Daily Development for Monday, November 1, 2004
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

MORTGAGES; ASSIGNMENTS OF RENTS: What's up with the Uniform Assignments of Rents Act?

Your editor is on the road again, returning from a two day meeting to work on the draft of the Uniform Assignments of Rents Act - a new drafting project proposed to NCCUSL by the Joint Editorial Board on Uniform Real Property Acts, a Uniform Laws support group co-sponsored by various groups interested in real estate law reform: the ABA Section on Real Property, Probate & Trust Law and the American College of Real Estate Lawyers, the Community Associations Institute and the American College of Mortgage Attorneys. Those who find distasteful knowing "how sausage is made" can stop here, 'cause we're gonna talk about where the proposed law now stands and why.

The JEB proposed this drafting project not because there isn't already state law on assignments of rents, but because there is a lot of pretty poor law - both statutory and common law - and there was a perception that a cleaner, well thought out approach that took into account current bankruptcy issues would be a welcome tonic. Without a doubt, the statute would provide direct benefits primarily to real estate secured lenders, who would have greater clarity and certainty in perfecting and enforcing their interests. The benefit to borrowers is that a happy lender is easier to deal with, at lower cost, than one constantly worried about little nits and nats of uncertainty in the background law.

The Committee's work is not done. It will have one more meeting with Reporter Wilson Freyermuth, a professor at Missouri/Columbia (visiting at North Carolina) before a final draft is submitted to NCCUSL in August. But most of the difficult issues appear to be resolved (subject always to last minute surprises); and here's a summary.

The first major question the drafters addressed is what constitutes "rents" covered by the Act. This is a more difficult issue than one might think. Of course, we all know that rents include monies payable in exchange for a temporary (less than perpetual) right of possession of real estate. But what about situations where the primary consideration is paid not for possession but for what might be called "non-possessory occupancy," such as kiosks in shopping centers, boat slips and anchorages, small telecommunications equipment mounted on rooftops, and billboards? If these interests are not defined by state law as "rents," the lender's security interest might not be recognized as surviving through a bankruptcy filing under Bankruptcy Code Section 552b, which applies expressly to rents, but not other future income of the bankrupt. Further, the committee felt that most in the real estate industry view these types of interests as in the nature of rents. Consequently, the draft de!
rents as including not only monies paid for possession but also for the "occupancy" of real estate.

Then there's the question of hotel revenues. Here, the bankruptcy code has been amended specifically to address security interests in these revenues as surviving bankruptcy, but still it is important that there be clarity as to what kind of filing needs to occur to perfect security interests in these revenues - real property filings or UCC filings? The committee concluded, again, that the trade was of the view that assignments of real estate rents applied to these interests, although there was general acknowledgment that careful lenders filed their rent assignments both in the land records office and the UCC records. The draft Uniform Act makes clear that these interests also are treated as "rents" for occupancy.

On the other hand, other revenues received by real estate operators that are paid primarily in exchange for the provision of services on the property rather than for the use of the property itself, such as fees paid for various services provided in a full service hotel (such as room service or visits to a spa), boat rentals, and similar revenues are not treated as rents. The Committee rejected the broader concept that "rents" should include monies paid for the "use" of real estate in addition to "possession" and "occupancy." The comments to the definition section will provide a "laundry list" of interests that are covered and not covered. The idea was to track, to the greatest possible extent, accepted industry notions of what are personal property and what are real estate rents.

The statute then goes on to tie down the perfection issue, stating that recording of a rents assignment in the real property records makes that interest "perfected," which is the magic concept by which the Bankruptcy Code determines whether such interests will be recognized in bankruptcy. The statute indicates that perfection occurs regardless of whether "activation" of the interest will ever occur and regardless of whether it occurs prior to the bankruptcy filing and whether or not it is for security purposes.

As to the activation event, the statute provides a range of options for the rents assignee. Activation may occur through notice to the assignor (borrower/landlord), demanding that it pay over rents as collected, but the assignee can also go directly to the source and file a demand on the tenant. Once the tenant receives the notice, with all the detail that the statute provides (including advice to seek a lawyer if there is confusion), the tenant pays the landlord at its peril. Its rent obligation is not satisfied by wrongly paying rents over to the landlord. The only exception has to do with tenants occupying the premises as their primary residence. The drafters concluded that it as inappropriate to put such parties to a choice as to who to pay with their home occupancy at stake. Payment to either party satisfies the rent obligation in this case, and Professor Freyermuth is drafting language dealing with the assignee's notice to the landlord’s management agent.

The Act makes clear that activation by notice does not, in and of itself, make an assignee a mortgagee in possession, but really doesn't absolve the mortgagee of the danger of falling into this status by taking other steps to manage or enhance rent collection through actions more consistent with possession, such as carrying out work on the property, threatening tenants with eviction, etc.

As to a receiver, the statute makes clear that the existence of a stipulation for a receiver in a rents assignment is an independent basis for equitable discretion to appoint a receiver, even when the value of the property exceeds the unpaid loan balance. This is consistent with the notion espoused by the Act that the rents interest created by an assignment constitutes a separate form of additional security, and not simply an aspect of the mortgage on the underlying real estate. An unresolved issue is whether the Act can or should dictate that a court *must* appoint a receiver where the existence of a binding assignment is shown. Your editor is concerned that this raises questions of balance of powers for one thing and that in any event it inappropriately meddles with equitable discretion of the court, which often provides a desirable “play in the joints.” We’ll talk more about this at the next meeting.

