Contributed by Rich Mullen
We can all remember the sage advice of our elders – whether we actually ever listened is another story. Judge Lane from the Bankruptcy Court for the Southern District of New York recently reminded us of one of those important lessons – actions speak louder than words – by concluding that both pre- and postpetition rents from real estate owned by the debtor were not property of the debtor’s estate because a lender took sufficient affirmative steps to enforce its right to the rents under an “absolute” assignment of the rents.
In Soho 25 Retail, the debtor owned certain units that operated as prime retail space in downtown Manhattan. As is typical with commercial real estate financing, the debtor’s lender obtained a mortgage on its property and an assignment of leases and rents. The assignment was drafted as an absolute assignment of rents, with the lender granting a “license” to the debtor borrower to collect and use the rents until the occurrence of an event of default. Of course, once the lender’s loan was repaid, the borrower would have the unfettered right to the rents.
After the debtor defaulted on its loan, the lender sent the debtor a notice of default and terminated the debtor’s license to collect rents. The lender also notified all the debtor’s tenants that rent should be paid directly to the lender. Additionally, the lender initiated a state court foreclosure action and requested the appointment of a rent receiver. After entering a default judgment, the state court appointed a rent referee, who issued a report and directed the referee to sell the property. The debtor, however, commenced its bankruptcy case before the public auction.
In the debtor’s chapter 11 case, the debtor and the lender vigorously disagreed about the legal effect of the assignment. The debtor argued that, under New York law, an assignment of rents is not self-executing and does not become effective until a lender affirmatively asserts its rights to those rents, which it claimed the lender had failed to do. On the other hand, the lender argued that the assignment agreement was absolute and self-executing, and, therefore, the lender was not required to take any affirmative steps to enforce its rights to the rents. Alternatively, the lender argued that it had taken sufficient affirmative steps to protect its interest in the rents.
Notwithstanding that the clear purpose of the assignment of rents was to provide security for the lender’s loan, Judge Lane concluded that the language of the assignment agreement indicated that the parties intended the agreement to be an absolute assignment and that the assignment agreement provided the debtor with nothing more than a revocable license in rent that was revoked after the debtor defaulted under the loan agreements. In reaching this conclusion, the Bankruptcy Court relied upon, among other things, language stating that the assignment was absolute, was intended to be unconditional, and was not just an assignment for additional security. The Bankruptcy Court also relied on language indicating that the lender would have full power to demand, collect and receive any and all rents as a result of the debtor’s default. Judge Lane rejected the debtor’s arguments that other language stating that the assignment was being given as an additional security demonstrated that the assignment agreement was meant only as security for the underlying mortgage.
Although Judge Lane quoted Chief Judge Arthur J. Gonzalez for the proposition that “New York law is, at best, unclear on the topic of whether an absolute assignment of rent transfers title to the rent upon execution of the instrument,” he concluded that “the majority of New York state cases are of the view that an absolute assignment is not permitted, regardless of the language of the agreement.” In fact, treatment of an absolute assignment of rents literally and not looking past the form of the agreement to its substance appears to be gaining increasing acceptance in New York bankruptcy courts, and the Third Circuit. At least one bankruptcy court, though, has looked at the language of section 541(a)(6), which specifically refers to “rents . . . from property of the estate,” and has concluded that federal bankruptcy law preempts state law on assignments of rents in determining whether rents constitute property of the estate. Other courts also have looked beyond the form of absolute assignments to conclude that postpetition rents were cash collateral of the lender, but still property of the debtor’s estate.
Soho 25 Retail does not address the effect of section 541(a)(6) or the “murky legal question” posed by Chief Judge Gonzalez because Judge Lane concluded that the lender had taken all the necessary actions following the event of default to make the absolute assignment of rents effective under New York law. The Bankruptcy Court indicated that neither the ultimate sale of the property nor actual possession was required. Instead, the lender’s commencement of the foreclosure action and the state court’s appointment of a referee were significant affirmative steps and, together with the lender’s application to seek relief from the automatic stay, were sufficient affirmative steps that entitled the lender to the rent. Accordingly, the Bankruptcy Court concluded that the rents were not property of the debtor’s estate and could not be used by the debtor to fund a plan of reorganization until the underlying debt was satisfied.
From a lender’s perspective, Soho 25 Retail certainly reaffirms that, where permissible under state law, an absolute assignment of rents with a license to the debtor to use the rents prior to a default provides the lender with significant protection. Indeed, if Soho 25 Retail is followed, such a structure might provide nearly complete control over a borrower’s fate once the assignment is effectively revoked. Although the lender in Soho 25 Retail had gone far down the path towards foreclosure before the debtor filed for bankruptcy protection, borrowers need to be concerned about what the “point of no return” might be where they will lose access to what may well be their only source of cash flow. One issue borrowers will have to consider is whether they should seek chapter 11 protection early in the process to bolster any argument that, even if Soho 25 Retail is followed, the lender did not take sufficient steps to divest the borrower of its interest in rents. It remains to be seen how bankruptcy courts will resolve the “murky legal question” concerning the enforceability of an absolute assignment absent sufficient affirmative steps being taken by a lender.