In Putnal the debtor proposed to use rents over the objection of an undersecured mortgagee. As a result, the court was faced the question of determining what, if anything, was required to provide adequate protection of the mortgagee’s interest in the rents.
As discussed in a prior blog, if both the debtor and the mortgagee have an interest in rents, they are classified as “cash collateral,” which means that the debtor must obtain the consent of the mortgagee or court approval in order to use the rents. (See Assignment of Rents: Absolute May Not Be So Absolute.) Under Section 363(e) of the Bankruptcy Code, if the mortgagee objects to use of its collateral, the court “shall prohibit or condition such use, sale or lease as is necessary to provide adequate protection of such interest.”
Under Section 361 of the Bankruptcy Code, adequate protection may be provided by requiring cash payments, additional or replacement liens, or such other relief “as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.” In cases where a mortgagee is oversecured, the equity cushion may be sufficient to provide adequate protection. However, in this case the mortgagee was undersecured.
The debtor argued that (1) at a minimum it was entitled to use rents to cover maintenance expenses at the property, (2) the mortgagee did not have a separate interest in the rents, but rather a “single, unified interest in the land and rents” that was adequately protected as long as the value of the real estate did not decline, and (3) if the mortgagee had a separate interest in rents, the interest was protected as long as it received compensation for anticipated deterioration and obsolescence of the property.
As support, he cited a case in which a court held that a replacement lien in future rents was adequate protection, and that rents should not be treated as a separate interest since the value of the underlying property incorporates the value of the future income stream. The debtor also cited a second case that adopted a replacement lien on future rents as adequate protection.
The Putnal court was not convinced. According to the court, more recent cases have rejected the replacement lien theory as invalid because the mortgagee already has a lien on future rents so that a replacement lien would be illusory. The court also concluded that a security interest in post-petition rents was separate from a mortgagee’s interest in the real estate.
In the first instance, this means that any use of rents results in a dollar-for-dollar reduction in the collateral value. However, the court also agreed with cases holding that rents can be used to protect the property or otherwise benefit the mortgagee. Accordingly, the court authorized use of rents for the following:
- $5,000 for an appraisal to determine the best disposition of the property, which the court found benefited the mortgagee.
- Management costs and attorney fees required to negotiate an extension of a current lease.
- Overhead type expenses relating to the property, such as expenses of travel to the property to oversee repairs.
Allowing a debtor to use rents to operate and maintain its property is certainly a critical element for any attempt to reorganize a real estate project. However, the piece that is missing is the ability to pay professional fees required to proceed with a reorganization. As noted previously, if the debtor cannot use rents for professional fees when the mortgagee is undersecured (since the professional fees do not benefit the mortgagee), this may mean that bankruptcy is not a viable option.
Vicki R. Harding, Esq