Daily Development for Monday, December 15, 2003 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu Uniform Mortgagee Access To Rents from Income Producing Property Act - draft of November, 2003. I attended the first meeting of the drafting committee for this Act over the weekend. In addition to the official members of the drafting committee, there were was an ABA representative and one "observer" - from the California State Bar Real Estate Law Committee. I was surprised by this, as I expected that there would be a number of industry groups with a significant interest in how this statute comes out. Perhaps this report will whet some appetites and we'll have a larger attendance at the next meeting, which will be in Chicago, probably at the Drake Hotel, on April 16 & 17. This project was initiated by the Joint Editorial Board on Uniform State Real Property Acts in response to three primary problems: 1. Massive common law uncertainty as to the method by which assignments of rents for security are perfected and the effect of such assignments as against third parties prior to the actual activation of the assignments. 2. Some uncertainty as to whether the bankruptcy law "fix" adopted in 1994 will in fact be effective to protect secured creditors holding such assignments during the next cycle of real estate foreclosure problems that is sure to come some day. The problem is that, prior to 1994, many bankruptcy courts concluded that mere recordation of a rents interest was not "perfection" of that interest insulating it from the strongarm power. Even worse, some courts held that if the clause was worded as an "absolute assignment," that made a difference, even if the way the parties actually acted under the assignment remained the same. The 1994 amendment was intended to provide that recordation satisfies the requirement for perfection for bankruptcy purposes. The reporter for the committee, Wilson Freyermuth, a bankruptcy scholar from the University of Missouri, has substantial doubts that the bankruptcy courts will construe the language of the amendment to accomplish the desired goal, despite the fact that that goal is quite clear in the legislative history. I concur that the history is a lot more clear than the language on this point, and this is particularly troubling because other drafts, that were quite specific "fixes" of the problem, were rejected. 3. Clarifying and standardizing the procedures for actually collecting the rents under these assignments. These vary widely from state to state for no apparent good reason. The first meeting gave us a very good start, but left open a number of tantalizing issues that definitely ought to lead industry groups - lenders, borrowers and bankruptcy lawyers - to schedule a visit to the next meeting. Although uniform laws are designed to be state law legislation, the bankruptcy courts are required to follow state law characterization of interests that are not specially characterized in the federal laws. So the Uniform Act, if adopted, will have an impact on bankruptcy court interpretations. In a nutshell, here are the important issues that are still wide, wide, open. 1. The first concern is whether the Act, which characterizes rents interests as real property interests, will classify as "rents" monies paid for the right to "possess, use, or occupy" the property or just monies paid for the right to "possess." The broader definition is intended to pick up, most importantly, revenues for hotels, but would also apply to such things as boat slip rentals, stadium receipts, license fees, and a variety of other payments made for activities that are not deemed "possession." One argument made in favor of the inclusion of these types of revenues is that, except for hotel revenues, which are the subject of another specific bankruptcy law amendment, these revenues currently are not generally classified as "rents" flowing from the property (or may not be) and therefore the creditor's interest in such items is not protected in bankruptcy. They would be regarded as post-petition income and available to the trustee or debtor in possession to fund reorganization efforts, including (to the chagrin of the lender) litigation against secured creditors. Obviously both borrower groups and lender groups would like to have a stake in how this statute characterizes these interests, and the Committee would like to hear from both. Another issue relevant here is whether it is appropriate to address these "unrents" as real property interests in light of the fact that they have traditionally been viewed as personal property and Article Nine interests. The concern is that we might be laying traps for the unwary who are used to dealing with these kinds of interests under the UCC and might find themselves unperfected or underprotected because they did not recognize that the basic legal assumptions had changed while their agreements and recording practices did not. Finally, one might well ask whether, as a matter of policy, all the other provisions of the Act, which primarily deal with the concept that rents are real property, ought to apply to these types of interests as well. 2. A second concern, equally important and equally controversial, is whether the assignee of rents ought to have a non-waivable duty to apply those rents, at the demand of the assignor or tenant, to pay for taxes, insurance, "preservation and maintenance" of the property, or even to perform the lease covenants. At least as to the first three items, there is substantial sentiment on the committee that this ought to be the case, since a receiver would have such duties were a receiver appointed to collect the rents. The argument on the other side is that current law gives the assignee the right to make its own judgment as to whether the allocation of collected rents to these expenses is in its own economic interest as a secured creditor. In the most typical case, the creditor will permit rents to be used to pay many of these expenses, since it has an interest in the underlying value of the real estate at foreclosure time. But this is not always the case, particularly when the seized rents are significant in amount. Further, there is the "if its ain't broke, don't fix it," argument. Currently the universal law is that the assignee may seize rents without having any responsibility to apply them to these purposes. The real genesis of the drafting project was not to change this law, and there is some question as to whether such a gratuitous change in the common law ought to be carried out. Those in favor of the change say that "basic fairness" is always on the table. They argue that its only fair that lenders ought to use the monies for those things that the tenant expected them to be used for, even though the tenant took its interests subordinate to the lender's mortgage rights. Those opposed to such a change argue that the basic fairness in commercial lending settings is what the lender, through an economic bargain, requires to secure the loan, nothing more and nothing less, so long as the law is clear and no one is surprised by the rules. A market operating on full information with adequate competition (and of course lenders do compete on issues of real concern to borrowers) assures what fairness needs to be assured. The opponents to change argue that the unrestricted right of the assignee to collect rents is the virtually universal rule except for the foreclosure controls instituted in the equity of redemption and a few anti-deficiency rules, does it make sense to tinker with this one aspect of the relationship? 3. A third unresolved issue is whether, turning on the above distinction, there should be a special rule concerning "additional rents" - monies paid specifically to pay for maintenance, operation, taxes and insurance, pursuant to formulae based upon the prior years experience. Practitioners with experience on the committee noted that currently lenders view it to be their right to collect these monies as assignees and to have discretion as to whether to use them for the identified purposes or to apply them in reduction of the debt. Some on the committee felt that even if the assignee did not have a general duty to apply collected rents to pay taxes, insurance and maintenance costs, it ought to have the duty to apply these specially identified revenues to those purposes. Others felt that the identification of when and how these monies would be applied would be too complex, and in any event lenders would respond to any special statute in this area by adopting a practice of require borrowers to enter into gross leases. In response to the latter argument, some noted that net leases with "additional rent" pass through payments have been a universal business practice for a long time, have an independent economic reasons for existence, and are unlikely to change as a consequence of this legislation. There are any number of other open issues still to be discussed, or eligible to be reopened, such as the priority of the holder of an unactivated rents interest against judgment lienholders, the relative priority of multiple assignees, before and after activation, how rents assignments are activated (the draft provides for several methods, including simply notice to the tenant), whether residential tenants can continue to pay the landlord with impunity (draft says yes - since the lender can always get a receiver), and dozens of other issues of great interest to mortgage geeks. The Act also does everything it can to bring about the automatic enforcement of clauses providing for the appointment of a receiver. It does not address the liability of mortgagees in possession except to say that an assignee is not a mortgagee in possession by virtue of collecting rents or by virtue of co- operating with the assignor’s demand to apply collected rents to maintenance expenses. I encourage interested parties to get themselves involved in this process. A few nights on a weekend in Chicago is a small price for you or your clients or trade groups to pay to insure a voice at the table on this potentially very important uniform law. To get a copy of the next draft, and to figure out how to be included as an observer (there is a process), contact Wilson Freyemuth, the Reporter, at the University of Missouri, freyermuthr@missouri.edu or the editor, who can pass you on to the right party. Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA. 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