Daily Development for Monday, November 5, 2001

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

This DD is a combination of the original efforts of Jack Murray, reporter, and the extensive editing and supplementing of the editor. Obviously, the latter takes the blame for any problems, while the former gets credit for any quality.

MORTGAGES: ASSIGNMENTS OF RENTS; HOTEL REVENUES: Hotel room revenues are cash collateral and property of the debtor's bankruptcy estate, even though the deed of trust describes the assignment of the hotel revenues as "absolute" and "unconditional." Under language of mortgage, revenue assignee must take affirmative action in the event of default to terminate the debtor's right to collect the rents.

In re 5877 Poplar, L.P., 2001 Bankr. LEXIS 1233 (W.D. Tenn., Sept. 27, 2001)

In this Chapter 11 single-asset bankruptcy case, the debtor, a Tennessee limited partnership, owned and operated a Comfort Inn Hotel in Memphis. LaSalle National Bank ("LaSalle"), by virtue of assignments from prior banking institutions, was the current trustee for the holders of security interests in a mortgage securing the hotel property, in the amount of $3,389,000. LaSalle sought a determination that, by virtue of the language contained in the deed of trust, the hotel revenues were absolutely and unconditionally assigned to it and were therefore its property and not part of the bankruptcy estate. LaSalle also sought a ruling terminating the automatic stay.

The applicable provision in the deed of trust stated that "Borrower absolutely and unconditionally assigns and transfers to Lender and grants to the Lender a security interest in any and all leases and other occupancy or use agreements . . . including, without limitation, room rents and room revenues, if any . . . " This provision further provided that, so long as no default existed, the borrower was granted a license to collect the rents and revenues from the property. The deed of trust also contained a separate clause that granted the lender a security interest in all of the right, title and interest of the borrower in any and all intangible property.

LaSalle argued that it had terminated the debtor's right to collect the hotel revenues by sending a termination letter to the debtor before the debtor filed its Chapter 11 petition.

The court first found that the hotel revenues were clearly property of the estate under 541(a) of the Bankruptcy Code ("Code"), which covers "fees, charges, accounts or other payments for the use or other occupancy of rooms and other public facilities in hotels, motels, or other lodging properties," and constituted "cash collateral" under

363(a) of the Code (which includes "payments for the use and occupancy of rooms").

The court stated that applicable state law would determine whether the room revenues had been absolutely assigned pre-petition. According to the court, "Tennessee [courts] distinguish grants of security interests and absolute assignments as two entirely distinct methods for creating credit against collateral which a party may borrow funds (citations omitted)." Id. at 14. The court further noted that "[u]nder Tennessee law an assignment of rents is presumed to be a pledge of rents as security (citations omitted)," and that "courts ordinarily are reluctant to construe assignments as absolute, especially when such a result fails to reflect the intent of the parties."

Id.. The court also stated the familiar rule that "ambiguous language in a contract is construed against the drafter." Id. at 18.

Examining the language of the applicable provision in the deed of trust, the court stated that even though the adverbs "absolutely" and "unconditionally" were utilized, "the same sentence must be read in the conjunctive since the language following the assignment reads '. . . and grants the Lender [Bank] a security interest . . .' in all rents and revenues." Id. at 18-19. Therefore, the court ruled, "the language seems to reflect an intent to create a security interest." Id. at 19. The court in effect ruled that LaSalle could not have it both ways, i.e., the clause could not state on the one hand that the assignment of rents and revenues was absolute and unconditional, and yet also state that it was intended to secure a debt. The court further noted that -- unlike other cases where absolute assignments of rents and revenues were upheld -- the assignment was not contained in a separate and independent document and did not contain clarifying language to the effect that it was "not an assignment for additional security only."

Id. at 21 (citing In re Kingsport Ventures, L.P., 251 B.R. 841, 848 (Bankr. E.D. Tenn. 2000)).

The court further found that the language in the deed of trust did not provide for automatic termination of the debtor's license to collect rents in the event of default; rather, the clause provided that LaSalle had the right "to terminate the aforesaid license granted . . . and to enter upon the premises." The court construed this language as requiring LaSalle to take "affirmative action" in the event of default to terminate the lease. According to the court, "[t]he language here indicates that a prerequisite to the right to collect the rents is entry upon the premises, and a true or absolute assignment should clearly demarcate that a creditor is entitled to the rents without the requirement of re-entry." Id. at 22.

Finally, the court held that, by virtue of language in the deed of trust stating that upon payment in full of the debt LaSalle would have no further interest in the rents and room revenues, the debtor had retained a reversionary interest in the rents and revenues and this "release" provision indicated that "the assignment provides additional security for the indebtedness, not an absolute assignment." Id. at 23. Therefore, after considering the "totality of the circumstances" and applicable state law, the court ruled that the assignment in this case failed to constitute an absolute assignment.

The court also rejected LaSalle's motion to terminate the automatic stay, ruling that the debtor had established that the property was necessary for an effective reorganization and that LaSalle's security interest was adequately protected based on the equity in the property, sufficient insurance in effect on the property, and the fact that the debtor had obtained a letter of intent for a sale of the property for $4 million, which would satisfy in full the debt owed to LaSalle.

