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Beware Of Dog Assignment Of Rents

Contributed by David G. Litvack

If a lender has a security interest in all of a hotel borrower’s real property and obtains an assignment of rents from such property, do the lender’s security interests encompass revenues derived from the use of the hotel’s rooms (i.e., “room revenues”)?  A recent decision by the United States Bankruptcy Court for the District of Colorado held they do not and found that broad definitions of “rent” in loan documents may not include room revenue.

Background

In In re HT Pueblo Properties, LLC, the debtor owned a Ramada Inn encumbered by approximately $5.2 million of debt, including $3.1 million owed to its senior secured lender.  The obligation to the secured lender was secured pursuant to a security agreement, a deed of trust, and an assignment of rents.

The security agreement granted the lender a security interest in the debtor’s “collateral” defined as “furniture, fixtures, and equipment” and all “rents, monies, payments . . . arising out of . . . [the] disposition of any of the property described in th[e] Collateral section.”  The deed of trust and assignment of rents each stated that the lender possessed a security interest in rents.  The deed of trust defined “rents” as “all present and future rents, revenues, income, issues, royalties, profits, and other benefits derived from the [subject] Property”, and the assignment of rents defined “rents” as “all rents, revenue, income, issues, royalties, bonuses, accounts receivable, cash or security deposits, advance rentals, profits and proceeds from the Property.”

Shortly after the commencement of the debtor’s case, the lender sought to prohibit the debtor’s use of cash collateral to fund operating expenses.  The lender argued that because it held a perfected security interest in all of the debtor’s property – including an assignment of rents – any room revenues constituted cash collateral subject to such interest.  The debtor, however, argued that the relevant loan documents did not grant the lender a security interest in room revenues, and, therefore, pursuant to section 363(a) and section 552(b) of the Bankruptcy Code, the room revenues did not constitute cash collateral.

Section 552(b)(2) of the Bankruptcy Code permits a secured lender to retain a floating security interest in, among other things, postpetition rent and hotel room revenues acquired by a debtor after commencement of the case to the extent provided in a prepetition security agreement.  Accordingly, the lender argued that section 552(b)(2) expressly provides that, if a secured creditor’s prepetition security agreement extends to room revenues, the security agreement also extends to all such revenues acquired by a debtor postpetition.

The debtor, however, asserted that the operative loan documents, including the security agreement, were insufficient to create an enforceable security interest in room revenue.  Rather, the debtor argued that such documents were sufficient only to create an enforceable security interest in the debtor’s physical assets, and not room revenues.

Moreover, the debtor asserted that the assignment of rents was ineffective as to room revenues because any such assignment should have been recorded with the Secretary of State pursuant to Article 9 of the UCC, and not with the county clerk.  Article 9 of the UCC governs secured transactions where security interests are taken in personal property, whereas state real property laws govern security interests that are taken in real property, including security interests in leases or rents.  The lender asserted that it had complied with applicable recording requirements because room revenues are not personal property subject to Article 9 of the UCC, but rather “rents” which can be assigned and fall outside the scope of Article 9.

Analysis

Application of section 552(b) of the Bankruptcy Code

Under section 363(a), rents are considered cash collateral when they are “subject to a security interest as provided in section 552(b).”  At the outset, the HT Pueblo court noted that although the Bankruptcy Code gives special treatment to security interests in rents and room payments held by hotel operators, an enforceable security interest must still exist.

To determine if the lender possessed an enforceable security interest in the room revenues, the court looked at the definitions of “rent” contained in the relevant deed of trust and assignment of rents.  The court found that, although the language was fairly broad, it did not create a clear security interest in “fees, charges, accounts, or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties” as required by section 552(b)(2).

The court also noted that, under section 552(b), the security agreement is the instrument that must contain the key language and that ancillary documents (such as a financing statement) cannot establish the security interest in room revenues.  In HT Pueblo, the relevant security agreement granted the lender a security interest only in the proceeds from disposition of the collateral, not in the proceeds from the operation of the collateral.  The court found that revenues derived from operating a hotel did not constitute a “disposition” of property and, thus, did not fall within the definition of “collateral” contained in the security agreement.  Because the lender did not possess an enforceable security agreement in the room revenues, the court ruled that section 552(b)(2) did not apply, and the room revenues did not constitute cash collateral.

