Town Center Flats, LLC v. ECP Commercial II LLC (In re Town Center Flats, LLC), 855 F.3d 721 (6th Cir. 2017) –

A commercial mortgagee exercised its assignment of rents prior to bankruptcy. After it then commenced a foreclosure action, the debtor filed bankruptcy. The mortgagee filed a motion to prohibit the debtor from using rents. The bankruptcy court determined that the rents qualified as cash collateral of the bankruptcy estate and denied the motion. The district court reversed, and the debtor appealed to the 6^th Circuit.

Under state law (Michigan) a mortgagee may exercise its assignment of rents after a default by recording a notice of default and serving the notice and a copy of the mortgage on the tenants. That gives the mortgagee a right to collect rents that is binding on both the debtor and the tenants.

In opposing the motion, the debtor noted that it would have no income to work with for its plan of reorganization if the rents were not part of the bankruptcy estate. The bankruptcy court’s determination that the rents were “cash collateral” meant that both the debtor and the mortgagee had an interest in rents. Although as a condition of using the rents, the debtor was required to provide adequate protection of the mortgagee’s interest in the rents.

On appeal to the district court, the mortgagee argued that there had been a transfer of ownership in the rents. The district court agreed and vacated the bankruptcy court decision, and the debtor appealed.

The 6^th Circuit began by noting that the traditional rule under state law was that an assignment of rents was unenforceable because it interfered with the right of redemption. The rules evolved over the years as legislation was enacted authorizing assignment of rents for trust mortgages, and then later for commercial mortgages.

The court cited various state cases that it interpreted to mean that upon completion of an assignment of rents there can be a transfer of ownership from the debtor to the mortgagee. In this case the loan documents contained typical language that the debtor “‘irrevocably, absolutely and unconditionally’ transferred its right in a ‘present, absolute and executed assignment of the Rents and of the Leases.'” Given the apparent intent to assign rents to the maximum extent permitted by law, the 6^th Circuit concluded that there was in fact a transfer of ownership of rents prior to bankruptcy.

The debtor argued that the statute clearly authorized only an assignment of rents as security, as opposed to an absolute assignment. Among other things, the title of the statute was “Assignment of Rents to Accrue as Additional Mortgage Security.” However, the court concluded that an assignment for security did not preclude a transfer of ownership.

The debtor also argued that it retained rights in the rents that were sufficient to bring them within the bankruptcy estate. Under the loan documents if the debtor cured its defaults then it was able to start collecting rents again. Consequently, it argued that the rents should be viewed as a stream of payments with the debtor holding a contingent future interest in those rents. However, the court focused on the distinct period between the event of default and the potential future cure and found that the mortgagee had the sold interest in rents during that period.

The debtor also pointed out that the state courts have placed restrictions on how the mortgagee can use collected rents. Generally, the mortgagee must apply the rents to its debt or use them in connection with the property, such as payment of property taxes and insurance policy premiums. The 6^th Circuit’s rejoinder was that there was no case law concluding that these restrictions created property rights vested in the debtor.

Consequently, the court concluded that the rents were not part of the bankruptcy estate because there was a transfer of ownership and the debtor did not retain any residual rights. Accordingly, the 6^th Circuit reversed the bankruptcy court.

A single asset real estate case reorganization is virtually impossible without the ability to use rents. My personal view continues to be that an analysis along the lines of this case is incorrect. A discussion of the “transfer of ownership” concept (and the analogy to a deed of trust) fails to take into account that Michigan is a lien theory, not title theory, state. Further, it is evident that there was not an absolute assignment of rents. A mortgagee does not have carte blanche to use the rents, but rather is restricted to applying rents to its debt or using them to preserve its primary collateral – the property. And once the debt is paid in full, the rents clearly revert to the debtor. The mortgagee has no further interest. Under Whiting Pools, a debtor’s right of redemption is sufficient to bring property into the bankruptcy estate.

Note that even if the debtor can use rents for operation, maintenance and development of the property, which arguably provides adequate protection of the mortgagee’s interest in the rents (since this protects and enhances the mortgagee’s primary collateral), a debtor probably will not be able to obtain approval to use rents to pay bankruptcy costs, particularly professional fees – which also poses a major hurdle for a reorganization. However, bringing rents into the bankruptcy for use in connection with the property is at least a start.

Vicki R Harding, Esq.