Mc0084 Assignment Of Rents

The U.S. Court of Appeals for the Sixth Circuit recently concluded that Michigan’s assignment of rents statute sufficiently deprived the assignor of the ownership of the rents such that the rents could not be included in the assignor’s bankruptcy estate.

The primary issue before the Court was whether Michigan’s assignment of rents statute allowed the assignor to retain sufficient rights in the rents for the rents to be included in the assignor’s bankruptcy estate.  The bankruptcy court determined that the debtor’s assignment of the rents gave the assignee a security interest in the rents but did not change the ownership, and the assignor still maintained a property interest in the rents even after the assignment.

The Sixth Circuit disagreed, concluding that an assignment of rents, if recorded and a default occurs, is a transfer of ownership rights in the rents and the assignor no longer has an interest in them.

A copy of the opinion is available at:  Link to Opinion.

The appellant debtor owned a multi-unit residential complex, and it financed the construction of the building with a $5.3 million loan that was later assigned to the appellee creditor.  The loan was secured with a mortgage and an agreement to assign rents to the creditor in the event of default.

In the agreement to assign rents, the debtor “irrevocably, absolutely and unconditionally [agreed to] transfer, sell, assign, pledge and convey to Assignee, its successors and assigns, all of the right, title and interest of [debtor] in . . . income of every nature of and from the Project, including, without limitation, minimum rents [and] additional rents . . . .”

The agreement purported to be a “present, absolute and executed grant of the powers herein granted to Assignee,” while simultaneously granting a license to the debtor to collect and retain rents until an event of default, at which point the license would “automatically terminate without notice to [debtor].” Rents from the residential complex are the debtor’s only source of income.

The debtor ultimately defaulted on the loan, and the creditor sent a notice of default. The notice complied with the terms of the agreement and with Mich. Comp. Laws § 554.231, which allows creditors to collect rents directly from tenants of certain mortgaged properties. The following day, the creditor recorded the notice documents in Macomb County, Michigan, completing the last step required by the statute to make the assignment of rents binding against both the debtor and the tenants of the property.

Within a month of recording the notice documents, the creditor filed a complaint against the debtor, and requested the appointment of a receiver to take possession of the debtor’s property.  Approximately one week later, the debtor filed for Chapter 11 bankruptcy relief. The parties reached an interim agreement to allow the debtor to continue to collect rents from the tenants of the complex, with $15,000 per month used to pay down the debt to the creditor and the remainder of the rents used for authorized expenses.

The creditor filed a motion to prohibit the debtor from using rents collected after the petition was filed. The debtor opposed the motion and pointed out to the bankruptcy court that the company would have no income to work with in its Chapter 11 reorganization plan if the rents were not part of the bankruptcy estate.

The bankruptcy court agreed with the debtor and denied the creditor’s motion. The bankruptcy court determined that the assigned rents qualified as cash collateral in the bankruptcy estate, meaning, under Chapter 11, that the debtor must provide “adequate protection” to the creditor before using the cash.

The creditor appealed to the trial court and argued that Michigan law established a transfer of ownership in the assigned rents from the debtor to the creditor. The trial court agreed with the creditor and vacated the bankruptcy court’s decision. The debtor appealed to the Sixth Circuit.

On appeal, the Sixth Circuit identified the issues as first determining the extent of property rights held by the assignor and assignee of rents under Michigan law, and then second was whether the rights retained by the assignor are sufficient for the rents to be included in the assignor’s bankruptcy estate.

The Sixth Circuit began its analysis by first evaluating the evolution of Michigan’s assignment of rents statute.  Originally, the traditional rule in Michigan was that an assignment of rents was unenforceable because it would interfere with a mortgagor’s right of redemption.  As a result, the default rule in Michigan is that an assignment of rents is unenforceable.

However, a statute enacted in 1925 created a right to assign rents for properties subject to trust mortgages.  Then, in 1953, Michigan enacted Mich. Comp. Laws § 554.231, which allowed the assignment of rents for additional categories of properties, including those “with any mortgage on commercial or industrial property.”

The Michigan statute specifically provides:

Hereafter, in or in connection with any mortgage on commercial or industrial property . . . it shall be lawful to assign the rents, or any portion thereof, under any oral or written leases upon the mortgaged property to the mortgagee, as security in addition to the property described in such mortgage. Such assignment of rents shall be binding upon such assignor only in the event of default in the terms and conditions of said mortgage, and shall operate against and be binding upon the occupiers of the premises from the date of filing by the mortgagee in the office of the register of deeds for the county in which the property is located of a notice of default in the terms and conditions of the mortgage and service of a copy of such notice upon the occupiers of the mortgaged premises. Mich. Comp. Laws § 554.231.

