Daily Development for Wednesday, July 26, 2000

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

This is the second DD reporting on this case, following up on yesterday's DD discussing other elements of the case.

BANKRUPTCY; ASSIGNMENT OF RENTS; "ACTIVATION:" Finding that prior state court rulings on the subject were interlocutory only and not entitled to preclusive effect of any kind, Second Circuit rules that the Bankruptcy Court properly held that the debtor was not liable for rents collected during the time period *after* the mortgagee's demand *until* the mortgagee obtained a judicial sequestration order, because Florida law authorizing the seizure of rents by simple demand cannot Constitutionally apply to mortgages executed prior to its effective date, even if the demand for rents is made thereafter.

In re Ormand Beach Associates Limited Partnership, 184 F.3d 143 (2d. Cir. 1999).

The creditor, an RTC note purchaser, made an aggressive bid to recover about three years of rents received by the owner after an initial letter demand for rents form the RTC. After making the demand, however, the RTC had taken took no further enforcement action for a long period of time (until the note purchaser took over). The acquiring creditor's unsuccessful arguments for recovering the old rents included: criminal contempt, fraudulent transfer, civil theft of personal property, and even a claim that personal liability for payment of the mortgage was a covenant running with the land that had "attached" to the debtor, a nonassuming grantee.

The demand for rents in 1989 had tracked the language of a 1987 Florida statutory provision stating that upon default a creditor could seize rents pursuant to a rent assignment by notifying the debtor to pay rents over to it. There was some issue in the case as to whether the 1989 demand had been served upon the correct party, but the court sees some land mines in that issue, and deftly sets it aside to discuss primarily the issue of the validity of the demand even assuming that it had been properly served.

In July of 1992, a Florida court ultimately entered an order in favor of the new mortgage holder which had purchased the note from the RTC . The courts order sequestered some of the rents, and a few months later the court entered an order providing for the sequestration of all the rents since the 1989 demand. The sum total of net rents collected during that period was close to two million dollars, but only $170,000 in net rents were collected after the July order.

The debtor filed for bankruptcy, and the bankruptcy court refused to find the current owner of the property liable for any deficiency, a decision reported in the DIRT DD for April 25.

This ruling focussed attention on the rents that had been collected but expended by the debtor since 1989 for purposes other than management of the project. The mortgagee raised various theories to establish a claim in bankruptcy for these monies. All, of course, were predicated on the notion that the 1989 demand validly created an interest in those rents in the mortgagee, a fact already found by the Florida courts.

The bankruptcy court ruled that the Florida court orders finding that the rents arising after 1989 were to be sequestered were "interlocutary," since the court reserved until completion of the foreclosure a determination as to how the rents ought to be distributed. Consequently, the bankruptcy court did not deem itself bound by language in the state court orders determining that the rents were properly the property of the creditor after the 1989 demand.

The court then turned to the issue of whether in fact the 1989 demand did give the mortgagee the right to possession of the rents, available for distribution to the mortgagee as security. The court acknowledged that the demand satisfied the requirements of the 1987 statute, but held that the statute could not amend the "substantive" rights of the debtor as they were created in a 1983 mortgage. In 1983, the court concluded, the Florida common law provided, consistent with the "lien theory," that the rents in a rent assignment were not available to the mortgagee until a court sequestered them.

To alter that result, even in 1989, the court ruled, would alter the substantive rights of the parties and interfere with the Constitutional property rights of the debtor.

Reporter's Comment: Within a year or two the last of these "RTC inaction" cases will have worked their way through the court system. The "reanimated" (suddenly aggressive) RTC note purchaser, such as the creditor here, rarely succeeds in recovering rents collected and spent by the owner during the period of time (sometimes years) while the RTC passed the note around to various servicing agents and loan marketeers, all the while making no effective enforcement efforts. Just as unsuccessful are the note purchaser's efforts to retroactively assess default rate interest, late charges and the like, to cover the inaction period.

Editor's Comment 1: OK, it's a bankruptcy case and, like most others, horribly result oriented. But we're not talking about a bankruptcy judge here, but the good ole' Second Circuit Court of Appeals, making a pronouncement of constitutional proportion, no less.

Where the parties have entered into a contract providing for the mortgagee to have a security interest in the rents, the usual expectation is that, notwithstanding "absolute" language of the instrument, the parties really don't intend that the mortgagee have a priority claim to treat these rents as security unless and until the rents assignment is "activated."

In the late 80's, because of rampant confusion as to the difference between "activation" and "perfection" for bankruptcy purposes, many states enacted statutes intended to permit rents assignees to take relatively simple steps to "activate" their assignment rights. The court here holds that the Florida version worked such a change in the common law that it could not be applied to a 1983 mortgage.

But is that really correct? Isn't the substantive right at stake here the security interest? If the debtor, for instance, had voluntarily turned the rents over to the mortgagee in the pre1987 regime, would the mortgagee have had a priority claim to them as against other creditors of the debtor? The answer is yes, and the reason is that the mortgagee really did have a security interest in those rents, even without a judicial determination. In Florida (we will assume) pre1997, the law required that a court make a determination whether grounds existed for the seizure of the rents where the debtor refused to give them up. But this determination was simply an acknowledgment that the circumstances alleged by the mortgagee that were the basis for its rights arising existed. The rights arose on the basis of the facts, not on the basis of the judicial determination.

In short, the editor's view is that the court probably is incorrect in determining that the judicial sequestration established substantive rights of the mortgagee in the rents. Rather, it was a procedure to recognize substantive rights that already existed, and consequently Florida was free to change its procedure by statute as to events arising after the date of enactment, even events relating to preenactment mortgages.

Comment 3: Note that the editor said that the court "probably" was incorrect. An argument for the other side is that the lien theory actually recognizes that the debtor "owns" the rents until foreclosure, as an emblement of the debtor's possession rights. In some jurisdictions, a court could take away possession only if waste was occurring on the property. If this was the basis for a court's sequestration of rents prior to 1987, then arguably a judicial determination of waste was a precursor to the creation of any rights in rents in the mortgagee. There is some old authority to suggest this kind of thinking in some states, but the vast majority of states, even prior to 1987, had concluded that their courts would enforce agreements to give mortgagees access to rents upon default. If the basis of the Florida court's pre 1987 rulings on rents was that the rents assignment was enforceable, then clearly the Florida statute holding that it is enforceable upon default even without a judicial determination is a mere change in procedure, and should be applied to mortgage relationships arising prior to enactment.

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

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