Prepetition Post-Default Rents: Who Gets the Cash – Round 2?

In re Prospect Studios, L.P., 478 B.R. 367 (Bankr. W.D. Mo. 2012)

In Prospect Studios, the law firm representing a chapter 11 debtor requested court authority to apply a prepetition retainer to payment of its fees.  Since the source of the retainer was post default rents, a mortgagee with an assignment of rents objected on the basis that it had a perfected security interest in the rents.

The debtor was a single asset real estate debtor that owned an apartment complex.  It owed ~$8.5 million on a loan that was secured by a deed of trust, including an assignment of leases and rents clause, on the apartment complex.  Prepetition the law firm deposited a retainer of $25,000 into its trust account.  Since essentially all of the debtor’s income came from rents, it was clear that the source of the retainer was prepetition post default rents collected from tenants.

The lender (CSFB), contended that there had been an absolute assignment of rents.  Thus the debtor’s rights were limited to a license to collect rents that automatically terminated after it went into default.  However, the court found that, notwithstanding the language of the loan documents, the assignment of rents was for security so that the rents remained property of the debtor’s bankruptcy estate.  (This was based on prior state court and bankruptcy cases finding that a deed of trust did not affect an absolute conveyance, noting that Missouri is a “lien theory” state.)

Alternatively CSFB contended that it had a perfected security interest in the rents so that they constituted cash collateral.  (Under Section 363 of the Bankruptcy Code, if the collected rents constitute cash collateral, then the debtor may not use the cash without the lender’s consent or a court order.)  The threshold question was whether CSFB had a perfected lien in the funds constituting the retainer.

Although a security interest is generally granted in a recorded deed of trust or separate assignment of rents, “unlike other security interests in real estate, an assignment of rents clause ‘lies dormant until certain steps are taken to activate, or perfect, such assignment.’”  According to the Prospect Studios court, the lender’s interest in rents become fully protected only after default and either possession of the real estate or some action “equivalent to possession.”  Until then, a judgment creditor could garnish the rents.  Further, once rents are collected and deposited, they are no longer “rents” in the same way that accounts receivable are no longer receivables once collected.

Although CSFB had a recorded assignment of rents that could be used to claim a security interest in the rent proceeds, it did not perfect its interest in either rents or proceeds.  According to the court, CSFB could have perfected its interest in the collected rents by filing a UCC financing statement covering proceeds of rents, accounts, or other intangibles under Article 9 of the UCC.  Since it did not do so, it did not have a security interest in the proceeds.

Given that the purpose of perfection is to put third parties on notice, the court felt that rents should be viewed differently once they are paid and no longer tied to the real property: if a lender making a loan wanted to take a security interest in rents owed by tenants, it would look to the real property records to determine competing interests; whereas, if it wanted to take a security interest in money being held in the debtor’s bank accounts, it would logically look to UCC filings.  So if a lender wanted to have a perfected security interest in the proceeds of rents after they had been paid over, it should both record an assignment of rents in the land records and file a UCC financing statement.  Since CSFB was not perfected in the proceeds based solely on the recorded assignment of rents, and since it provided no evidence that it had filed a UCC financing statement, it could not prevail against a lender without knowledge of its unperfected security interests.  Consequently, the law firm was allowed to apply the retainer to its fees.

As an aside, it is not clear that the court is correct that a UCC financing statement would serve to perfect a security interest in rents collected by a debtor and deposited in a bank deposit account.  As the court noted, once collected the funds lose their status as an account or general intangible, and the automatic perfection in proceeds can be limited.  A secured creditor might be able to argue that the funds could be traced, or the issue might arise during the temporary 21 day automatic perfection period, but otherwise the secured creditor would have to take steps to perfect an interest in the deposit account.  If the secured creditor is the institution that holds the deposit account, it has automatic perfection.  Otherwise, the secured creditor would require a control agreement.

Control of cash is critical in all bankruptcy cases and poses particular challenges for a single asset real estate debtor.  With respect to post-petition rents, the Bankruptcy Code was amended so that arguments concerning “activation” of the assignment of rents and whether an assignment of rents is fully perfected prior to exercise are no longer an issue.  However, as illustrated by this case, that resolution does not extend to the status of prepetition rents.  As a debtor approaches a bankruptcy filing, control of rents can be an important strategic consideration, particularly in jurisdictions that do not recognize an absolute assignment of rents to a lender.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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