The statute also contains a provision addressing the validity of the assignment:

The assignment of rents, when so made, shall be a good and valid assignment of the rents to accrue under any lease or leases in existence or coming into existence during the period the mortgage is in effect, against the mortgagor or mortgagors or those claiming under or through them from the date of the recording of such mortgage, and shall be binding upon the tenant under the lease or leases upon service of a copy of the instrument under which the assignment is made, together with notice of default as required by [the above section]. Mich. Comp. Laws § 554.232.

According to the Sixth Circuit, under Michigan law, the assignor of the rents no longer has a valid interest in the rents “once an assignee has: 1) entered into an agreement to assign rents; 2) recorded that agreement; and 3) default has occurred,” because the assignee’s rights “are perfected and binding against the assignor.”  The Court cited to several Michigan cases for the general proposition that the assignment of rents is a complete transfer of ownership so long as the three requirements have been met.

One of the cases the Sixth Circuit relied on was from the Michigan Court of Appeals, in which that court held that a prior-perfected interest in assigned rents had priority over an interest held by a judgment creditor who sought to garnish rents. See Otis Elevator Co. v. Mid-America Realty Investors, 522 N.W.2d 732, 733 (Mich. Ct. App. 1994). The Sixth Circuit emphasized the holding from that court that the judgment creditor could not garnish the rents because the assignor no longer had an ownership interest in them.

The Sixth Circuit rejected the debtor’s argument that the statute only authorized the assignment of a security interest, not the ownership rights.  According to the Court, the language of the statute did not support such a narrow interpretation and courts interpreting the statute have consistently concluded that the statute authorizes the assignment of ownership of the rents.

The Court also referenced the broad language in the debtor’s assignment agreement that “irrevocably, absolutely and unconditionally” transferred the debtor’s right in a “present, absolute and executed assignment of the Rents and of the Leases” from the debtor’s property.  The court concluded this language evidenced the debtor’s intent to transfer ownership in the assigned rents.

Next, the Sixth Circuit rejected the debtor’s argument that it retained certain rights to the assigned rents.  The Court concluded that the language contained in Mich. Comp. Laws § 554.232 established that the rents were the property of the assignee during the discrete period from the time of the default until the time of potential future cure, if any.

Finally, the Sixth Circuit ruled that even though it is well-established that the scope of a Chapter 11 bankruptcy was designed to be broad, the assigned rents at issue could not be included in the debtor’s estate.  The Court referenced several bankruptcy court rulings interpreting Michigan law that concluded the assigned rents under Mich. Comp. Laws § 554.231 should not be included in the debtor’s estate.  The Sixth Circuit rejected the underlying bankruptcy court’s policy concern that removing the sole stream of income for a debtor would eliminate relief under Chapter 11, and concluded that Michigan law is clear on the issue.

Accordingly, the Sixth Circuit reversed the order of the bankruptcy court.

Effective on June 17, 2011, Texas enacted the Texas Assignment of Rents Act (“TARA”) and, in doing so, has codified the common law concept that an assignment of rents given as security for a real estate loan is deemed to be the grant of a security interest in rents, even if given in the form of an absolute assignment.  Texas now joins a number of other states that have enacted legislation largely patterned after the Uniform Assignment of Rents Act (“UARA”) which was promulgated in 2005 by the National Conference of Commissioners of Uniform State Laws.[1]  The TARA has been added to the Texas Property Code (the “Property Code”) as a new Chapter 64.  The TARA is intended to clarify the process for creating, perfecting, and enforcing a security interest in rents. 

In 1981, the Texas Supreme Court held in Taylor v. Brennan, 621 S.W.2d 592 (Tex. 1981) that a security interest in rents does not become operative until the lender takes affirmative steps to enforce the security interest.  In regards to collateral assignments of rents, the Texas Supreme Court stated “that an assignment of rentals does not become operative until the mortgagee obtains possession of the property, or impounds the rents, or secures the appointment of a receiver, or takes some other similar action.”  Taylor v. Brennan, 621 S.W.2d at 594.  One negative consequence of Taylor v. Brennan for mortgage lenders was that in a priority contest between a mortgage lender with a recorded, but unenforced assignment of rents, and a judgment lien creditor that had obtained and served a writ of garnishment on rents, the judgment lien creditor would have priority.   

