Daily Development for Friday, August 18, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

I’ve had this item queued up as a DD all day, and have had calls in to the attorneys to check my facts.  I just can’t believe the court did what it appears to have done.  As the attorneys haven’t call me back, and I don’t have anything better for today, I’m posting this.  I think I’ve read it properly, and, if so, it’s a world class bad decision - and from a federal circuit court.  If I’m wrong, I’ll let ya know.)  Ed.

MORTGAGES; ASSIGNMENTS OF RENT: Rents collected by receiver “in trust” prior to bankruptcy filing belong to mortgagee, and not to bankruptcy estate, at least when mortgagee has first asserted possession of premises to collect rents.

Sovereign Bank v. Schwab, 2005 U.S. Lexis 13383 (6th Cir. 7/06/05)

Borrower defaulted on three Pennsylvania commercial properties and Lender filed a foreclosure action and obtained a default judgment in April, 1999.  Apparently, in Pennsylvania, judgment precedes the foreclosure sale and sales don’t always happen immediately thereafter.  At least that didn’t happen here.  As of September, 2000, the borrower remained in possession and was collecting rents.  Pursuant to its assignment of rents, Lender then notified the tenants to pay rents directly to it.  Less than a month later, Lender sought and obtained an appointment of itself as receiver to “‘take possession, charge and control of the mortgage properties.” 

In January, 2001, the bank finally foreclosed on the properties and bought at the sale.  The court states that they were sold to the bank “for cost,” whatever that means.  The editor fears that it means that the bank bid in its debt, which then throws the rest of the opinion into doubt.

 In February, 2001, Borrower filed for Bankruptcy and filed an action seeking collection of the rental funds collected by the receiver.  The bankruptcy court found in favor of the Trustee and ordered release of the funds, commenting that Lender’s possession of the property pre-foreclosure was “as custodian and not owner.”  The federal district court affirmed.

On appeal, Held: Reversed.

The Sixth Circuit Panel held that the mortgagee, by exercising its assignment of rents and taking possession under Pennsylvania law, obtained “title to the rents.”  As indicated above, the court seems to be saying that the mortgagee got to keep these rents even though, in addition to amounts collected at foreclosure, the mortgagee would have obtained more than the total amount of money owed by the borrower. 

The court cited as authority an earlier Sixth Circuit decision, also purporting to interpret Pennsylvania law, Commerce Bank v. Mountain View Village, Inc., 5 F.3d 34 (3d Cir. 1993).  In that case, the Third Circuit concluded that pre-petition rents were not property of the estate for purposes of the bankruptcy court’s using them during the bankruptcy proceeding, even giving adequate protection to the lender for their value.  The case is based upon the fact that Pennsylvania is a title theory state.  Later, it also cited First Fid. Bank v. Jason Realty., L.P., 59 F. 3d 423 (3d Cir. 1995), applying New Jersey law, which further relied upon the fact that the assignment of rents in question was based upon an “absolute assignment.”   (New Jersey is a lien theory state, so the “title theory argument doesn’t apply.  Further, the assignment in this case didn’t have the “absolute” language.)  The Mountain View Village opinion is a distinct minority in the U.S., even with respect to !

 following the title theory of mortgages.   Jason Realty, similarly, has been widely criticized in relying upon the wording of the assignment of rents.  Note, however, that in both Mountain View and Jason there had not been a foreclosure.  Thus, the lender’s debt was still outstanding an unpaid.  In this case, so far as the editor can make out, the foreclosure was complete and there was no deficiency.  These rents, to the extent that they had been security, represented surplus.

The court appears to be concluded that the bank got absolute ownership of the rents when it passed into possession pursuant to its “title,” even prior to foreclosure. 

Comment 1: If the editor is correct in his understanding of this case, then this is a truly dreadful opinion.  There is no theory of mortgage law that purports to permit the mortgagee to obtain more than it is owed, or to collect rents or to hold possession in any capacity other than as security holder.  Prior to foreclosure, everything that the lender does is as a secured lender and not as an owner of the property or, for that matter of the rents.

The court panel here consisted, in the end, of only two judges, because one judge  resigned prior to the time the opinion was filed, and apparently was not involved in the decision.  The judge who wrote the opinion was Chief Judge of an International Trade Court, sitting by designation.  Maybe there’s a chance fore a rehearing here.

Comment 2: Pennsylvania may be a good candidate for the new Uniform Access to Rents Act just adopted by the National Conference of Commissioners on Uniform State Laws.  Assignments of rents laws generally in America are in a jumble, precisely because they are often fodder for bankruptcy disputes and the law becomes a tactical football being kicked around by result oriented federal bankruptcy judges with no responsibility for the well being of the law in the states from which it purportedly is derived.  Unfortunately, the Third Circuit cases, dreadful and out of step as they are, tend to favor lenders - a natural constituency that usually is needed to pass financial legislation.  In general, the Uniform Act favors the lenders’ position, so lenders may conclude that the Act provides a desirable clear road map to a landscape that, even though favorable for them today, may change dramatically tomorrow.

Comment 3: Just so the record is straight: Jason and Mountain View are bad.  This case (assuming the lender bid in the debt) is atrocious.  It is an embarrassment for a Federal Circuit Court to get the law so wrong, even though it is understandable when one reads the language of Jason and Mountain View.  They are so badly written that someone who really didn’t understand the legal issues might well get misled.  But isn’t it the court’s job to figure out these issues?

Readers are encouraged to respond to or criticize this posting.

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