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Keeping It Real

Rents Absolutely Not Cash Collateral... in Certain Circumstances

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Court rules rent payments are not necessarily cash collateral a debtor can use in bankruptcy.

The United States Court of Appeals for the Sixth Circuit decided that under certain circumstances, pursuant to Michigan law and language in the underlying mortgage, rents generated from the operation of the business are not cash collateral and, therefore, not available for a debtor to use in a bankruptcy proceeding. 

The appellate court in Town Center Flats LLC v ECP Commercial II, LLC, 16-1812 (6th Cir., 2017) resolved a split among the bankruptcy judges in Michigan whether rents can be absolutely assigned to preclude rents from being cash collateral. The appellate court found that given that the debtor did not retain a sufficient right in the assigned rents under Michigan law, those rents were not included in the bankruptcy estate and, therefore, deprived the debtor of the use of such funds to operate and reorganize.

The underlying mortgage provided that the borrower “irrevocably, absolutely and unconditionally” agreed to transfer, sell, assign, and pledge and convey to the lender all of the right, title and interest of the borrower in the income of every nature including without limitation, rents.

The agreement to assign rents further provided that the assignment was to be a “present, absolute and an executed grant of the powers granted to the lender” while simultaneously granting a license to the borrower to collect and retain rents until an event of default, at which time the license would “automatically terminate without notice to the borrower.”

After the borrower defaulted on its obligations to pay the loan, the lender provided, pursuant to Michigan law, the required notices to the tenants of the property, and the lender recorded the notice documents with the register of deeds. As a result, the lender fulfilled the two-step requirement as provided for under Michigan law after default. 

Roughly a month after the lender provided notice to the tenants of the default and recorded the notice of default, the borrower filed for bankruptcy. The issue before the court was whether the debtor retained any residual rights in the rents so that the rents would be cash collateral which the debtor could use by providing adequate protection to the lender pursuant to the bankruptcy code.

The appellate court held that given the language in the underlying assignment documents and given the lender had completed the two-step process pursuant to Michigan law, at the time of the filing of bankruptcy, the debtor did not retain any rights in the rents. As such, the rents were not cash collateral and the debtor could not use the rents to operate and reorganize. Given that the lender not only had the strong language in the assignment of rents, but also had completed the two-step process required under Michigan law after default, the appellate court had no problem finding that under the facts presented, the borrower did not retain any rights in the rents at the time of the filing for bankruptcy. 

It is unclear, however, from the opinion as to whether the outcome would have been the same if the lender had not completed the two-step process after default and only had the “absolute” language in the assignment of rents. Typically, the debtor files for bankruptcy before the lender has completed the two-step process after default in filing the notice of default and providing notice of the default to the tenants.

It is also unclear whether the outcome would have been different if the language in the assignment of rents was not “absolute.”  It would behoove lenders to closely review their loan documents, especially their assignment of rents to make the language in the assignment of rents as “absolute” as possible to follow the appellate court’s decision. It is also important for the lender, upon default, to quickly complete the two-step process of recording the notice of default and providing notice of the default to the tenants before the debtor files for bankruptcy. 

Given the appellate court’s decision, lenders will have more leverage, but still need to be vigilant to protect and preserve their rights. Lenders can, under the proper circumstances, drastically shorten a bankruptcy proceeding if the lender is successful in excluding the rents as property of the estate preventing the debtor from utilizing the rents to operate and to reorganize.

Borrowers also need to closely review the loan documents, especially the Assignment of Rents, to determine if the assignment is “absolute.” Borrowers will also need to be diligent upon default to quickly file for bankruptcy to attempt to prevent the lender from having a perfected interest and attempt to provide adequate protection to the lender to use the rent as cash collateral to reorganize.

Tags: Bankruptcy, Real Estate

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