Ae06 Assignment Of Rents

The U.S. Court of Appeals for the Sixth Circuit recently concluded that Michigan’s assignment of rents statute sufficiently deprived the assignor of the ownership of the rents such that the rents could not be included in the assignor’s bankruptcy estate.

The primary issue before the Court was whether Michigan’s assignment of rents statute allowed the assignor to retain sufficient rights in the rents for the rents to be included in the assignor’s bankruptcy estate.  The bankruptcy court determined that the debtor’s assignment of the rents gave the assignee a security interest in the rents but did not change the ownership, and the assignor still maintained a property interest in the rents even after the assignment.

The Sixth Circuit disagreed, concluding that an assignment of rents, if recorded and a default occurs, is a transfer of ownership rights in the rents and the assignor no longer has an interest in them.

A copy of the opinion is available at:  Link to Opinion.

The appellant debtor owned a multi-unit residential complex, and it financed the construction of the building with a $5.3 million loan that was later assigned to the appellee creditor.  The loan was secured with a mortgage and an agreement to assign rents to the creditor in the event of default.

In the agreement to assign rents, the debtor “irrevocably, absolutely and unconditionally [agreed to] transfer, sell, assign, pledge and convey to Assignee, its successors and assigns, all of the right, title and interest of [debtor] in . . . income of every nature of and from the Project, including, without limitation, minimum rents [and] additional rents . . . .”

The agreement purported to be a “present, absolute and executed grant of the powers herein granted to Assignee,” while simultaneously granting a license to the debtor to collect and retain rents until an event of default, at which point the license would “automatically terminate without notice to [debtor].” Rents from the residential complex are the debtor’s only source of income.

The debtor ultimately defaulted on the loan, and the creditor sent a notice of default. The notice complied with the terms of the agreement and with Mich. Comp. Laws § 554.231, which allows creditors to collect rents directly from tenants of certain mortgaged properties. The following day, the creditor recorded the notice documents in Macomb County, Michigan, completing the last step required by the statute to make the assignment of rents binding against both the debtor and the tenants of the property.

Within a month of recording the notice documents, the creditor filed a complaint against the debtor, and requested the appointment of a receiver to take possession of the debtor’s property.  Approximately one week later, the debtor filed for Chapter 11 bankruptcy relief. The parties reached an interim agreement to allow the debtor to continue to collect rents from the tenants of the complex, with $15,000 per month used to pay down the debt to the creditor and the remainder of the rents used for authorized expenses.

The creditor filed a motion to prohibit the debtor from using rents collected after the petition was filed. The debtor opposed the motion and pointed out to the bankruptcy court that the company would have no income to work with in its Chapter 11 reorganization plan if the rents were not part of the bankruptcy estate.

The bankruptcy court agreed with the debtor and denied the creditor’s motion. The bankruptcy court determined that the assigned rents qualified as cash collateral in the bankruptcy estate, meaning, under Chapter 11, that the debtor must provide “adequate protection” to the creditor before using the cash.

The creditor appealed to the trial court and argued that Michigan law established a transfer of ownership in the assigned rents from the debtor to the creditor. The trial court agreed with the creditor and vacated the bankruptcy court’s decision. The debtor appealed to the Sixth Circuit.

On appeal, the Sixth Circuit identified the issues as first determining the extent of property rights held by the assignor and assignee of rents under Michigan law, and then second was whether the rights retained by the assignor are sufficient for the rents to be included in the assignor’s bankruptcy estate.

The Sixth Circuit began its analysis by first evaluating the evolution of Michigan’s assignment of rents statute.  Originally, the traditional rule in Michigan was that an assignment of rents was unenforceable because it would interfere with a mortgagor’s right of redemption.  As a result, the default rule in Michigan is that an assignment of rents is unenforceable.

However, a statute enacted in 1925 created a right to assign rents for properties subject to trust mortgages.  Then, in 1953, Michigan enacted Mich. Comp. Laws § 554.231, which allowed the assignment of rents for additional categories of properties, including those “with any mortgage on commercial or industrial property.”

The Michigan statute specifically provides:

Hereafter, in or in connection with any mortgage on commercial or industrial property . . . it shall be lawful to assign the rents, or any portion thereof, under any oral or written leases upon the mortgaged property to the mortgagee, as security in addition to the property described in such mortgage. Such assignment of rents shall be binding upon such assignor only in the event of default in the terms and conditions of said mortgage, and shall operate against and be binding upon the occupiers of the premises from the date of filing by the mortgagee in the office of the register of deeds for the county in which the property is located of a notice of default in the terms and conditions of the mortgage and service of a copy of such notice upon the occupiers of the mortgaged premises. Mich. Comp. Laws § 554.231.

The statute also contains a provision addressing the validity of the assignment:

The assignment of rents, when so made, shall be a good and valid assignment of the rents to accrue under any lease or leases in existence or coming into existence during the period the mortgage is in effect, against the mortgagor or mortgagors or those claiming under or through them from the date of the recording of such mortgage, and shall be binding upon the tenant under the lease or leases upon service of a copy of the instrument under which the assignment is made, together with notice of default as required by [the above section]. Mich. Comp. Laws § 554.232.

