“[T]he debtor … did not retain sufficient rights in the assigned rents under Michigan law for those rents to be included in the bankruptcy estate,” held the U.S. Court of Appeals for the Sixth Circuit on May 2, 2017. In re Town Center Flats LLC, 201 U.S. App. LEXIS 7733, *2 (6th Cir. May 2, 2017). Relying on Michigan law and the language of the relevant documents, the court reversed the bankruptcy court’s holding that gave the Chapter 11 debtor access to the assigned rents as operating funds during its reorganization.
The Sixth Circuit acknowledged the debtor’s asserted “policy concern that excluding the assigned rents from the estate would effectively foreclose Chapter 11 relief for companies like [the debtor here] that own single property and receive their sole stream of revenue from rents of that property.” Id. at *16. Courts continue to debate the issue.
Bankruptcy Code (“Code”) § 363(a) defines “cash collateral” to include not only “cash,” but also “rents, … subject to a security interest as provided in § 552(b) … whether existing before or after the commencement of a [bankruptcy] case … .” (emphasis added). Although Code § 552(a) generally provides that property acquired by the debtor after the commencement of a bankruptcy case is not subject to a lender’s pre-bankruptcy security interest or mortgage, § 552(b)(2) allows a lender’s pre-bankruptcy lien on rents to extend to post-bankruptcy rents. When the lender’s security interest or mortgage (i.e., lien) extends to post-bankruptcy rents, Code § 363(c)(2) bars the debtor or the trustee from using that “cash collateral” unless the lender “consents” or the court, after appropriate notice and hearing, “authorizes such use … .” The court may condition that use, though, on the debtor’s providing the lender with “adequate protection … against diminution in value of its collateral … .”). In re SCOPAC, 624 F.3d 274, 278 n.1 (5th Cir. 2010), relying on Code § 363(e).
Lenders often hold an absolute assignment of rents, however, not a mere lien. In so-called “title theory” states, the lender may have title to and exclusive ownership of post-bankruptcy rents depending on the terms of the assignment and the applicable state law. The Third Circuit, for example, has held that a debtor’s absolute assignment of rents transferred all rights and interests in the rents to the lender under New Jersey law. In re Jason Realty, L.P. 59 F. 3d 423, 427 (3d Cir. 1995) (finding that Chapter 11 debtor had no interest in any post-bankruptcy rents under New Jersey law and could not use them to fund its reorganization, even under the limitations imposed for the use of cash collateral; the U.S. Supreme Court has mandated “that we interpret the assignment as New Jersey courts would construe it outside the bankruptcy context”). First Fidelity Bank, N.A. v. Eleven Hundred Metroplex Assocs., 190 B.R. 510, 513 (S.D.N.Y. 1995) (Sotomayor, D.J.) (“assignments granted to the lenders absolute title to the rents under New Jersey law, not merely a security interest”; assignment was “virtually a carbon copy” of the assignment considered in Jason Realty); Sovereign Bank v. Schwab, 414 F.3d 450 (3d Cir. 2005) (applying Pennsylvania law, bank that enforced its rights under mortgage gained legal title to rents; rents were thus not part of debtor’s estate). Thus, when a court construes the assignment of rents to be absolute, neither the debtor nor a trustee will be able to use the rents, for the rents belong exclusively to the lender. See generally, K.R. Heidt, “The Effect of the 1994 Amendments on Commercial Secured Creditors,” 69 Am. Bankr. L.J. 395, 404 (1995).
