Assignment of Rents: Absolute May Not Be So Absolute – Round 2

In re Augusta Center, LLC, 491 B.R. 298 (Bankr. S.D. Ga. 2013) –

The debtor owned and operated a hotel property.  After it filed bankruptcy, it asked the court for authorization to use cash collateral (e.g. rents and revenues of the hotel).  The lender objected, arguing that the debtor had absolutely conveyed its interest in rents and revenues so that the bankruptcy estate did not have any remaining interest.  The bankruptcy court denied the lender’s objection.

As discussed in a prior blog (Assignment of Rents: Absolute May Not Be So Absolute), there are special rules applicable to a debtor’s use of “cash collateral” – meaning cash or cash equivalents in which both the bankruptcy estate and a third party have an interest.  This specifically includes rents or profits of property and payments for use or occupancy of hotels.  To the extent that rents constitute cash collateral, the debtor must get either the consent of the mortgagee or court approval.

As also discussed, there were a number of older cases that argued that a mortgagee did not have an interest in postpetition rents (as would be required to make the rents cash collateral) unless it had taken all steps required to start collecting rents itself.  However, that issue was largely resolved by amending the Bankruptcy Code, so that Section 552(b)(2) now specifically provides that a prepetition security interest generally extends to postpetition rents and payments for use or occupancy of hotels.  Today the battleground is more likely to be whether the debtor retains an interest in rents after there has been a default.

The Augusta opinion included extensive quotes from the security documents:

  •  In a number of places the documents stated that the assignment of rents and revenues constituted “a present, absolute assignment and not an assignment for additional security only.”
  • Notwithstanding the absolute assignment, the lender granted to the debtor “a revocable license to collect and receive” the rents and revenues.
  • However, the license was revocable after an event of default, and upon revocation the lender was entitled to all of the rents and revenues.  (The security documents also provided that the lender was entitled to immediate possession of the property with a right to collect rents in its own name after an event of default.)
  • The debtor also waived “to the extent permitted by law” the benefit of all redemption laws.
  • The assignment of rents terminated once the debt was paid in full.

Given that there was a prepetition default and exercise of rights, the key question for the court was whether the debtor had a sufficient interest in the rents under state law so that they were part of the bankruptcy estate.

After the debtor defaulted in payment of the debt, the parties entered into a forbearance agreement.  After the debtor defaulted under the original forbearance agreement, the agreement was modified.  After the debtor defaulted under the modified forbearance agreement, the lender accelerated the debt, notified the debtor that attorney fees could be avoided if the debt was paid in full within 10 days, revoked the debtor’s license to collect rents, and notified the debtor that it was required to surrender possession of the property.  Given this scenario, the lender argued that rents did not become property of the bankruptcy estate, and therefore could not be used by the debtor as cash collateral.

First, the court addressed the creditor’s rights to rents.  Under applicable law, there were two opposing lines of cases:  one line held that once the creditor complied with any terms of the assignment of rents provision prepetition, it was not required to take any further action in order to claim the rents.  A second line of cases required the lender to take steps to dispossess the debtor.  Regardless, in this case the lender had done everything required under either view, so it was clear that the lender had a current choate interest in the rents.

That left the question of whether the debtor held any residual rights.  The court quoted another bankruptcy case in which a court held that the debtor “retains an equitable interest in the rents, and whether the interest is depicted as a ‘reversionary interest’, a ‘right of redemption’ or the like, it is an interest which becomes property of the bankruptcy estate.”

The lender argued that this case was distinguishable because it did not include a retained license to use the rents as was the case in Augusta, and cited a different case that held that a subordinate equitable interest in rents that cannot be asserted until the debt is paid in full did not prevent the debtor from being deprived of any interest in the rents for purposes of bankruptcy.

In addition to noting that the case cited by the lender was governed by different state law, the Augusta court disagreed with this conclusion.  In the court’s view, (1) a mere license is sufficient to cause the rents to become property of the estate, and (2) revocation of the license does not deprive the debtor of its equitable interest.  The rents cannot be divorced from the land:  “rents and profits are incorporeal hereditaments, part of the bundle of rights known as possession… if the debtor is entitled to continued use of the tree during the rehabilitation period, if rehabilitation is continuously demonstrated to be possible, surely he is also entitled at the same time to use of the fruits of the tree.”  In this case, the debtor retained an equitable interest in the rents and would be unable to reorganize without their use.

In response to the argument that the debtor had waived its right to redemption (i.e. the right to recover the property by paying the debt), the waiver was limited “to the extent permitted by law,”  and common law is very protective of a mortgagor’s right of redemption and may not be waived in the original mortgage.

For these reasons, the lender’s objection was denied, and the debtor’s motion for authorization to use cash collateral was set for a hearing.

Typically the ability to use rents is the lynchpin of a real estate bankruptcy case.  In jurisdictions where courts hold that an absolute assignment of leases and rents can totally and finally divest a debtor of its interest in rents, a bankruptcy is probably not feasible unless the debtor’s principals have very deep pockets.

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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