The Act does not apply to the situation where the mortgagee takes possession directly for the purpose of collecting the rents, since in many jurisdictions this right is available at common law or by statute without the existence of an assignment of rents. The Act concerns itself only with actions taken to enforce rents assignments.

Certainly the most fireworks in this drafting project were expended over the issue of whether the assignee that collected rents as a "straight assignee" had any obligation to maintain the property. Many on the committee were originally of the view that for the assignee to collect rents that the tenants were paying in exchange for expected services, without the assignee having any duty to perform these services, seemed unfair. (Traditionally, all rents, including CAM charges and other rents “earmarked” for special purposes are picked up in a standard rents assignment.) The editor and others pointed out that the law today gives the mortgagee discretion to apply such collected rents directly to the debt, but that tenants who have economic power can "bargain out" of this situation by bargaining for a rent withholding right or otherwise, and also that the rule probably doesn’t apply to permit the assignee to avoid the implied warranty of habitability. Further, the tenants stil!
l have
an action in damages with the landlord, who would be the party that agreed to provide the services and the party primarily responsible for their not being provided to the tenants.

Some found unsatisfactory the answer that the tenant could always bargain for better treatment, noting that many commercial tenants are"mom and pop" operations who lack the clout or sophistication to bargain for protection from the mortgagee's rights. They also were unhappy with the answer that this situation reflects existing law, believing that NCCUSL should not condone a situation that they viewed as fundamentally unfair. Ultimately, however, they became convinced that the small tenant were weak simply because of their position in the marketplace, and that ways proposed to help them - by imposing duties on assignees to spend rents to perform lease covenants or maintain the real estate - would, if enacted, result in a destruction of the freedom of contract principle (which in turn would undermine the entire commercial lending process), make the deals more cumbersome to carry out, and in the end provide no real benefits to the “moms and pops.” Perhaps more to the point, it!
was n
oted that the only logical supporters of law reform in this area are lenders, and lenders are unlikely to push hard for the adoption of legislation that diminishes their existing security interests. So language helpful to tenants in these cases likely would never see the light of day in any event, and the drafting effort would be a waste of time.

Finally, those with reservations concerning giving the mortgagee continued freedom to apply the rents to the debt, rather than to the maintenance of the property, were convinced by the argument that the percentage of cases where this really occurs is very, very small. The vast majority of lenders move quickly to get a receiver appointed to collect rents and manage the property. Receivers, as neutral stakeholders, have an obligation to spend the rents to maintain the value of the rents and real estate security, and this includes servicing the lease obligations that generate these rents as well as other maintenance. Mortgagees tend to do this because otherwise they are exposed to liability as mortgagees in possession if they take any act to preserve the property or keep the tenants there (or, for that matter, if they evict unsatisfactory tenants). Consequently, most mortgagees collect under an assignment only for the brief interim period prior to get the receiver appointed. F!
, most lenders who do take under an assignment without using a receiver are likely to expend monies to maintain the property and even service the leases because it is in their best interest to do so.

After discussing all of this at considerable length over the bulk of three meetings, the Committee approved language that preserves the landlord's rights to receive the rents and apply them only to pay the debt, consistent with the terms of the rents assignment. Landlords need not pay out of rents any costs of maintenance or preservation of leases. But the statute does provide that if the parties do not agree otherwise, tenants preserve legal rights that might arise from the failure of the landlord to perform, rights that might including rent offset (in isolated cases) or recoupment.

Further the statute states specifically that the Act does not preclude any right a tenant might have to obtain an equitable receivership itself to collect and apply the rents. Under what circumstances might an tenant be able to seek a receivership? Consider the case where the rent includes a component that consists of "CAM" charges or other, similar charges specifically earmarked for the payment of taxes, insurance or maintenance costs. Even though the assignment expressly permits the lender to seize these rents without applying them to their intended purpose, a court of equity might view this situation as inequitable, and respond by appointing a receiver with instructions that might protect tenants in this situation to some degree. At present, the Act does not contain any language that defines when a court should act in this area, and no one on the Committee was aware of any precedent other than in the implied warranty of housing area.

Comment: The editor has served on two other NCCUSL drafting committees, and continually is amazed at how hard the commissioners and advisors on these committees work to identify the various interests that might be affected by their project and to resolve in advance any conflicts that might block the process of putting out an act that will enjoy a welcome reception at various state legislatures. Unlike, for instance, the ALI process resulting in a Restatement, the ultimate value is to produce clear, easily accepted legal rules that make business work better, rather than the pursuit of a particular reporter's or committee's view of what rules would make the world more "just and equitable." The NCCUSL groups do not view themselves as having a monopoly on the concepts of "justice:" and "equity," and recognize that different interest groups tend to define these concepts in ways that suit their best economic interests. The NCCUSL groups with which the editor has worked instead, !
try to
find non-ideological compromise solutions that really make difficult situations work better. (There was recently an ALI/NCCUSL flap about some UCC provisions dealing with software sales, and the Editor was not a commissioner at the time all this went down and makes no comment about where the right side was on that one.)

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