According to the Sixth Circuit, under Michigan law, the assignor of the rents no longer has a valid interest in the rents “once an assignee has: 1) entered into an agreement to assign rents; 2) recorded that agreement; and 3) default has occurred,” because the assignee’s rights “are perfected and binding against the assignor.”  The Court cited to several Michigan cases for the general proposition that the assignment of rents is a complete transfer of ownership so long as the three requirements have been met.

One of the cases the Sixth Circuit relied on was from the Michigan Court of Appeals, in which that court held that a prior-perfected interest in assigned rents had priority over an interest held by a judgment creditor who sought to garnish rents. See Otis Elevator Co. v. Mid-America Realty Investors, 522 N.W.2d 732, 733 (Mich. Ct. App. 1994). The Sixth Circuit emphasized the holding from that court that the judgment creditor could not garnish the rents because the assignor no longer had an ownership interest in them.

The Sixth Circuit rejected the debtor’s argument that the statute only authorized the assignment of a security interest, not the ownership rights.  According to the Court, the language of the statute did not support such a narrow interpretation and courts interpreting the statute have consistently concluded that the statute authorizes the assignment of ownership of the rents.

The Court also referenced the broad language in the debtor’s assignment agreement that “irrevocably, absolutely and unconditionally” transferred the debtor’s right in a “present, absolute and executed assignment of the Rents and of the Leases” from the debtor’s property.  The court concluded this language evidenced the debtor’s intent to transfer ownership in the assigned rents.

Next, the Sixth Circuit rejected the debtor’s argument that it retained certain rights to the assigned rents.  The Court concluded that the language contained in Mich. Comp. Laws § 554.232 established that the rents were the property of the assignee during the discrete period from the time of the default until the time of potential future cure, if any.

Finally, the Sixth Circuit ruled that even though it is well-established that the scope of a Chapter 11 bankruptcy was designed to be broad, the assigned rents at issue could not be included in the debtor’s estate.  The Court referenced several bankruptcy court rulings interpreting Michigan law that concluded the assigned rents under Mich. Comp. Laws § 554.231 should not be included in the debtor’s estate.  The Sixth Circuit rejected the underlying bankruptcy court’s policy concern that removing the sole stream of income for a debtor would eliminate relief under Chapter 11, and concluded that Michigan law is clear on the issue.

Accordingly, the Sixth Circuit reversed the order of the bankruptcy court.

Q: What is the difference between a general assignment of rents and leases and a specific assignment of rents and leases, and when should I include them in my term sheet for a commercial real estate financing of an Ontario property?

A: In situations where a borrower owns real property in Ontario that either is or will be leased to third party tenants, a lender should consider obtaining either a general assignment of rents and leases or a specific assignment of rents and leases in addition to a mortgage on the secured property. Like a mortgage, an assignment of rents and leases should be registered against title to the subject property, and in addition, should be registered under the applicable personal property security legislation as the rents and leases that are being secured by the assignment fall within the definition of personal property under that legislation. [1]

An assignment of rents and leases, be it a general assignment of rents and leases or a specific assignment of rents and leases, provides a lender with two principal benefits which may be realized by the lender after an event of default:

  1. it permits the lender to receive the rent payments that the borrower/landlord would otherwise be entitled to, and this revenue stream from the tenants is a significant asset that should be secured; and,
  2. it permits the lender to step into the shoes of the borrower/landlord and exercise all of the rights and remedies available to the landlord to ensure that the full benefit and value of the lease is realized by the lender, which includes for example, the right to demand payment in the event of non-payment of rent by a tenant and to assign the lease to a purchaser in the event of a power of sale proceeding.

The only difference between a general assignment of rents and leases and a specific assignment of rents and leases is the revenue streams and leases to which they apply. A general assignment of rents and leases applies to all present and future rental income and leases in respect of a particular property. Once in place, a general assignment of rents and leases gives the lender a right to the rental income and the ability to exercise all of the rights of the landlord under a lease in respect of all leases of the property, including but not limited to any new leases, subleases or assignments of lease entered into after the assignment is granted and registered. In contrast to this, a specific assignment of rents and leases only applies to leases which are specifically listed in the document. In the event that any of the specifically listed leases expire or are terminated, and/or a new lease or sublease is put in place, the specific assignment of leases will not apply to this new lease or sublease and the lender will have no right to the rental income or rights resulting from the new lease or sublease.

In most lending situations, the lender will prefer a general assignment of rents and leases as it provides the most comprehensive security. The lender will have security over all rental income, and be able to exercise the rights of the landlord, regardless of who the tenants are in the future, or what leases the borrower has in place at the time of default under the terms of the loan or credit facility. However, where there is a principal or anchor tenant that represents a preponderance of the rental income, and/or the borrower objects to a general assignment of rents and leases securing all rents and leases as too broad a security interest, the lender may only be interested in securing the rental income and landlord rights associated with a specific principal or anchor lease, or a particular group of leases. In such a situation, a specific assignment of rents and leases may be a reasonable compromise position for a lender to adopt. Alternatively, in situations where multiple lenders are taking security in a particular parcel of real property, specific assignments of rents and leases allow the various lenders to divide the rental income and leases among themselves, with each lender only obtaining security in a specifically agreed upon lease or group of leases.

The above is a general overview of general and specific assignments of rents and leases.

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