Reporter's Comment 1: This outcome is unsurprising, based on the language in the assignment-of-rents provision in the deed of trust and the oft-stated reluctance of courts to construe assignments as absolute and thus deprive the bankruptcy estate of much-needed cash. (The court in this case specifically mentioned its "conscious objective of preserving the Debtor's ongoing business." Id. at 26. The court also noted that the rents and revenues from the property "represent the Debtor's sole source of funding to operate the hotel and to continue to administer the Chapter 11 estate." Id. at 25).

Reporter's and Editor's Comment 1: The court in 5877 Poplar, however, may be offering a potential "roadmap" of actions a lender conceivably could take to enable a court to uphold the validity and enforceability of an absolute assignment of rents, even where no action has been taken to seize them. The court mentions the relevant "factors in analyzing a purported absolute assignment as constituting a pledge of rents as: 1) the failure to clearly express the assignment as absolute and unconditional; 2) use of the term "additional security" before the rent assignment clause of the document; and 3) the failure to provide distinct headings or separate paragraphs denoting the assignment apart from the collateral securing the indebtedness" (citing Randy Rogers, Assignment of Rents Clauses Under California Law and in Bankruptcy: Strategy for the Secured Creditor, 31 Hastings Law Journal 1433, 1453 (1980)). In re 5877 Poplar, supra, 2001 Bankr. LEXIS 1233 at 14. To understand this issue adequately, perhaps a little "primer" is necessary concerning the recent history of this issue:

Reporter's and Editor's Comment 2: During the 1970's and 80's, a significant dispute arose as to whether assignments of rents that had not been "activated" prior to bankruptcy could be avoided as "unperfected" when bankruptcy was filed. The Bankruptcy Reform Act of 1994 ("Reform Act") amended 552 of the Code to provide that, for bankruptcy purposes, a lender's pre-petition security interest in rents will apply to post-petition rents to the extent provided in the security agreement even if some additional action other than recording (such as written notification to tenants, the appointment of a receiver, or taking possession of the property) is normally required of a secured creditor under applicable state law to perfect its interest in the rents prior to the bankruptcy filing.

Section 552, as amended, provides that hotel revenues, whether designated as fees, charges, accounts, or otherwise, that are subject to a pre-petition security interest are expressly considered cash collateral and, therefore, may not be used by the debtor without the lender's consent. Although this section essentially creates a federal law of perfection for rents and makes state law requirements regarding perfection inapplicable, it does not make such state law requirements irrelevant. To determine the extent of the creditor's post-petition security interest in the rents, one must still review applicable non-bankruptcy law as well as the creditor's agreement with the debtor.

Cash collateral is cash or cash equivalents that the debtor receives in which the lender has a security interest. Thus, the debtor is restricted from using the cash unless the lender consents to such use or the court finds that the lender's security interest in the cash is adequately protected. When a lender has previously recorded a mortgage or assignment of rents, the cash should be the lender's collateral in most real estate bankruptcy cases. State law regarding perfection is now inapplicable if the debtor and creditor entered into a pre-petition security agreement covering rents from the debtor's property and if the agreement was properly recorded.

Left unresolved between and within the states is the issue of whether possession (or some other affirmative action, such as the appointment of a receiver) is a method of perfection (in addition to recordation) or of making a perfected lien "choate," that is, whether possession is necessary to enforce or activate the lien so that the lender is entitled to collect the rents. The perfection of a lien places third parties on notice that the lender has an interest in the rents that is superior to that of other secured creditors. Perfection thus establishes priority but not a determination as to title and the right to possession of the rents, as between the parties, to the recorded security instrument. In Illinois, for example, perfection is attained through recordation, obtaining possession through foreclosure proceedings, or obtaining a recorded notice of foreclosure that provides constructive notice of a lien on the property. See, e.g., In re Century Inv. Fund VIII Ltd. Partnership, 937 F.2d 371 (7th Cir. 1991); Jones v. Salem Nat'l Bank (In re Fullop), 6 F.3d 422, 430 (7th Cir. 1993). The Illinois cases uniformly recognize, however, that a mortgagee must either obtain the appointment of a receiver, obtain possession of the property through foreclosure or a deed in lieu of foreclosure or obtain an injunction or other court authorization to enforce or to activate the mortgagee's perfected right to collect the rents from the mortgagor. Other jurisdictions also require that the mortgagee, in addition to the recording of the mortgage or the assignment of rents instrument must take certain steps, before it will be entitled to collect the rents from the property.

Lenders occasionally argue that an assignment of rents worded as a present assignment gives the lender an "activated" right to the rents regardless of whether any action has been taken to seize them. The issue might come up in an effort by a lender to seize rents accumulated in a rents fund or to restrict the expenditure of monies in such a fund for operating purposes. State courts and federal bankruptcy courts may -- and often do -- hold that an "absolute" assignment of rents is in fact a security interest for the debt and can only be exercised upon a subsequent default by the borrower, because such an "absolute" assignment of rents was never intended to transfer absolute ownership of the rents as of the date that the mortgage and assignment of rents were executed; rather, it either became effective only upon a subsequent default by the borrower or else it involved a "revocable license" in favor of the lender, such revocation occurring upon a loan default.

