Restructuring

Contributed by David G. Litvack
If a lender has a security interest in all of a hotel borrower’s real property and obtains an assignment of rents from such property, do the lender’s security interests encompass revenues derived from the use of the hotel’s rooms (i.e., “room revenues”)?  A recent decision by the United States Bankruptcy Court for the District of Colorado held they do not and found that broad definitions of “rent” in loan documents may not include room revenue.
Background
In In re HT Pueblo Properties, LLC, the debtor owned a Ramada Inn encumbered by approximately $5.2 million of debt, including $3.1 million owed to its senior secured lender.  The obligation to the secured lender was secured pursuant to a security agreement, a deed of trust, and an assignment of rents.
The security agreement granted the lender a security interest in the debtor’s “collateral” defined as “furniture, fixtures, and equipment” and all “rents, monies, payments . . . arising out of . . . [the] disposition of any of the property described in th[e] Collateral section.”  The deed of trust and assignment of rents each stated that the lender possessed a security interest in rents.  The deed of trust defined “rents” as “all present and future rents, revenues, income, issues, royalties, profits, and other benefits derived from the [subject] Property”, and the assignment of rents defined “rents” as “all rents, revenue, income, issues, royalties, bonuses, accounts receivable, cash or security deposits, advance rentals, profits and proceeds from the Property.”
Shortly after the commencement of the debtor’s case, the lender sought to prohibit the debtor’s use of cash collateral to fund operating expenses.  The lender argued that because it held a perfected security interest in all of the debtor’s property – including an assignment of rents – any room revenues constituted cash collateral subject to such interest.  The debtor, however, argued that the relevant loan documents did not grant the lender a security interest in room revenues, and, therefore, pursuant to section 363(a) and section 552(b) of the Bankruptcy Code, the room revenues did not constitute cash collateral.
Section 552(b)(2) of the Bankruptcy Code permits a secured lender to retain a floating security interest in, among other things, postpetition rent and hotel room revenues acquired by a debtor after commencement of the case to the extent provided in a prepetition security agreement.  Accordingly, the lender argued that section 552(b)(2) expressly provides that, if a secured creditor’s prepetition security agreement extends to room revenues, the security agreement also extends to all such revenues acquired by a debtor postpetition.
The debtor, however, asserted that the operative loan documents, including the security agreement, were insufficient to create an enforceable security interest in room revenue.  Rather, the debtor argued that such documents were sufficient only to create an enforceable security interest in the debtor’s physical assets, and not room revenues.
Moreover, the debtor asserted that the assignment of rents was ineffective as to room revenues because any such assignment should have been recorded with the Secretary of State pursuant to Article 9 of the UCC, and not with the county clerk.  Article 9 of the UCC governs secured transactions where security interests are taken in personal property, whereas state real property laws govern security interests that are taken in real property, including security interests in leases or rents.  The lender asserted that it had complied with applicable recording requirements because room revenues are not personal property subject to Article 9 of the UCC, but rather “rents” which can be assigned and fall outside the scope of Article 9.
Analysis
Application of section 552(b) of the Bankruptcy Code
Under section 363(a), rents are considered cash collateral when they are “subject to a security interest as provided in section 552(b).”  At the outset, the HT Pueblo court noted that although the Bankruptcy Code gives special treatment to security interests in rents and room payments held by hotel operators, an enforceable security interest must still exist.
To determine if the lender possessed an enforceable security interest in the room revenues, the court looked at the definitions of “rent” contained in the relevant deed of trust and assignment of rents.  The court found that, although the language was fairly broad, it did not create a clear security interest in “fees, charges, accounts, or other payments for the use or occupancy of rooms and other public facilities in hotels, motels, or other lodging properties” as required by section 552(b)(2).
The court also noted that, under section 552(b), the security agreement is the instrument that must contain the key language and that ancillary documents (such as a financing statement) cannot establish the security interest in room revenues.  In HT Pueblo, the relevant security agreement granted the lender a security interest only in the proceeds from disposition of the collateral, not in the proceeds from the operation of the collateral.  The court found that revenues derived from operating a hotel did not constitute a “disposition” of property and, thus, did not fall within the definition of “collateral” contained in the security agreement.  Because the lender did not possess an enforceable security agreement in the room revenues, the court ruled that section 552(b)(2) did not apply, and the room revenues did not constitute cash collateral.
Analysis of Article 9 of the UCC
The court then held that, under Colorado law, room revenue constitutes personal property subject to Article 9 of the UCC, not an interest in real property (i.e., rents), which can be assigned pursuant to real property law.  The court noted that Article 9 of the UCC applies to all transactions that create security interests in personal property, regardless of the form of the transaction or the name that the parties give to it.  Accordingly, the court ruled that the lender’s assignment of rents was invalid as to the room revenues because room revenues are not real property subject to assignment.  The court disagreed with the lender’s position that section 552(b)(2) causes all hotel room revenues to become “rents” that can be assigned, by definition.  Although the court did not expressly state what the outcome would be if room revenue were deemed to constitute “rent,” it seems that the consequence of such a ruling would be that, at least in certain states, pursuant to an absolute assignment of rents, room revenues would not be property of a debtor’s estate available for use as cash collateral.  For example, in In re Jason Realty, L.P., the Third Circuit held that assigned rents were not property of the debtor’s estate where the relevant assignment agreement evidenced absolute assignment of title to the rents.
Conclusion
Although the HT Pueblo court cautioned that much of the decision was based upon the specific facts and Colorado law, there is much to take away from the decision.  Drafters of security agreements in connection with hotels must take special care to ensure that room revenues are brought into the purview of the applicable security agreements.  Importantly, drafters should also heed the warning of the HT Pueblo court that such specific language must be in the security agreement itself, and not just in ancillary documents.  Lastly, for those lenders seeking to perfect an absolute assignment of a hotel’s room revenues, any such assignment of room revenue may only give a lender an Article 9 security interest in such revenues.  Simply designating room revenues as “rent” in an assignment of rents likely will not allow a lender to draft around Article 9 of the UCC to obtain more favorable state law real property rights.