Analysis of Article 9 of the UCC

The court then held that, under Colorado law, room revenue constitutes personal property subject to Article 9 of the UCC, not an interest in real property (i.e., rents), which can be assigned pursuant to real property law.  The court noted that Article 9 of the UCC applies to all transactions that create security interests in personal property, regardless of the form of the transaction or the name that the parties give to it.  Accordingly, the court ruled that the lender’s assignment of rents was invalid as to the room revenues because room revenues are not real property subject to assignment.  The court disagreed with the lender’s position that section 552(b)(2) causes all hotel room revenues to become “rents” that can be assigned, by definition.  Although the court did not expressly state what the outcome would be if room revenue were deemed to constitute “rent,” it seems that the consequence of such a ruling would be that, at least in certain states, pursuant to an absolute assignment of rents, room revenues would not be property of a debtor’s estate available for use as cash collateral.  For example, in In re Jason Realty, L.P., the Third Circuit held that assigned rents were not property of the debtor’s estate where the relevant assignment agreement evidenced absolute assignment of title to the rents.

Conclusion

Although the HT Pueblo court cautioned that much of the decision was based upon the specific facts and Colorado law, there is much to take away from the decision.  Drafters of security agreements in connection with hotels must take special care to ensure that room revenues are brought into the purview of the applicable security agreements.  Importantly, drafters should also heed the warning of the HT Pueblo court that such specific language must be in the security agreement itself, and not just in ancillary documents.  Lastly, for those lenders seeking to perfect an absolute assignment of a hotel’s room revenues, any such assignment of room revenue may only give a lender an Article 9 security interest in such revenues.  Simply designating room revenues as “rent” in an assignment of rents likely will not allow a lender to draft around Article 9 of the UCC to obtain more favorable state law real property rights.

~This guest blog post is from one of our highly regarded Marketplace Partners, R. Kymn Harp. We love our Marketplace Partners as they are truly dedicated to the CRE industry via their partnership to support CRE in their participation in the tBL Marketplace.

Contributed by R. Kymn Harpauthor ofIntent to Prosper and attorney at RSP Law, Chicago, Illinois.

“How can you have any pudding, if you don’t eat your meat?”
~
Pink Floyd

Assignments of Rents. Here’s a topic that doesn’t pop up in light conversation very often.

Assignments of Rents. Virtually every commercial real estate financing includes an assignment of rents – either as a separate instrument, or in the mortgage, or both. We think we know what it means, and what protection it provides. But do we?

Assignments of Rents. What could assignments of rents possibly have to do with Pink Floyd?

It has been suggested on occasion, only half-jokingly, that I don’t like lenders. That is really not true. Lenders are valuable participants in the commercial real estate market. Without lenders, few of my clients could buy, develop or own commercial real estate projects. Commercial lenders provide valuable liquidity to the market (usually) and allow commercial real estate developers and investors to leverage available resources.

For years, I have described commercial lenders and their borrows as “friendly adversaries”. Friendly, because they need each other. Adversarial, because their interests are not always completely aligned. They are each necessary complements to the other.

In good times, all typically works well, with lenders and borrowers sharing a common goal -financing a viable commercial project that makes each of them an attractive return.

In troubled times, like we have seen over the past several years, lenders and borrowers can find themselves at odds. The current economic downturn has been particularly brutal because the commercial real estate market has seen an unprecedented collapse in property values and tenant rental revenue. Lenders often blame the borrower, because the loan has ended up in default. Realistically, for most commercial real estate borrowers, there is little if anything they could have done to prevent a default, save not acquiring and financing the project in the first place – which, in hindsight, most borrows wish, as much as most lenders wish, had been the case. But neither borrowers nor lenders foresaw the dramatic financial debacle we have been experiencing since 2008.

Still, we are where we are. Commercial real estate borrowers are holding projects with substantially lower values than existed five or six years ago, and may be in default of their mortgage loans. Not unreasonably, commercial real estate lenders want their money back.

Assuming the lender has properly documented and administered its commercial real estate loan, the lender should be in the driver’s seat. All else being equal, with a properly documented and administered commercial loan, a lender has a powerful arsenal of enforcement tools at its disposal.

