Daily Development for
Thursday, February 18, 1999

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

The following contribution is from Jim Stillman of Los Angeles, the reporter on bankruptcy matters for the ABA Quarterly Report:

BANKRUPTCY; UNDERSECURED CLAIMS; APPLICATION OF RENTS; DEBTOR'S ATTORNEY'S FEES: When the secured creditor's bid at the foreclosure is equal to the value of the collateral according to the Bankruptcy Court's previous valuation under section 506(a), in connection with the debtor's failed plan of reorganization, but still less than the secured debt, the creditor may apply rents collected in a rent fund to the debt and the debtor has no right to apply "excess" rents held by a receiver to payment of its attorney's fees.

In re 1441 Veteran Street Co., 144 F.3d 1288 (9th Cir. 1998).

"When the purpose behind a particular valuation no longer exists, that valuation becomes irrelevant," the Court of Appeals wrote (p. 1991). Therefore, the determination that the creditor held a secured claim for only $10.1 million of its $13 million loan was not binding on the question whether the creditor had been "paid in full" at the foreclosure sale. The creditor is entitled to have rents applied to the full amount of the debt after the stay is lifted. There was no reason here to depart from the general rule that administrative expenses or the general costs of reorganization may not be charged against secured collateral.

Reporter's Comment: Once again, the question of what to do with postpetition rents generated by "undersecured" mortgage collateral is fumbled from the bench, not once but twice (by a California Bankruptcy Court and District Court) before the Court of Appeals throws a flag on the play.

The rule should be that the net rents must be accounted for as the undersecured creditor's collateral. As each dollar is collected, the value of the security increases; therefore, rents may not be spent as "free cash" to pay debtor's counsel barring extraordinary circumstances, nor may rents be applied to reduce the principal of the undersecured claim. This is true whether the rents are collected during the case or after relief from stay; whether the 506 valuation is made at the beginning, middle or end of the case; and whether the purpose of the valuation is sale, use or reorganization.

The result here would have been different had the creditor credit bid the full amount of its debt ($13 million) at the sale; under California law, the creditor would be deemed to have satisfied the debt in full, and the creditor's security interest in the rents would have been extinguished.

Editor's Comment: As Mr. Stillman points out, the problem for the creditor is that bankruptcy laws do not give the undersecured creditor "adequate protection" in the form of interest on an undersecured debt. But, in cases in which rents form a part of the security, as rent payments continue to accrue, the amount of security available to the creditor will increase. If this process continues, the debt could become oversecured, in which case the debt should then accrue interest in bankruptcy.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1 - 6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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.