In a “lien theory” state, however, a lender will not be entitled to possession of rents even if it holds legal title to the property. In re Millette, 186 F.3d 638, 644 n.10 (5th Cir. 1999) (In “title theory” states, mortgagee holds title to land from outset alone until debt satisfied; in “lien theory” states, the borrower holds title to land and mortgagee has lien; in “intermediate theory” states, the borrower maintains title to the property, but once the loan is in default, the mortgagee immediately receives title and right to possess the property); Commerce Bank v. Mountain View Village, Inc., 5 F.3d 34, 38 (3d Cir. 1993) (“The title theory [in Pennsylvania] permits the creditor to enter the land upon default, but in lien states, the creditor is required to foreclose or have a receiver appointed”). See In re Buttermilk Towne Center, LLC, 442 B.R. 558, 567 (BAP 6th Cir. 2010) (rents are part of debtor’s estate under Kentucky law; rent assignment language “isolated” in context of entire agreement; rents served only as “additional security”; assignment ended when underlying debt satisfied). In re Guardian Realty Group, 205 B.R. 1, 4 (D.D C. 1997) (in dicta, court disagreed with Jason Realty, and noted that in determining whether mortgages “constitute a mere security interest, or instead, ownership,” under Delaware law, courts “must look to the substance of state law rights, not merely the label that state law places on them.”); In re Princeton Square Associates, 201 B.R. 90, 95-96 (Bankr. S.D.N.Y. 1996) (in single-asset Chapter 11 real estate cases, debtor in possession should be permitted to use rents to maintain property even though rents had been assigned to lender prior to bankruptcy, constituting an absolute transfer of title under New Jersey law). Recent cases decided under New York law are split. CompareIn re Loco Realty Corp., 2009 WL 2883050 (Bankr. S.D.N.Y. June 25, 2009) (held, when debtor signed assignment of rent under New York law, debtor prevented from spending rent) and In re Soho 25 Retail, LLC, 2011 WL 1333084 (Bankr S.D.N.Y. Mar. 31, 2011) (held, rent not property of estate under New York law because debtor at most had revocable license to rent; thus unavailable to debtor); withIn re South Side House, Inc., 474 B.R. 391 (Bankr. E.D.N.Y. 2012) (held, assignment of rent under New York law was in nature of pledge for additional security only; debtor retained sufficient pre-bankruptcy interest sufficient to bring rent within estate).
The debtor owned a residential complex in Michigan subject to a $5.3-million mortgage “and an agreement to assign rents to the [mortgagee] in the event of default.” Id. at *2. Specifically, the debtor “irrevocably, absolutely, and unconditionally [agreed to] transfer, sell, assign, pledge and convey to [lender], its successors and assigns, all of the right title and interest of [the debtor] in … income of every nature of and from the [property], including, without limitation, minimum rents [and] additional
rents … .” Id. at *2-*3. The assignment purported to be a “present, absolute and executed grant of the powers herein granted to [lender],” while “granting a license to [the debtor] to collect and retain rents until an event of default, at which point the license would ‘automatically terminate without notice to [the debtor].’” Id. at *3. Of course, the rents were the debtor’s “only source of income.” Id.
When the debtor later defaulted, the lender sued in the Michigan State Court, seeking, among other things, foreclosure and the “appointment of a receiver to take possession of” the debtor’s property. Id. at *4. The debtor then filed a Chapter 11 petition, causing the lender to move for an order preventing the debtor “from using rents collected after the [Chapter 11] petition was filed.” In response, the debtor argued that it “would have no income to work with in its Chapter 11 reorganization plan if the rents were not part of the bankruptcy estate.” The bankruptcy court agreed, denied the lender’s motion, finding that the rents constituted cash collateral. Id. at *5. After the district court vacated the bankruptcy court’s decision, the Sixth Circuit agreed to dispose of the debtor’s appeal on the merits.
Federal courts, explained the Court of Appeals, must rely on state law to determine property rights and the extent to which a property interest is included within the debtor’s estate. Id. at *4-*5.
Assignment of Rents in Michigan
A relevant Michigan statute provides in pertinent part that an “assignment of rent shall be binding upon [the debtor] only in the event of default in the terms and conditions of [the] mortgage … .” Id. at *5. The Michigan statute also provides that the assignment of rents, “when so made, shall be a good and valid assignment of the rents to accrue under any lease or leases in existence or coming into existence during the period the mortgage is in effect … .” Id. at *6.
The Michigan Supreme Court, when construing this statute in another case, held that the lender stands “in the shoes of the mortgagor until the debt is paid, with all his rights to the rents and profits, as long as he, under the general law of mortgages could enjoy them.” Id. at *9, quoting Smith v. Mutual Benefit Life Ins. Co., 362 Mich. 114, 520 (1960). Moreover, the Michigan Court of Appeals held that a “prior perfected interest in assigned rents had priority over an interest held by a judgment creditor who sought to garnish rents.” Id. at *9, citing Otis Elevator Co. v. Mid-America Realty Investors, 206 Mich. App. 710 (Mich. Ct. App. 1994).
“Michigan courts have generally treated the assignment of rents as a transfer of ownership once the agreement has been completed and recorded and a default has occurred.” Id. at *9-*10. Relying on its analysis of Michigan law, therefore, the court found “that the Michigan Supreme Court would treat a completed assignment of rents as a transfer of ownership.” Id. at *10.