That said, lenders must still comply with the law. Assuming they can pass the test of having a properly documented loan that has been properly administered in a manner that does not violate the rights and interests of the borrower, the mere fact that a lender is owed millions of dollars and has a secured interest in the borrowers project (including, yes, an assignment of rents) does not mean a lender can do whatever it wishes to collect its loan without regard to applicable law.

Do I dislike lenders? No. What I abhor are lenders and their attorneys who ignore the law – which already wildly favors lenders – and take steps in direct contravention of the law to collect their loans. With the legal enforcement deck already stacked in their favor, there is no excuse for lenders to overreach and violate the law in their enforcement efforts. When they do, they should fully expect that I will object on behalf of my borrower clients and seek to hold them accountable. We will pursue compensatory and punitive damages, when appropriate, petition to have their unlawful actions reversed, and will press to have their equitable remedies, including their equitable remedy of foreclosure, curtailed or barred.

Follow the law, and a lender should expect to get what the law provides. Violate the law, and a lender should expect to suffer the consequences.

Enforcement of an Assignment of Rents is a case in point. The law in Illinois, and in most other states, is crystal clear. It is an extension of common law doctrine that has developed over centuries. If a lender is going to require an Assignment of Rents, and plans to enforce the Assignment of Rents, it is incumbent upon the lender to know the law governing Assignments of Rents.

The leading case in Illinois on the effect and enforceability of an Assignment of Rents provision, whether in the mortgage or in a separate document, is Comerica Bank-Illinois vs. Harris Bank Hinsdale, et al, 284 Ill.App.3d 1030, 220 Ill.Dec. 468, 673 N.E.2d 380 (1st. Dist. 1996).

The Comerica case involved a dispute between a property owner/mortgagor and a first and second mortgagee as to who was entitled to collect the rents from shopping center tenants after the mortgagor’s default in payment of the a first mortgage and second mortgage.

The assignment of rents provision in the mortgage provided that, after a default, Comerica could collect rents from the property without taking possession of the property, and without exercising other options under the mortgage.

Comerica, the first mortgagee, sent a notice to tenants that the mortgagor was in default under its mortgage and that under the assignment of rents provision in its mortgage Comerica was entitled to collect the rents. Thereupon Comerica began collecting rents.

The property owner/mortgagor and the second mortgagee objected.

In summary, the Comerica court held as follows:

1. At common law, it was strictly held that the mortgagee must take actual possession before being entitled to rents.

2. A clause in a real estate mortgage pledging rents and profits creates an equitable lien upon such rents and profits of the land, which may be enforced by the mortgagee upon default by taking possession of the mortgaged property.

3. The possession requirement reflects the public policy in Illinois which seeks to prevent mortgagees from stripping the rents from the property and leaving the mortgagor and the tenants without resources for maintenance and repair.

4. Courts will not enforce private agreements that are contrary to public policy.

5. “To obtain the benefits of possession in the form of rents, the mortgagee must also accept the burdens associated with possession – the responsibilities and potential liability that follow whenever a mortgage goes into default. The mortgagee’s right to rents, then, is not automatic but arises only when the mortgagee has affirmatively sought possession with its attendant benefits and burdens”.

6. A mortgagee may be entitled to rents once a receiver is appointed as an incidence of being in “constructive possession”, since having a receiver appointed constitutes affirmative action by the mortgagee, under court authorization.

7. In a foreclosure action, the mortgagee is not entitled to rents until judgment has actually been entered unless the mortgage agreement permits the mortgagee to obtain prejudgment possession.

8. A mere filing of a foreclosure action or request for appointment of a receiver is not sufficient to trigger a mortgagee’s right to collect rents. The receiver must actually be appointed. “The mortgagee is not entitled to the rents until the mortgagee or a receiver appointed on the mortgagee’s behalf has taken actual possession of the real estate after default.”

9. Where a mortgagee does not obtain prejudgment possession of the property (through a court appointed receiver or as a mortgagee in possession), and where rents are collected during a time while the mortgagor remained in possession of the property, the rents so collected belong to the mortgagor.

