Assignment of Rents: Absolute May Not Be So Absolute

In re MRI Beltline Industrial, L.P., 476 B.R. 917 (Bankr. N.D. Tex. 2012) –

In MRI Beltline the debtor moved for authority to use rents received from tenants of commercial buildings that it owned, and for a “carve out” to permit it to use rents for administrative expenses (including its attorney fees).  In response, the mortgagee asserted that the debtor did not have any interest in the rents, and thus could not use them, because its assignment of rents was absolute.

Although a debtor is generally authorized to use its assets in the ordinary course of business, there are special rules applicable to “cash collateral” – meaning cash or cash equivalents in which both the bankruptcy estate and a third party have an interest.  This specifically includes rents.  To the extent that rents constitute cash collateral, the debtor must either get the consent of the mortgagee or court approval to use them.

A number of older cases turned on whether a mortgagee had to exercise its assignment of rents in some fashion prior to the bankruptcy in order to retain an interest in post‑petition rents.  If a court found that the mortgagee’s lien did not extend to post-petition rents, the rents would not be cash collateral (since only the debtor would have an interest), and the debtor would be free to use rents without the mortgagee’s consent or court approval.

This issue was resolved by an amendment to Section 552 of the Bankruptcy Code, which now provides that if a mortgagee has a security interest that extends to rents of a property prior to bankruptcy, then generally its security interest will extend to rents acquired after commencement of the case.  Consequently the mortgagee will have an interest and the rents will constitute cash collateral.

Today there are a number of cases going in the other direction:  The mortgagee contends that there has been an absolute assignment of rents so that the debtor does not have any interest.  Consequently the rents are not part of the bankruptcy estate, and the debtor does not have any right to use them.

MRI Beltline is one of these cases.  The court analyzed the issue under Texas law.  To begin with, the court noted that the label given to the treatment of rents in the loan documents does not resolve the issue.  Intent is key and can override the language.  In examining state case law, the court noted that Texas is a lien theory state, which means that a mortgagee is not the owner of the property and is not entitled to rents until it takes possession of the property, has a receiver appointed or takes some other similar action.  On the other hand, state courts have also held that there can be an “absolute” assignment that automatically transfers rents to a mortgagee when a specified condition occurs (typically a default), which serves to pass title to the rents to the mortgagee.

The court also noted that Texas bankruptcy courts have taken a couple of different approaches.  One court decided to examine four indicia to determine intent:  statement of intent to assign absolutely; statement of mortgagor’s obligation to collect solely for the benefit of the mortgagee; language eliminating a requirement that the mortgagee institute legal action to assume control of the rents; and language providing for automatic transfer of rights upon a default or other condition.  Another bankruptcy court focused on a Supreme Court case, U.S. v. Whiting Pools, Inc., 462 U.S. 198, 103 Sup. Ct. 2309, 76 L. Ed., 2d 515 (1983), which in essence provides that property remains in the estate as long as the debtor has even a contingent interest.  With respect to rents, the mortgagee has an interest in rents until its debt is paid in full.  At that point, the rents revert to the debtor.  With respect to specific rent payments, it is not until the rents are applied to the debt that equitable title transfers.  The bottom line is that under this analysis a debtor retains equitable title to future rents, despite a purported “absolute” assignment.

After outlining these various analyses, the MRI Beltline court decided it was not necessary to choose one since Texas has adopted legislation that provides rules regarding the effect of an assignment of rents.  Among other things, the statute provides:

An assignment of rents creates a presently effective security interest in all accrued and unaccrued rents arising from the real property described in the document creating the assignment, regardless of whether the document is in the form of an absolute assignment, an absolute assignment conditioned on default or other event, an assignment as additional security, or any other form.  The security interest in rents is separate and distinct from any security interest held by the assignee in the real property from which the rents arise.

Accordingly, the court concluded that the mortgagee had only a security interest, and did not have title to the rents.

The debtor also specifically requested a rolling “carve‑out” of $15,000 per month to allow it to use the rents for payment of administrative expenses, including attorneys’ fees.  Since the mortgagee objected, the court was required to consider what would be required to provide adequate protection of the mortgagee’s interest in its collateral.  It declined to approve the carve-out because the “small equity cushion” that it previously found protected the mortgagee’s interests was quickly eroding, and there was no assurance that the debtor would be able to confirm its plan of reorganization or that the mortgagee would be paid in full.

Control of cash is always critical to a bankruptcy case, and the status of rents continues to be a hotly contested area.  From the debtor’s perspective, this issue may be a significant consideration in whether to file a bankruptcy since the ability to use rents to pay its professionals may make the difference between a bankruptcy that is viable and one that is not.

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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