In a significant ruling impacting commercial real estate lenders in Michigan, the Sixth Circuit Court of Appeals has ruled that an absolute assignment of rents that had been fully perfected (by demanding payment from tenants to the lender and related recording) precludes a debtor from asserting that such rents can be used as cash collateral in bankruptcy. The reasoning is that these rents do not constitute property of the bankruptcy estate. As such, the debtor could not use the rents to fund its operations during its Chapter 11 case.
Background
The borrower Town Center Flats, LLC owned a 51-unit multifamily
complex in Michigan. The mortgagee ECP Commercial II, LLC had an
assignment of rents as part of the collateral for a $5.3 million
loan made to Town Center. The assignment of rents provided that
Town Center "irrevocably, absolutely, and unconditionally
[agreed to] transfer, sell, assign, pledge, and convey" the
rents to ECP. Town Center retained a license to collect the rents
so long as an event of default had not occurred. The rents were the
only income Town Center generated in its business operations.
On December 31, 2013, the borrower defaulted on its obligations to
ECP, and ECP subsequently sent a notice of default and directed
tenants to pay their rents to ECP directly. ECP also recorded the
notice of default with the Register of Deeds, which made the
assignment binding on both Town Center and the tenants. On January
23, 2015, ECP filed a judicial foreclosure action against Town
Center.
To stave off foreclosure, Town Center filed for bankruptcy under
Chapter 11. ECP requested that the bankruptcy court prohibit Town
Center from using postpetition rents, because Town Center no longer
had an ownership interest in the rents. The bankruptcy court
disagreed and allowed Town Center to use postpetition rents as cash
collateral in its bankruptcy case. In doing so, the bankruptcy
court reasoned that: (1) the rents constituted cash collateral
because ECP had a security interest (rather than ownership
interest) in such rents and (2) if Town Center could not collect
the rents, it would have no income to reorganize. ECP appealed and
the district court vacated the bankruptcy court's opinion. The
appeal to the Sixth Circuit Court of Appeals followed.
Analysis
The Sixth Circuit rejected the bankruptcy court's reasoning
and found in favor of ECP. The Court noted that Michigan courts had
consistently interpreted an assignment of rents as a transfer of
ownership in the rents, and that was particularly true in this case
where the language of the assignment was broad and where the
mortgagee had followed all of the steps to perfect its assignment
of rents.1
Town Center then argued that even if ownership of the rents had
transferred to ECP, Town Center retained a residual
"contingent future interest" in the rents if and when
Town Center cured its default. The Court also rejected this
argument, concluding that ECP has the sole interest in the rents
even if Town Center later cured its default.
Finally, Town Center noted that because Michigan law restricts how
an assignee can use rents (that is, rents must be applied to the
mortgage debt), then Town Center still retained a residual right in
the rents. The Sixth Circuit declared, "Neither the Michigan
Supreme Court nor the Michigan Court of Appeals has concluded that
these restrictions on the assignee's use of rent money create a
property right vested in the assignor. We decline to create a new
rule of Michigan property law on this issue . . . ."
The Sixth Circuit acknowledged the Bankruptcy Court's public
policy concern that a ruling in favor of the mortgagee would
deprive single asset real estate debtors of funds necessary to
reorganize. However, the Court concluded that Michigan law was
clear on the issue and governed – despite other public policy
concerns.
Takeaway
Michigan law allows for transfers of ownership in rents from the
borrower to the lender when: (1) an agreement to assign rents
indicates an intention to transfer such ownership; (2) a default
has occurred; and (3) to the extent the lender wishes the
assignment of rents to be effective against the tenants, the
requisite notices have been recorded under state law and properly
served on each tenant. When such requirements have been satisfied,
a borrower may no longer claim an ownership interest in the rents.
As a result, such rents are not property of the borrower's
bankruptcy estate and may not be treated as cash collateral in the
bankruptcy case. 11 U.S. C. § 541; 11 U.S.C. § 363. As a
result, commercial lenders in Michigan should carefully consider
invoking their rights under an assignment of rents clause as a
potential means of forestalling single asset real estate bankruptcy
cases.
The case is Town Center Flats, LLC v. ECP Commercial II
LLC (In re Town Center Flats, LLC), Case No. 16-1812 (6th Cir.
May 2, 2017).
Footnote
1 MCL 554.231
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