Contributed by Rich Mullen
We can all remember the sage advice of our elders – whether we actually ever listened is another story. Judge Lane from the Bankruptcy Court for the Southern District of New York recently reminded us of one of those important lessons – actions speak louder than words – by concluding that both pre- and postpetition rents from real estate owned by the debtor were not property of the debtor’s estate because a lender took sufficient affirmative steps to enforce its right to the rents under an “absolute” assignment of the rents.
In Soho 25 Retail, the debtor owned certain units that operated as prime retail space in downtown Manhattan. As is typical with commercial real estate financing, the debtor’s lender obtained a mortgage on its property and an assignment of leases and rents. The assignment was drafted as an absolute assignment of rents, with the lender granting a “license” to the debtor borrower to collect and use the rents until the occurrence of an event of default. Of course, once the lender’s loan was repaid, the borrower would have the unfettered right to the rents.
After the debtor defaulted on its loan, the lender sent the debtor a notice of default and terminated the debtor’s license to collect rents. The lender also notified all the debtor’s tenants that rent should be paid directly to the lender. Additionally, the lender initiated a state court foreclosure action and requested the appointment of a rent receiver. After entering a default judgment, the state court appointed a rent referee, who issued a report and directed the referee to sell the property. The debtor, however, commenced its bankruptcy case before the public auction.
In the debtor’s chapter 11 case, the debtor and the lender vigorously disagreed about the legal effect of the assignment. The debtor argued that, under New York law, an assignment of rents is not self-executing and does not become effective until a lender affirmatively asserts its rights to those rents, which it claimed the lender had failed to do. On the other hand, the lender argued that the assignment agreement was absolute and self-executing, and, therefore, the lender was not required to take any affirmative steps to enforce its rights to the rents. Alternatively, the lender argued that it had taken sufficient affirmative steps to protect its interest in the rents.
Notwithstanding that the clear purpose of the assignment of rents was to provide security for the lender’s loan, Judge Lane concluded that the language of the assignment agreement indicated that the parties intended the agreement to be an absolute assignment and that the assignment agreement provided the debtor with nothing more than a revocable license in rent that was revoked after the debtor defaulted under the loan agreements. In reaching this conclusion, the Bankruptcy Court relied upon, among other things, language stating that the assignment was absolute, was intended to be unconditional, and was not just an assignment for additional security. The Bankruptcy Court also relied on language indicating that the lender would have full power to demand, collect and receive any and all rents as a result of the debtor’s default. Judge Lane rejected the debtor’s arguments that other language stating that the assignment was being given as an additional security demonstrated that the assignment agreement was meant only as security for the underlying mortgage.
Although Judge Lane quoted Chief Judge Arthur J. Gonzalez for the proposition that “New York law is, at best, unclear on the topic of whether an absolute assignment of rent transfers title to the rent upon execution of the instrument,” he concluded that “the majority of New York state cases are of the view that an absolute assignment is not permitted, regardless of the language of the agreement.” In fact, treatment of an absolute assignment of rents literally and not looking past the form of the agreement to its substance appears to be gaining increasing acceptance in New York bankruptcy courts, and the Third Circuit. At least one bankruptcy court, though, has looked at the language of section 541(a)(6), which specifically refers to “rents . . . from property of the estate,” and has concluded that federal bankruptcy law preempts state law on assignments of rents in determining whether rents constitute property of the estate. Other courts also have looked beyond the form of absolute assignments to conclude that postpetition rents were cash collateral of the lender, but still property of the debtor’s estate.
Soho 25 Retail does not address the effect of section 541(a)(6) or the “murky legal question” posed by Chief Judge Gonzalez because Judge Lane concluded that the lender had taken all the necessary actions following the event of default to make the absolute assignment of rents effective under New York law. The Bankruptcy Court indicated that neither the ultimate sale of the property nor actual possession was required. Instead, the lender’s commencement of the foreclosure action and the state court’s appointment of a referee were significant affirmative steps and, together with the lender’s application to seek relief from the automatic stay, were sufficient affirmative steps that entitled the lender to the rent. Accordingly, the Bankruptcy Court concluded that the rents were not property of the debtor’s estate and could not be used by the debtor to fund a plan of reorganization until the underlying debt was satisfied.
From a lender’s perspective, Soho 25 Retail certainly reaffirms that, where permissible under state law, an absolute assignment of rents with a license to the debtor to use the rents prior to a default provides the lender with significant protection. Indeed, if Soho 25 Retail is followed, such a structure might provide nearly complete control over a borrower’s fate once the assignment is effectively revoked. Although the lender in Soho 25 Retail had gone far down the path towards foreclosure before the debtor filed for bankruptcy protection, borrowers need to be concerned about what the “point of no return” might be where they will lose access to what may well be their only source of cash flow. One issue borrowers will have to consider is whether they should seek chapter 11 protection early in the process to bolster any argument that, even if Soho 25 Retail is followed, the lender did not take sufficient steps to divest the borrower of its interest in rents. It remains to be seen how bankruptcy courts will resolve the “murky legal question” concerning the enforceability of an absolute assignment absent sufficient affirmative steps being taken by a lender.