For public policy reasons (as evidenced by the court's holding in 5877 Poplar, supra), courts historically have been generally reluctant to construe an assignment-of-rents clause or document as absolute. See, e.g., In re Century Investment Fund VIII Ltd. Partnership, supra, 937 F. 2d at 377 ("although unambiguous provisions granting entitlement to rents immediately upon default are upheld, the Wisconsin courts have disapproved of such clauses, since they afford an easy way of avoiding the state's lien theory of mortgages and of taking legal title and right of possession from the mortgagor"); In re Harvey Road Associates VIII , 140 B.R. 302, 304 (Bankr. D. Mass. 1992) (ruling that an assignment with the grant of a license back to the mortgagor to collect the rents until a default occurs under the loan documents "creates the functional equivalent of an equitable mortgage applied to rents, and . . . the assignee's rights are conditional and not absolute"); In re McCann, 140 B.R. 926, 927 (Bankr. D. Mass. 1992) (holding that Ohio law does not recognize an "absolute" assignment of rents). These court decisions often require some action to "activate" the rents assignment Regardless of the wording or characterization in the assignment-of-rents document,

Prior to passage of the Reform Act, however, some jurisdictions had upheld the validity of such absolute assignments. See, e.g., FDIC v. International Property Management, Inc., 929 F. 2d 1033, 1038 (5th Cir. 1991) (holding that an assignment-of-rents document stating unambiguously that the assignment "is intended to be absolute, unconditional and presently effective" indicated an intent that the mortgagee should have the right to the rents immediately upon default and constituted an absolute assignment of, as opposed to a security interest in, the rents); In re Century Inv. Fund VIII Ltd. Partnership, supra, 937 F. 2d at 378-380 (finding that where the assignment-of-rents document provided for an absolute assignment of all rents and leases upon a default by the mortgagee, under applicable state law (Wisconsin) the mortgagee's lien on the rents arose upon the mortgagor's default and the pre-petition filing of the foreclosure proceeding perfected this lien); Homecorp v. Secor Bank,

659 So. 2d 15, 20 (Ala. 1994) ("[w]here there has been an absolute assignment of the rents, the assignee has the right to demand the rents from the tenant or from the assignor"); In re Dacey, 80 B.R. 206, 209-210 (D. Nev. 1987) (holding that because both the mortgagor and mortgagee had agreed that the assignment of rents provision was "absolute," it was immediately enforceable upon the mortgagor's default); cf. In re Geary's Bottled Liquors, Inc., 184 B.R. 408, 413 (Bankr. D. Mass. 1995) (ruling that an "absolute" assignment of rents, although conditioned on a default by the mortgagor, is still an absolute assignment, and noting that "if this case had been filed after October 22, 1994, both rent assignments might have been validated by 11 U.S.C. 552(b)(2), as added by 215(a) [sic] of the Bankruptcy Reform Act of 1994 . . . which is effective on that date").

The Reporter is of the view that Section 552(b) of the Code, as amended by the Reform Act, is intended (among other things) to prevent a lender from claiming that merely by describing its pre-petition interest in the rents as "absolute" in a mortgage or separate assignment-of- rents document, the debtor no longer has any interest in the rents after the bankruptcy filing. The focus in bankruptcy cases is now on the determination of whether the creditor has a valid lien on post-petition rents by virtue of an unavoidable pre-petition lien on the real property that generates the rents. Thus, 552(b) (hopefully) now eliminates lenders' arguments -- which formerly prevailed in some jurisdictions -- that because assignments of rent were "absolute" under the applicable state law, borrowers no longer had any interest in them when bankruptcy proceedings were commenced even though no enforcement or collection actions with respect to such rents had been commenced by the lenders.

The Editor concurs with the Reporter's views, but believes under state common law existing even prior to the Bankruptcy Reform Act, there was little merit to the argument that an assignment worded as "absolute" should be viewed as "activated" by that language even when the debtor was permitted to collect and utilize the rents in the conduct of its business.

Editor's Comment 1: For some evidence that the wisdom of the Reporter's and Editor's views, set forth above, is not universally recognized, see the bizarre decision in Millette v. E.B. Inc., 1999 WL 6422208 (5th Cir. 8/24/99) (The DIRT DD for 9/8/99) (giving mortgagee priority claim to rents as against garnishor prior to any activation); MacArthur Executive Associates v. State Farm Life, 190 B.R. 189 (D.N.J. 1995) (The DIRT DD for 5/6/96), following,m after the adoption of the Reform Act, the Third Circuit views expressed in In re Jason Realty, 59 F.3d 423 (3d Cir. 1995) to the effect that absolute assignments create possessory claims in the mortgagee as to rents accruing both before and after bankruptcy). Also see Broadcast Music, Inc. v. Hirsch, _____ F.3d. _____ (9th Cir.

1/15/97) [Nos. 95-56144, 95-56185], the DIRT DD for 4/7/97 (which may also mirror the Jason rationale.)

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

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