No Security Interest
The circuit court also rejected the debtor’s argument that the Michigan statute only gave the lender a security interest in the assigned rents. Id. at *11. The language of the underlying agreements broadly confirmed the irrevocable, absolute and unconditional transfer of the rents to the lender. The debtor clearly had “assigned the rents to the maximum extent permitted by Michigan law.” Therefore, reasoned the court, the debtor had transferred ownership “in the assigned rents to [the lender] before the bankruptcy petition was filed.” Id. at *12.
No Residual Interest
The court further rejected the debtor’s argument that it had retained a residual interest in the rents. Any restriction on the lender’s use of the rents did not give the debtor any vested rights, for the Michigan appellate courts have held that a debtor has no interest in the rents after the assignment, depriving the debtor-assignor of any residual property rights. Id. at *14.
Finally, the court’s holding “is in line with the majority of bankruptcy court decisions that have addressed this issue.” Id. at *15. Despite the negative impact of its holding on single-asset real estate debtors, the Sixth Circuit stressed that “Michigan law … is clear on the matter and governs despite other policy concerns.” Id. at *16.
Authored by Michael L. Cook.
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Available Remedies in Addition to an Action for Foreclosure: Part I Receiverships and Sequestration of Rents
By Kelly A. Karstaedt, Esq.
Aside from foreclosing on a piece of real property, a Lender may utilize numerous other methods to recoup monies left unpaid on a mortgage note and to take control of a piece of property that may be losing value based on improper management. In this first installment piece, we will look at the purpose and process for appointing a receiver and sequestering rental income generated by the property.
Appointment of a receiver is an equitable remedy that rests in the discretion of the court. Carolina Portland Cement Co. v. Baumgartner, 99 Fla. 987, 1003 (Fla. 1930). While a provision in a mortgage allowing for the appointment of a receiver upon default is afforded considerable weight, a receivership is not a matter of right. Id. Receivership is an extraordinary remedy which must be exercised with caution as it is in derogation of the legal owner’s fundamental right to possession of the property. Alafaya Square Assoc., Ltd. v. Great Western Bank, 700 So.2d 38, 40 (Fla. 5th DCA 1997). The role of a receiver is to preserve the value of the secured property. Id. The power of a court of equity to appoint a receiver will not be exercised merely because it can do no harm. Edenfield v. Crisp, 186 So.2d 545, 548 (Fla. 2nd DCA 1966). A receiver is an officer of the court who acts under the supervision of the court. SEC v. Elliott, 953 F.2d 1560, 1577 (11th Cir. 1992).
There is a relatively high burden that must be met by the Plaintiff before a court of equity will consent to appointing a receiver in a foreclosure action. First, the Plaintiff must demonstrate that it has a likelihood of success in the foreclosure action. The law requires a strong reason to believe that the party asking for a receiver will recover before one can be afforded. Carolina at 1006. Second, there must be evidence of waste or threat of impairment to the collateral before a court can properly appoint a receiver. It is an abuse of discretion to make such an appointment in the absence of a showing that the secured property is being wasted or otherwise subject to serious risk of loss. Alafaya at 40. In Alafaya, the Court found that evidence of disrepair to the property’s parking lot or degradation to the exterior of the building did not constitute waste or any impairment of the property. In Atco Construction & Dev. Corp. v. Beneficial Savings Bank, F.S.B., 523 So.2d 747 (Fla. 5th DCA 1988), the Court did not find waste even though there were outstanding property taxes owing and no hazard insurance on the property. The Court reasoned that this did not amount to waste because the value of the property was sufficient to secure the mortgage loan. Id. The Third District Court of Appeal agreed to this ruling by stating that a receiver was inappropriate where there was no showing that the owner was wasting the mortgaged property or subjecting it to serious risk of loss, or that the value of the property was insufficient to secure the mortgage loan. ANJ Future Investments, Inc. v. Alter, 756 So.2d 153, 154 (Fla. 3rd DCA 2000).
A request for appointment of a receiver must either be made as a prayer for relief in the initial complaint or as a separately filed motion. Testimony in support of the motion or request for relief must be taken at a hearing. The property owner must be given the opportunity to be heard at a hearing before a receiver can be appointed. Edenfield v. Crisp, 186 So.2d 545, 548 (Fla. 2nd DCA 1966). A receivership hearing is an evidentiary hearing at which the mechanics for presenting evidence and witness testimony is akin to a bench trial.
The usual rules of evidence will apply at the receivership hearing, including the owner of the mortgaged property being allowed to give an opinion as to the value of the property. The moving party should come prepared to identify a suitable receiver for the property should the judge request a suggestion. However, judges usually select their own receiver. The receiver must be an impartial individual, although in certain cases the owner of the property may act as receiver if all parties assent to same.
