Rents in Bankruptcy: Grab While You Can and You May Hold A Winning Hand

In re Madison Heights Group, LLC, 506 B.R. 728 (Bankr. E.D. Mich. 2013)

A mortgagee exercised its assignment of rents prior to bankruptcy. After a Chapter 11 case was filed, the debtor sought court authority to use rents from the property as cash collateral. The mortgagee objected, arguing that the rents were not part of the bankruptcy estate.

Under Section 363 of the Bankruptcy Code “cash collateral” is defined to mean cash and other cash equivalents – specifically including rents of property – in which both the bankruptcy estate and another entity (such as a mortgagee) have an interest. A debtor-in-possession may not use cash collateral unless either the other entity consents or the court authorizes the use. If requested by the other entity, the court must prohibit or condition use of cash collateral as necessary to provide adequate protection of its interests.

The question of whether the debtor and a mortgagee both have interests in rents has been the subject of extensive litigation. Historically, debtors argued that a mortgagee did not have an interest in post-petition rents unless it had exercised its assignment of rents prior to bankruptcy. However, Section 552 of the Bankruptcy Code (dealing with the post-petition effect of liens) was amended to specifically provide that if a lender had a security interest in rents prior to bankruptcy, the security interest generally extends to post-petition rents (although there is an exception to the extent that a court orders otherwise based on “the equities of the case”).

This largely resolved the dispute regarding a mortgagee’s interests in post-petition rents. However, there has been continuing litigation over whether a debtor has any interest in post-petition rents, particularly in cases where there is what purports to be an absolute assignment of rents to the mortgagee.

In Madison Heights, prior to bankruptcy an assignment of rents was executed and recorded, there was a default under the mortgage, and the lender recorded a notice of default and served the notice and the assignment of rents on tenants (which was the statutory procedure for exercising an assignment of rents under applicable state law).

Thus, the lender argued that as of the petition date the debtor had no ownership interest in the right to receive rent or the actual rent payments. Only the lender owned the rights and payments. Consequently, the rental income was not property of the bankruptcy estate and was not cash collateral.

In response, the debtor argued that the assignment of rents gave the lender only a security interest, not outright ownership. So, the rents were cash collateral and the debtor could obtain authority to use the rents by providing adequate protection of the lender’s interests.

The court acknowledged that there has been a split on this issue, with some cases favoring the lender’s view and others the debtor’s view. The court sided with the view that the debtor did not have any interest in the rents. It reconciled the language in the loan documents regarding an absolute assignment of rents with the statement that the assignment was intended for security by saying that there were elements of both an absolute transfer and security for payment: The assignment “has the effect of transferring ownership of the rents to the [mortgagee], but only until the mortgage is redeemed by the Debtor or the mortgage debt is fully satisfied, at which point the ownership of the rents revests in the Debtor. In this way, there was both an absolute transfer of ownership and a security component in the assignment of rents.” The court concurred with another decision that the debtor’s equitable interest is in future rents and not present rents.

The ability to use rents is critical to a debtor in a real estate case such as Madison Heights since the rents are the only source for funding. Even if a debtor is able to claim that rents are cash collateral and that it has a right to use them, it will still have significant restrictions on its ability to use the rents based on requirements for adequate protection of the mortgagee’s interest. Frequently this means that during the case rents may be used for ongoing expenses on the property (on the theory that this preserves the value of the mortgagee’s interests in the property itself), but not for payment of the debtor’s professionals.

When it comes to confirming a plan of reorganization, the debtor will generally be required to provide the mortgagee with the minimum payments necessary to support a cramdown (e.g. payments with a present value equal to the value of the collateral), while demonstrating that the proposed payments are feasible based on projections.

However, if the debtor is not allowed to use rents at all, typically it will have no way to proceed with a bankruptcy. In this case, after denying the debtor’s cash collateral motion, the court considered and granted the lender’s motion to dismiss the case in In re Madison Heights Group, LLC, 506 B.R. 732 (Bankr. E.D. Mich. 2013).  (It also denied reconsideration in In re Madison Heights Group, LLC, 506 B.R. 734 (Bankr. E.D. Mich. 2013).)

Based on its cash collateral ruling, the court saw only two possible plans: (1) a refinancing from another source sufficient to pay the lender’s debt in full, or (2) a sale in which the mortgagee was allowed to credit bid. However, there was no hope for the first alternative – since the debt was substantially greater than the value of the property, and the second alternative was the practical equivalent of a foreclosure sale – which the court concluded could be accomplished more quickly and cheaply outside of bankruptcy. Consequently, the court dismissed the case and also imposed a 180-day bar to refiling under its power to prevent an abuse of process pursuant to Section 105(a).

It is difficult to reconcile the court’s conclusion that the debtor’s right to rents after the mortgagee’s debt is paid in full or upon redemption is not sufficient to bring the rents within the bankruptcy estate with the Supreme Court’s decision in United States v Whiting Pools, 462 U.S. 198, 103 Sup. Ct. 2309, 76 Law. Ed. 2nd 515 (1983).

In Whiting Pools the IRS had a tax lien and prior to bankruptcy seized some of the debtor’s property pursuant to a levy and distraint. After the bankruptcy was filed, the IRS sought relief from the automatic stay to proceed with a tax sale, and the debtor counterclaimed seeking turnover of the property under Section 542 of the Bankruptcy Code. The two key issues were whether the property was part of the bankruptcy estate and whether the IRS should be treated like other secured creditors.

On the first issue, the Supreme Court emphasized that the scope of the bankruptcy estate is defined very broadly under Section 541 to include “all legal and equitable interests of the debtor as of the commencement of the bankruptcy case” including those made available through other sections of the Bankruptcy Code such as Section 542. So, in effect, the estate could be granted a possessory interest in property that was not held at the commencement of the case, which was sufficient to bring the property within the bankruptcy estate.

Under the Supreme Court’s analysis, although the IRS had special powers to enforce its tax liens that were greater than those of a private secured creditor, this did not equate to a full transfer of ownership prior to the sale: At no point does the IRS’ interest exceed the value of its lien, and the IRS is obligated to return any surplus to the debtor. The debtor’s rights are cut off only when the property is sold to a purchaser at a tax sale. The Court held that this was sufficient to bring the property within the bankruptcy estate.

The Court acknowledged that this gave a debtor greater rights than it would have outside of bankruptcy, but noted that Congress gave a creditor the right to adequate protection of its interests upon request to balance the interests of the creditor against the need to use the property for a reorganization.

In this case, under state law a borrower continues to have possession and the right to redeem the mortgaged property until expiration of a post foreclosure sale redemption period, and the right to rents is tied to the right of possession. Thus, a mortgagee can continue to exercise its assignment of rents (as derivative of the debtor’s possessory rights) until the redemption period expires even if it is not the purchaser at the foreclosure sale. However, if the property is not redeemed before expiration of the redemption period, then the purchaser at the sale obtains all rights to the rents (as incident to possession of the property), and the borrower and mortgagee have no further rights to the rents.

Thus, the mortgagee is in the same position as the IRS was in Whiting Pools. Until after the foreclosure sale and expiration of the redemption period, the mortgagee’s interest in the rents does not exceed the outstanding balance owed to it, and once its debt is paid in full, the debtor is entitled to the rents. Under Whiting Pools, this should be sufficient to bring the rents within the bankruptcy estate.

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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