In making its ruling, the Comerica court relied on Illinois case law, but, noting that the U.S. Supreme Court has required bankruptcy courts to apply State law in determining a mortgagee’s entitlement to rents [Butner v United States, 440 U.S. 48, 99 S. Ct. 914 (1979)], the Comerica court also found relevant bankruptcy decisions and Federal case law to be thorough and persuasive. Among other cases, the Comerica court found persuasive the bankruptcy court opinion in In re. J.D. Monarch Development Co. 153 B.R.829 (Bankr. S.D.Ill 1993).

In the case of In re. J.D. Monarch Development Co. 153 B.R.829 (Bankr. S.D.Ill 1993), the bankruptcy court, applying Illinois law, held as follows:

1. Illinois law recognizes the validity of an assignment of rents included in a mortgage of real estate.

2. Such an assignment creates a security interest in rents that is perfected as to third parties upon recording the mortgage in the real estate records.

3. As between the mortgagee and the mortgagor, however, the mortgagee is not entitled to the rents until the mortgagee or a receiver appointed on the mortgagee’s behalf has taken actual possession of the real estate after default.

4. This is so even though the mortgage instrument contains a specific pledge of the rents.

5. The mortgage does not create a lien upon rents to the same extent that it creates a lien upon the land. Rather, the inclusion of rents in a mortgage merely gives the mortgagee the right to collect rents as an incident of possession of the mortgaged property, and the mortgagee, after default, must take affirmative action to be placed in possession of the property to receive such income.

6. The requirement that a mortgagee enforce its lien on rents by possession of the real estate renders an assignment of rents different from security interests in other property.

7. Typically, a perfected lien gives the creditor an interest in a specific piece of property, whereas an assignment of rents allows the mortgagee to collect rents that come due after the mortgagee takes control of the property. To obtain the benefits of possession in the form of rents, the mortgagee must also accept the burdens associated with possession.

Notwithstanding the clarity of the law on this topic, there are lenders, and lenders’ counsel, and occasionally receivers, who ignore the law or choose to intentionally violate the law by seeking to take the benefits of rental projects by control of rents without accepting the burdens that come with possession. They want the good, but not the bad. The dessert, but not the main course. The pudding, but not the meat.

[Hence my opening reference to Pink Floyd: “How can you have any pudding, if you don’t eat your meat?” Even Pink Floyd understood the public policy applicable to assignments of rents!]

So what is the property owning borrower’s remedy for a lender violating the law by exercising dominion or control over rents payable to the borrower without first obtaining possession of the project?

How about conversion/civil theft? Let’s check-off the elements:

A proper complaint for conversion must allege the four elements of a cause of action for conversion:

(1) an unauthorized and wrongful assumption of control, dominion, or ownership by a lender over a borrower’s personalty (identifiable “rents” count); [ √ check]

(2) borrower’s right to the rents; [ √ check]

(3) borrower’s right to immediate possession of the rents; [ √ check]

(4) borrowers’ demand for possession of the rents. [easy to do: √ check]

“Punitive damages” are available where a defendant willfully or wantonly converts the property of another. Is there any legitimate doubt – especially in Illinois – especially since the court’s clear and unequivocal Comerica decision in 1996 – that a lender who unilaterally converts the rents of a borrower to its own use without taking lawful possession of the rental project does so “willfully or wantonly” in disregard of the project owners’ rights to those rents?

If a lender is intentionally violating the law as it relates to the security for its loan, particularly as it relates to an assignment of rents executed within or in conjunction with a mortgage debt, might the lender also be guilty of “unclean hands” relative to the mortgage security, with the result that a lender might be equitably barred from foreclosing its mortgage in a court of equity? Stay tuned…

The point is not that I wish to prevent a lender from enforcing its legal rights under its loan documents. The point is, a lender must enforce its legal rights within the bounds of the law, just like everyone else.

I didn’t make the rules, but I will enforce them. If a lender insists on violating the law vis-à-vis one of my borrower clients, it should expect to suffer the consequences.

This is not a threat – it is a promise.

Thanks for listening.
Kymn

R. Kymn Harp is a seasoned attorney and trusted advisor to commercial real estate investors, lenders, and developers. He is a partner in the Chicago, Illinois law firm of Robbins, Salomon & Patt, Ltd. and may be reached at (312) 456-0378 or [email protected]. For more information, visit his website http://www.rsplaw.com

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