The order appointing a receiver will delineate the scope of the receiver’s authority. Courts are often inclined to give the receiver broad range over the duties it may perform when in charge of the property. The owner of the property should pay close attention to the responsibilities listed in the order to ensure the receiver cannot take certain actions, such as leasing or selling the property, without the owner’s prior approval or a hearing before the court to make a determination.
Rule 1.620 of the Florida Rules of Civil Procedure requires the receiver to file an inventory of the property, under oath, within 20 days after appointment. An inventory and accounting of the property must be filed every three (3) months thereafter until an order discharging the receiver is entered. Rule 1.620 also includes a remedy for the receiver’s failure to file the required reports, including charging the receiver with the expenses associated with entering an order to file the required reports.
If a receiver is appointed, a bond must be posted by the receiver with good and sufficient surety, payable to the State, in an adequate amount to be fixed by the Court, conditioned on his faithful performance of his prescribed duties. Edenfield at 548. Further, some courts now require the Plaintiff to post a bond as well.
When a person’s conduct is restrained, or his business or property handed over to a receiver, the protection which such bonds afford should not be lightly dispensed with, but should be zealously guarded and uniformly enforced by the courts. Such orders for injunction and receivership may have serious and far reaching effects on a person’s liberty of action and his property or business. The party who initiates such drastic writs and processes should be made to place himself in a position of accountability, at least to the extent that the law specifies, to recompense his adversary for losses sustained, if it should be concluded ultimately that his action which brought it about was irregularly or improvidently invoked, or his cause without merit.
Belk’s Dept. Store v. Scherman, 117 So.2d 845, 848 (Fla. 3rd DCA 1960). An indemnity bond should be required of the Plaintiff prior to appointing a receiver. Id.
Another option for obtaining immediate funds on a defaulted mortgage note is to request the court enforce the assignment of rents provision of the mortgage agreement. Often times a mortgage will include language that, upon default, the Lender is entitled to collect any rental income, or other financial benefits, generated by the property. An assignment of rents may also be an entirely separate agreement, which must be recorded in the public records in order to become a valid lien.
It used to be that appointing a receiver and sequestering rents paid on a piece of property went hand in hand. Now, thanks to a change in statutory law, one does not necessarily require the other. Today, a Lender may request sequestration of rents due without the need to appoint a receiver to collect the rents. Fla. Stat. § 697.07 entitled “Assignments of Rents” states as follows in regards to a default under the terms of a loan which includes an assignment of rents:
(4) Upon application by the mortgagee or mortgagor, in a foreclosure action, and notwithstanding any asserted defenses or counterclaims of the mortgagor, a court of competent jurisdiction, pending final adjudication of any action, may require the mortgagor to deposit the collected rents into the registry of the court, or in such other depository as the court may designate. However, the court may authorize the use of the collected rents, before deposit into the registry of the court or other depository, to:
(a) Pay the reasonable expenses solely to protect, preserve, and operate the real property, including, without limitation, real estate taxes and insurance;
(b) Escrow sums required by the mortgagee or separate assignment of rents instrument; and
(c) Make payments to the mortgagee.
In order to make a valid request for sequestration of the rents, a Lender must first make a written demand for the rents to the mortgagor prior to making a demand to the court for deposit of the collected rents. It is within the court’s discretion to determine where the rents should be deposited and if there are any additional conditions for use of the rents, other than the requirement that the mortgagor account to the court and mortgagee for the receipt and use of the rents. Id. The Lender is also entitled to an expedited hearing on the matter in order to begin collecting on rental income as soon as possible.
An argument against sequestration will likely mirror those arguments set forth in Carolina v. Baumgartner for denying a receiver, which is the need to show waste of the property. However, these arguments may not coincide with strict statutory interpretation, which would likely lead a court to grant any requests for sequestration absent a showing of extraordinary circumstances. So, depending who you represent, you can argue traditional case law requirements or legislative intent in the construction of the statute.
These two additional counts to a foreclosure action often come at a price. It can become costly to appoint a receiver as the court may require a substantial bond to grant appointment as well as the cost of paying the receiver to act in such a capacity. A Lender must think carefully if the costs of these requests outweigh the potential relief before moving forward with either option. There are other, potentially lest costly, options for more immediate control and receipt of funds. But I’ll discuss those in my next article…
CATEGORY:Florida Business Litigation BlogPractice Areas:Banking and Lender Liability Law, Business Litigation, Creditors Rights and Commercial Collections