Lenders generally responded by requiring that their borrowers enter into absolute assignments of rents generally stating that the lender was the owner of any rental income at the time it was paid, regardless of whether the lender ever actually took possession of the rental income.  Absolute assignments, however, pose a different, albeit substantial, type of risk to mortgage lenders.  Namely, a true absolute assignment of rents could be construed to constitute a pro tanto payment of the loan obligation.  In the context of a mortgage loan, it could be argued that rents collected and kept by a property owner should be credited against the owner’s debt to the lender, even though the lender did not actually receive rent payments, because the lender “owns” the funds.  This pro tanto reduction concept has been addressed in several bankruptcy cases; although, the harsh results of a pro tanto reduction do not appear to have been applied in any reported bankruptcy decision or Texas decision.  In any event, the TARA (i) establishes that rents not actually received by a mortgage lender are not to be credited against the property owner’s debt, (ii) establishes that a lender with a recorded mortgage has priority and perfection of its lien on rents upon the filing of the mortgage, and (iii) sets out a statutory means of notice and enforcement of a lien against rents. 

The collateral assignment versus absolute assignment issue has been disputed in bankruptcy cases over the years.  While the general recognition that an assignment of rents is merely a security interest in rents prior to affirmative action by the lender typically prevails, mortgage lenders have continued to assert absolute ownership of rents under an assignment of rents.  See, e.g., In re Amaravathi Limited Partnership, 416 B.R. 618 (Bankr. S.D. Tex. 2009).  In essence, lenders have argued that rents subject to an absolute assignment from debtor‑owned property were not “property of the estate” and lender action to collect rents postpetition was not affected by the automatic stay.  The TARA will likely put an end to such fights in the future in Texas.

The TARA applies to all existing real estate loan transactions and includes the following highlights:

  • An enforceable security instrument secured by real property automatically creates an assignment of rents arising from the property unless the security instrument provides otherwise or the security instrument is governed by sections of the Texas Constitution relating to homestead home equity loans, homestead reverse mortgages, or financing related to a manufactured home used as a homestead.  Property Code, § 64.051(a).
  • An assignment of rents creates a security interest in all accrued and unaccrued rents arising from the real property.  Property Code, § 64.051(b).
  • An assignment of rents does not reduce the secured obligation, except to the extent that the lender actually collects the rents and applies (or is obligated to apply) the collected rents to the secured obligation.  Property Code, § 64.051(c).
  • Upon recordation in the county real property records, the security interest in the rents is perfected, and has priority over the rights of any subsequently acquired interest in the rents or the real property.  Property Code, § 64.052.
  • A lender may enforce an assignment of rents by notice to the obligor, notice to any tenant, or another method sufficient to enforce the assignment under other Texas law.  On and after the date of enforcement, the lender is entitled to collect all accrued, unpaid and future rents.  Property Code, § 64.053.
  • As to the obligor/owner, a lender’s enforcement is effected by providing a notice demanding that the obligor pay over the proceeds of any rents.  Property Code, § 64.054(a).
  • As to any tenant, enforcement is effected by providing the tenant a notice demanding that the tenant pay to the lender all unpaid accrued rents and all unaccrued rents as they accrue.  A copy of this notice must be provided to the obligor.  Property Code, § 64.055(a).
  • After a tenant receives an enforcement notice, subject to available defenses, the tenant must pay to the lender all unpaid accrued rents and all unaccrued rents as they accrue, unless the tenant has previously received a notice from another assignee of rents.  Property Code, § 64.055(c)(1).
  • A lender that collects rents following enforcement under the TARA is not obligated to apply the collected rents to the payment of expenses of protecting or maintaining the subject real property; however, a tenant’s continuing obligation to pay any rents will remain subject to the terms of the underlying lease agreement and any claims or defenses of the tenant arising from the landlord’s non-performance under the lease agreement.  Property Code, § 64.059.
  • Section 64.056 of the Property Code sets forth the specific form of notice to a tenant that will trigger enforcement of the assignment of rents as to the tenant. 
  • Enforcement of an assignment of rents, the application of proceeds, or the turnover of rents to the lender does not (1) make the lender a mortgagee in possession of the real property, (2) make the lender an agent of its obligor, (3) constitute an election of remedies that would preclude a later action, (4) make the secured obligation unenforceable, (5) limit any right available to the lender with respect to the obligation, or (6) bar a deficiency judgment.  Property Code, § 64.057.

The TARA will have in impact upon all assignments of rents that relate to Texas real estate.  Perhaps that impact will be most dramatic in bankruptcy cases, as debtors and lenders will likely no longer fight over the nature and effect of an assignment of rents in the context of cash collateral, property of the estate and the automatic stay.

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[1]        The TARA is substantially shorter than the UARA, reflecting the deletion of various UARA provisions, including provisions regarding the enforcement of assignments of rents through receiverships. 

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