Daily Development for Wednesday, September 8, 1999

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

BANKRUPTCY; ASSIGNMENTS OF RENTS; PERFECTION: Fifth Circuit rejects earlier interpretations of Mississippi law and concludes that an assignment of rents contained in a recorded mortgage is "perfected" as a matter of state law for purposes of priority against garnishors of the rents, *even as to rents accruing prior to any default by the mortgagor.*

Millette v. E.B. Inc., 1999 WL 6422208 (5th Cir. 8/24/99)

Although the opinion is byu the highly respected Edith Jones, and editor concludes the opinion is not only wrong, but seriously mixes the concepts of "perfection" and "activation." This is not a bankruptcy case, but the confusion here could spill over into subsequent Fifth Circuit bankruptcy decision.

The mortgagee here had a relatively standard assignment of rents clause assigning rents "as additional security" to the creditor, reserving in the debtor the right to collect the rents prior to default.

Before there was any default on the mortgage, a judgment lienholder sought to garnish the rents The mortgagee intervened in the garnishment action, arguing that it was perfected in its lien on the rents and had priority to all accrued rents from the time of such recordation.

Prior district court cases in Mississippi had held that the assignment of rents creates an "inchoate interest" that must be activated by some action of the mortgagee before it has priority as against other creditors.  The court distinguished these cases by holding that they were not based upon Mississippi law and, in any event, stated the "old" approach to priority of rents assignments.

Under the new approach, according to the court, a rents assignment "is effective as against the morgagor and, subject to the operation of the recordin act, as against third parties, upon execution and delivery." No activation of the rents interest is necessary. The court cites Section 4.2(b) of the Restatement (Second) of Property Mortgages (1997). It certainly means the Restatement (Third), which is the first and only Restatement edition on mortgages, published in 1997.

The rationale for the result, according to the court, is the perceived unfairness that would result when a mortgagee is unable to activate a rents interest and thus suffers as against third party claimants:

   "Under the prior approach, a mortaggee with a lien on rents or an   assignment of rents clause will nearly always lose a priority battle   with ajudgment creditor when the debtor has not defaulted on its   payments under a mortgage. A judgment creditor can perfect its   interest at any time by properly serving a writ of garnishment,   while a mortgagee is prohibited from taking the requisite   "additional action" to perfect until the debtor has defaulted. The   leads to a bizarre result: A mortgagee, which has done all it could   to secure its interest in the rents, loses priority to a judgment   creditor who had constructive knowledge of the recordation of the   mortgagee's assignment of rents."

Comment 1: The case is wrong on the interpretation, wrong on the policy, and wrong on the result. All of this likely results from a laudable aim to get rid of old authority at the District Court level that suggested that a mortgagee is not "perfected" until activated, and thus is subject to the strongarm power of a trustee in bankruptcy. This issue has been thoroughly discussed on these pages in the past and by the editor in several law review articles. Clearly, from the standpoint of bankruptcy law, and from the standpoint of perfected priorities in general, recordation of the assignment of rents is enough. But that conclusion does not lead to the further conclusion that the mortgagee has an "activated" interest in rents from the moment of foreclosure, even where the mortgage provides otherwise. Neither the facts of this case, nor the Restatement, nor good policy, compel the latter conclusion.

Here the result should have been that the rents collected prior to activation of the assignment by the mortgagee should have belonged to the garnishor, but that the garnishment should not have created any priority in the garnishor as to rents accruing thereafter.

Comment 2: The court justifies its contrary result by arguing that mortgagees otherwise are left with no ability to protect themselves against garnishment of rents by judgment creditors. This is demonstrably untrue. A mortgagee actually can collect or control rents from the outset of the mortgage relationship through a "lockbox" arrangement. The "lockbox" would create a fund in which the mortgagee has an actual security interest as of the moment the rents are paid, free of claims of junior creditors. Mortgagees frequently are doing exactly this. Not all mortgagors will agree to the arrangement, and the issue can be heavily negotiated. But mortagagees are not without a solution to the problem posed by the court.

The mortgagee clearly opted not to use a lockbox here. The mortgage provided expressly that the "Debtor can have the right to collect and retain the rents as long as the mortgage is not in default." The mortgage was not in default at the time of garnishment. If the debtor could have used the money for a trip to Aculpulco, who couldn't a legitimate judgmnent debtor garnish it?

Comment 3: The Restatement says nothing that compels the result reached by the court. The Restatement differentiates between the perfection of the rents interest as against third parties and the "activation" of that interest. Although Section 4.2 (b) of the Restatement indeed includes the language cited by the court and quoted above, Section 4.2 (c ) states that the mortgage can provide that the mortgagee's rights to collect and apply the rents shall be deferred until a given moment, such as default, and in that event "delivery of a demand for the rents" is necessary to activate the mortgagee's interest.

In this case, the mortgagor did not default, so the condition for activation of the rents interest did not arise, prior to the garnishment. After the garnishment, it is quite possible that the mortgage had provisions creating an event of default when a third party creditor established a lien on the security superior to that of the mortgagee, but at that time the mortgagee still would have had to send a notice in order to activate its claim under the Restatement. Probably it would also have had to send a notice of default under the mortgage as well.

The court here characterizes Mississippi as a "modified lien theory state," which usually means that where the mortgage is silent, the mortgagee can reach the rents immediately upon default. But the mortgage is not silent. It discusses the mortgagee's abilitity to reach the rents. As the Restatement notes, when the mortgagee has such a reserved right, it only makes sense that activation requires some affirmative act. See Restatement Section 4.2 Comment c. At the very least, the court should require such an affirmative act unless the mortgage clearly provides otherwise.

Comment 4: This case is now the subject of a certification petition to the Mississippi Supreme Court. The author urges Mississippi lawyers to seek clarification by the state court system. Creating an enforceable priority interest in rents when the mortgage provides expressly that the rents belong to the mortgagor prior to default is a bad idea it creates confusion, will lengthen the bargaining process for sophisticated parties who have some inkiling of what's going on here, and is unecessary in order to give lenders what the really need post default protection.

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