Daily Development for Friday, April 28, 1995

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

I've been looking for an interesting bankruptcy case to post that might have some general appeal. The following one is interesting not so much for its bankruptcy aspects as for its views on the issue of the preemptive effect of federally related contractual arrangements.

BANKRUPTCY; FEDERAL LOAN PROGRAMS; HUD REGULATORY AGREEMENTS; PRE-PETITION RENTS: Under provisions of a HUD regulatory agreement restricting expenditure of rents following default, parties receiving disbursements of funds constituting pre- petition rents must disgorge them to the estate. In re Indian Motorcycle Associates III Limited Partnership, 174 B.R. 351 (D. Mass. 1994). Provisions of a recorded Regulatory Agreement executed as part of a HUD coinsured loan stated that the borrower had no right to dispose of rents following default, and that any rents disbursed in violation of this agreement must be repaid to the "Project." The borrower used post-default rents to pay retainers to its professionals. Following the filing of a bankruptcy petition, the court ordered these funds repaid to the estate. The court relied upon authority that had established a preemptive rule relating to federal loans that a security interest in "leases, rents, profits and income" is "perfected" upon default, without the need for further enforcement action by the mortgagee to obtain possession or for appointment of a receiver. Here, however, there was not a federal loan, but a federally guaranteed loan. Further, the unlawfully distributed funds were not paid over to the lender in reduction of the mortgage debt, but rather paid into the project accounts, in accordance with the regulatory agreement. The mortgagee had a security interest in those accounts, however.

The court concludes that the recipients of the disbursements had constructive knowledge of the recorded regulatory agreement. It does not find that they had actual or constructive knowledge of the default (although, since they were attorney's for the bankrupt, it is likely that they did.) The court further concludes that the diversion constituted "a reduction in the value of the [lender's] collateral" (174 B.R. at 357) without analyzing whether other collateral adequately secured the creditor's position.

Comment: Perhaps the most interesting aspect of the case is the court's extension of federal preemption into the interpretation of the rights of two non-governmental parties - the borrower and the insured lender. Under the applicable Supreme Court case of Kimbell Foods, 440 U.S. 715 (1979), federal preemption should not apply simply to protect the federal treasury from loss, but only when there is an express, Congressionally authorized preemption power or when preemption is necessary or important to insure the carrying out of the federal mission. Under Kimbell, if preemption is useful, but not vital, the benefits of preemption to the federal program should be weighed against the costs to state interests. Although it is unclear whether state law would really have led to a different result here, the court clearly does not go through the analysis mandated by Kimbell. Where neither of the contracting parties in the dispute were governmental, the court should have been clearer as to the basis of its rulings on preemption.

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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