Sixth Circuit Determines that an Absolute Assignment of Rents Perfected Under Michigan State Law Takes Property out of a Bankruptcy Estate (In Re Town Center Flats, LLC, Case No. 16-1812 — Decided May 2, 2017)
If under state law perfection of an absolute assignment of rents is a transfer of property, then such rents could be excluded from property of a debtor’s bankruptcy estate. Debtor Town Center Flats, LLC owns a 53-unit residential apartment complex in Shelby Township, Michigan. Town Center financed construction of the building with a $5.3 million loan from ECP Commercial II LLC. The loan was secured by a mortgage, as well as an agreement to assign rents to the creditor in the event of default (the “Agreement”). Pursuant to the terms of the Agreement, Town Center “irrevocably, absolutely and unconditionally [agreed to] transfer, sell, assign, pledge and convey to Assignee, its successors and assigns, all of the right, title and interest of [Town Center] in … income of every nature of and from the Project, including, without limitation, minimum rents [and] additional rents….” The Agreement purported to be a “present, absolute and executed grant of the powers herein granted to Assignee,” while simultaneously granting a license to Town Center to collect and retain rents until an event of default, at which point the license would “automatically terminate without notice to [Town Center].”
On December 31, 2013, Town Center defaulted on its obligation to repay the loan. On December 22, 2014, ECP sent a notice of default and a request for the payment of rents to all known tenants of the Town Center property. The notice complied with the terms of the Agreement and with section 554.231 of the Michigan Complied Laws, which allows creditors to collect rents directly from tenants of certain mortgaged properties. The following day, ECP recorded the notice documents in Macomb County, Michigan, completing the last step required by the statute to make the assignment of rents binding against both Town Center and the tenants of the property. On January 23, 2015, ECP filed a complaint in the Circuit Court for Macomb County, Michigan, seeking foreclosure and requesting the appointment of a receiver to take possession of the Town Center property. Subsequently, on January 31, 2015, Town Center filed a petition for relief under chapter 11 of the Bankruptcy Code. On the petition date, Town Center owed ECP $5,329,329, plus attorney’s fees and costs.
At the commencement of the chapter 11 case, ECP and Town Center entered into interim agreement to allow Town Center to continue to collect rent from tenants of the complex, with $15,000 per month used to pay down the debt owed to EPC, and the remainder of the rents to be used for authorized expenses. Town Center defaulted on the interim agreement almost immediately. Consequently, in February 2015, ECP filed a motion to prohibit Town Center from using rents collected after the chapter 11 petition was filed. The bankruptcy court denied the motion, finding that the rents were property of Town Center’s bankruptcy estate because an assignment of rents creates a security interest, but does not change ownership. Simply stated, Town Center still had an interest in the rents. On appeal, the district court vacated the order of the bankruptcy court, finding that an assignment of rents is a transfer of ownership under Michigan law, and thus the rents should not be included in the chapter 11 estate. Appeal was then taken to the Sixth Circuit.
Property of an estate in bankruptcy is broadly defined by section 541 of the Bankruptcy Code as all legal or equitable interests of the debtor in property as of the commencement of the case. The Sixth Circuit, citing the Supreme Court’s decision in Butner v. United States, noted that property rights of a debtor in bankruptcy are determined under the law of the state in which the property is located, which in Town Center is Michigan. Turning to Michigan law, the Court cited section 554.231 of the Michigan Compiled Statutes, which provides, in pertinent part:
[I[n or in connection with any mortgage on commercial or industrial property … it shall be lawful to assign the rents, or any portion thereof, under any oral or written leases upon the mortgaged property to the mortgagee, as security in addition to the property described in such mortgage. Such assignment of rents shall be binding upon such assignor only in the event of default in the terms and conditions of said mortgage, and shall operate against and be binding upon the occupiers of the premises from the date of filing by the mortgagee in the office of the register of deeds for the county in which the property is located of a notice of default in the terms and conditions of the mortgage and service of a copy of such notice upon the occupiers of the mortgaged premises.”
Relying on a number of Michigan state court decisions that generally discuss assignment of rents under section 554.231 as ownership transfers, the Court held the rents generated by Town Center’s property were not property of its bankruptcy estate because perfection of the assignment of rents by ECP had transferred ownership to ECP.
Two key supplemental points were additionally addressed by the Court. First, the Court determined that Town Center’s right to receive rents once the mortgage is paid is not a residual property right that would serve to somehow supersede ECP’s present ownership interest and bring the rents into the bankruptcy estate. Second, the Court distinguished the Supreme Court’s decision in United States v. Whiting Pools. In that case, personal property had been seized by the Internal Revenue Service in satisfaction of a tax lien was determined to be part of the bankruptcy estate because the debtor retained an ownership interest until sale to a bona fide purchaser. The Sixth Circuit concluded by finding that the bankruptcy court’s decision was motivated by a policy concern that excluding the assigned rents from the estate would effectively foreclose chapter 11 relief for companies like Town Center that own a single property and receive their sole stream of revenue from rents of that property. “We recognize the concern of Town Center—and the bankruptcy court—that single-asset real estate entities may have limited options under [c]hapter 11 in this situation. Michigan law, however, is clear on the matter and governs despite other policy concerns.”