want to negotiate changes in the contract, that is permissible, but both parties have to agree to any changes.

What happens to funds paid to the builder? If the contract is terminated or if the builder commits a material breach of the contract terms, can the buyer recover the funds paid to the builder? The answer depends upon how the funds paid to the builder are classified for bankruptcy purposes and whether the builder has sufficient assets to re-pay the funds. Generally, funds paid to a builder will fall into one of two categories. They will either be a deposit for work to be done or they will be trust funds. If an owner has contracted with a builder to construct a home on a lot owned by the homeowner, funds are typically paid to the builder as construction progresses. If funds are advanced to the builder for the purpose of paying subcontractors and material suppliers, the funds are usually classified as trust funds in the hands of the builder. These are funds entrusted to the builder to pay third parties. If the builder breaches the implied trust and does not pay the funds to subcontractors and suppliers, this may be determined to be a fraudulent act and may subject the officers and other employees of the builder to personal liability for re-payment of the funds.

 There might also be criminal penalties but these are rarely enforced. When a buyer contracts with a builder for a home to be constructed on property owned by the builder, the builder typically requires a deposit when the contract is signed. If the plans and specifications for the builder's "stock" home are substantially altered, this deposit may be thousands of dollars. There is some protection for these deposit funds when a builder files bankruptcy, but not much. The bankruptcy code allows a priority claim for up to $2,425 for each consumer (a husband and wife would have a combined $4,850). A priority claim can elevate a claim in front of certain other claims and provide a better chance of recovering the funds. Two factors limit the protection afforded. First, the amount is limited to $2,425 per consumer. Second, even if the buyer has a priority claim, no funds will be received if there are no funds to pay the claim. Builders who are in bankruptcy may offer to hold all deposits as "trust funds." This may provide some limited protection.

If you are considering contracting with a builder in a Chapter 11 bankruptcy who offers to hold funds as trust funds, you should: require that the builder obtain bankruptcy court approval for the trust fund arrangement; require a specific written trust agreement; and require that all funds be held in a separate bank account with no other funds commingled. Even if you take the precautions outlined above and the deposit funds become trust funds, you may not be able to recover them if the builder does not honor the trust agreement and spends the funds. You might have a lawsuit against the officers of the company who participated in spending the trust funds, but if there are no funds to be had, you may not recover. A better choice for holding trust funds is to insist that they be held by a third party, such as a title company, under a specific written trust agreement.

The final question is: should a buyer consider contracting with a builder in a Chapter 11 bankruptcy? This question is difficult to answer because it depends upon so many factors. I can tell you that building a home is inherently more risky than simply purchasing a completed home, even if the builder is not in financial difficulty. When it is apparent that the builder is already in financial difficulty, the risk is substantially increased. If an owner is considering contracting with a builder in bankruptcy, they should seek competent legal counsel before signing the contract to make certain they fully understands the risks."