Absolute Assignments of Rents Are Not So "Absolute"
In exchange for a loan secured by commercial property, a lender often receives an absolute assignment of the property's leases and rents. But who owns those rents once the borrower files for bankruptcy protection? Debtors argue that the rents are property of the bankruptcy estate and constitute cash collateral available for their use during the case. Lenders, on the other hand, assert that the assignments convey ownership of the rents, and as such, the rents may be used only with their consent.
The answer depends not on bankruptcy law, but on the law of the governing jurisdiction1 – and then potentially on the measures that the lender undertakes following a default.
Two cases out of New York illustrate the importance of a lender's diligence in enforcing its rights under a mortgage and assignment of rents. In re Soho 25 Retail, LLC2 involved a note secured by a mortgage on commercial property as well as an Assignment of Leases and Rents that provided the lender with an absolute and unconditional assignment of the borrower's rights to the rents. Upon the borrower's default, the lender issued an appropriate notice to collect rent directly from the tenants, commenced a foreclosure action, requested the appointment of a receiver and obtained a default judgment. On the eve of the foreclosure sale, the borrower filed for chapter 11 protection in the U.S. Bankruptcy Court for the Southern District of New York.
The lender quickly filed for relief from the automatic stay to proceed with foreclosure, and asserted that the assignment was self-executing and absolute; that its terms gave the borrower only a revocable license to the rents while no default existed; and that the assignment expressly did not require the lender to undertake any affirmative acts to enforce it. The Bankruptcy Court noted that the majority of New York cases prohibit absolute assignments of rent, regardless of the language in the parties' agreement, and ruled that control of the property's rental revenues depended on the affirmative steps, if any, that the lender pursued toward asserting its interest in the rents.3 The court held that, in this instance, the lender had taken sufficient steps to make the assignment enforceable.
But in In re South Side House, LLC,4 decided just over a year later, the U.S. Bankruptcy Court for the Eastern District of New York reached a different conclusion. The underlying mortgage in South Side contained a similar, "absolute" assignment of rents provision. Although the lender commenced a foreclosure action, had a receiver appointed, and obtained summary judgment of foreclosure prior to the debtor's bankruptcy petition, the court ruled that these measures were insufficient to obtain control of the property's rental revenues.
The South Side court acknowledged other decisions that reached different results. However, the court observed that because New York operates under a "lien theory" of mortgages, an assignment of rents could not be "absolute" and a secured lender would acquire "title" to the property's rents only after foreclosing its lien at a sale. The court ruled that the lender's efforts to exercise control over the rents gave the lender only an enforceable interest in the rents – but not title – and permitted the debtor to utilize the rents, in the first instance, as cash collateral.5
Title Theory versus Lien Theory
Under the "title theory" of mortgages, a mortgage is considered a conveyance of the borrower's interest in property to the lender, which is restored upon satisfaction of the debt. As real property law evolved, the majority of states, including New York, abandoned this notion in favor of "lien theory," which treats mortgage transactions as secured debtor-creditor relationships. Under "lien theory," a lender must foreclose its lien before taking title to the collateral or, at a minimum, the lender must take affirmative steps in order to make a case for control over rents. Some states, such as Maryland,6 have enacted legislation to dispense with this requirement in order to eliminate inconsistent determinations as to what constitutes sufficient affirmative efforts by a lender – a dilemma reflected in the cases described above.
Instead of playing the odds in any particular bankruptcy case, lenders should protect against uncertainty by moving swiftly to enforce their rights under assignments of rent when borrowers default, particularly in lien theory states. Measures that directly affect payment of rent, such as issuing a notice advising tenants to pay rent to the lender (where authorized by the loan documents) and obtaining the appointment of a receiver, can be effective measures. It is crucial that lenders consult with counsel from the drafting of the loan documents to implementing rights upon default to ensure that their interests are protected.
1 Bankruptcy law determines what constitutes property of the estate, but state law determines the debtor's interest in a given item. See, e.g., Butner v. U.S., 440 U.S. 48, 54-55 (1979); In re Koreag Controle et Revision S.A., 961 F.3d 341, 349 (2d Cir.), cert. denied, 113 S. Ct. 188 (1992).
2 In re Soho 25 Retail LLC, No. 10-15114, 2011 WL 1333084 (Bankr. S.D.N.Y. Mar. 31, 2011).
3 Id. at *6-7 (citing 641 Ave. of the Ams. Ltd. Partnership v. 641 Assocs., 189 B.R. 583, 591 (Bankr. S.D.N.Y. 1995).
4 In re South Side House, LLC, 474 B.R. 391 (Bankr. E.D.N.Y. 2012).
5 In re South Side House, 474 B.R. at 403-07, 411-12.
6 Md. Code Ann., Real Property § 3-204 (LexisNexis 2010).
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