Rents and Leases: Mortgagee Concerns

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1 Rents and Leases: Mortgagee Concerns Mortgagee underwrites the commercial mortgage loan based on leases and rents from those leases Issues What rights does the mortgagee have to collect rents as against the mortgagor? What is the priority of the mortgagee s right to rents as against other creditors, such a junior mortgagee, a judgment creditor, or the trustee in bankruptcy (if borrower files for bankruptcy)? Problem: in a state where foreclosure takes a long time, the mortgagor may engage in rent skimming (or milking the rents from the property) E.g., Borrower stops making its mortgage payment, but collects the rents and uses them for other purposes Lender wants to be sure that rents are being applied to reduce the debt Especially so if the property is underwater, given that commercial loans are often nonrecourse For this reason, a mortgage typically includes an assignment of rents and leases that purports to give the lender a security interest in the rents The Title Theory of the Mortgage Historically, a mortgage = a transfer of actual legal title to the mortgaged land (even if only to secure a debt) As title holder, mortgagee could exercise that right at any time, unless parties agreed otherwise in the mortgage Thus, if Mortgagor defaulted, Mortgagee could take possession of the land, collect rents, and apply them to the debt (i.e., under title theory, mortgage implicitly covered rents), even prior to the date of a foreclosure sale About 10 states still follow title theory of mortgages The Lien Theory of the Mortgage Most states have now adopted the lien theory Mortgage is only a lien ; no transfer of legal title (or legal right to possession) occurs until foreclosure sale Under lien theory, until foreclosure, mortgagee s right to the land is not possessory Thus, mortgagee has no implicit right to collect rents (absent mortgagor s consent or mortgagor s abandonment of property, p. 360, note 2) Thus, in a lien theory state, the mortgagee can only get a right to rents that accrue prior to foreclosure by contract (e.g., by taking an assignment of rents ) 1

2 9 203(f). The attachment of a security interest in collateral gives the secured party the right to proceeds provided by Section (a). Except as otherwise provided in this article and in Section 2 403(2): (2) a security interest attaches to any identifiable proceeds of collateral (a)(64). Proceeds... means the following property: (A) whatever is acquired upon the sale, lease, license, exchange or other disposition of collateral; Personal Property vs. Real Property Under UCC Article 9, a lender s SI in collateral automatically extends to proceeds of that collateral E.g., Bank s security interest in Uphoff s car would extend automatically to rents, if Uphoff leased the car to Myers Should the same concept apply under the law of real property, if the mortgage is silent (if it says nothing about rents and leases)? Personal property has a short productive life (use/lease of it may consumes a significant portion of its economic value) Improved real estate also has a limited economic life (e.g., apartment building must be refurbished every so often; buildings need new roofs, etc.) Some portion of rents reflects a return on the original investment; prudent owner would set aside a portion of rents to fund capital reinvestment over time, to preserve land s going concern value Uniform Assignment of Rents Act [p. 385]: lease rents are analogous to proceeds, mortgage lien should also cover rents unless mortgage says otherwise In most mortgage transactions today, it doesn t make a practical difference whether the state is a title or lien theory state Reason: by executing an Assignment of Leases and Rents, the mortgagor expressly assigns leases and rents to the mortgagee (thus, mortgagor and mortgagee contract themselves into the intermediate position) Pre default: mortgagor can collect rents, spend them as it wishes, even in title theory states Post default: mortgagee can take steps to enforce its security interest in rents, collect them, and apply them to the debt, even in lien theory states 2

3 Discussion Problem Bailey owns Shopping Center ( Center ) with 20 tenants, financed by a mortgage from Equitable Bailey has defaulted on the mortgage Equitable files a judicial foreclosure proceeding (assume judicial foreclosure takes months to complete) Why wouldn t Equitable just take possession and operate the Center itself during foreclosure? Mortgagee in Possession Lender can become a mortgagee in possession of the mortgaged property prior to foreclosure, if either: (1) Mortgagor consents; or (2) Mortgagor abandons the property (putting property at risk of harm due to vandalism/lack of maintenance) Upon taking possession, mortgagee can operate property, collect rents from tenants, apply them to mortgage debt Mortgagee in Possession Problem: Mortgage lenders are very reluctant to take actual possession of land prior to foreclosure Potential premises liability (in tort) to 3 rd parties (e.g., Coleman v. Hoffman, p. 388) Duty to account for rents collected ( in the quasi character of a trustee, pp ) Duty of care to mortgagor (lender can t act solely to protect its own interest) Lenders want to collect rents and apply them to the debt without taking possession of land (and becoming a mortgagee in possession ) Collection of Rents The two most common methods for a lender to enforce an assignment of rents are: (1) Getting court to appoint a receiver (receiver operates and manages the property as agent of court, collects rents from tenants) (2) Notifying tenants of the assignment and directing them to pay their rent directly to the lender Once T receives such a notice, T can ONLY satisfy its rent obligation by paying the lender, not by paying the borrower (the landlord) 3

4 Bailey collects November rents from his tenants ($30,000 total), but instead of paying his mortgage payment, Bailey uses the money to pay Lambert Paving to resurface the parking lot Equitable sues Bailey and Lambert Paving, claiming (a) Bailey converted the lender s rents, and (b) Lambert Paving also converted those rents, in violation of Equitable s prior lien right, so Lambert Paving should turn over the money to Equitable (to be applied against the debt) As judge, how would you rule in that case? Once tenants pay their rents, the cash proceeds of those rents is personal property (money) At common law, money is negotiable; someone who takes money for value in good faith takes it free of any conflicting interest in the money Thus, Equitable can t enforce its lien on that money as against Lambert Paving (absent proof of collusion/bad faith by Lambert Paving) Rationale: ostensible ownership problem; how was Lambert Paving supposed to know the cash was proceeds of rents? [We wouldn t expect Lambert Paving to search the real estate records before accepting cash in payment!] Bankruptcy Code 544(a) In bankruptcy, the bankruptcy trustee can invalidate an unperfected security interest in the debtor s property under its strong arm power Trustee is deemed to have the status of a lien creditor of debtor s personal property (lien creditor has priority over an unperfected Article 9 security interest) [ 9 317(a)(2)] Trustee is deemed to have the status of a BFP of debtor s land (BFP would take land free of an unrecorded mortgage, under a state s recording act) Discussion Problem After defaulting on mortgage on Shopping Center, Bailey files bankruptcy petition Prior to bankruptcy, Equitable had not yet taken sufficient action to begin collecting rents It had not obtained appointment of a receiver It had not yet sent notification letters to tenants, directing them to pay rents directly to Equitable Trustee: Equitable had not perfected its lien on rents, so I can avoid its lien on the rents (and use the rents accruing during bankruptcy to pay unsecured creditors) Should this argument succeed? 4

5 In re Millette Chronology 8/92: Borrowers obtained $445K loan from Bank Bank records mortgage and assignment of rents 11/93: O Neal Steel gets judgment lien against the Borrowers ($165K judgment) 5/94: Borrowers lease office space to County O Neal Steel brings garnishment action against County (to garnish the rent payments it owes to Borrowers) Bank later intervenes in garnishment action Millette (one of the Borrowers) files for bankruptcy Bank s argument: we have first priority Our mortgage/assignment of rents was recorded ( perfected ) before O Neal Steel obtained its judgment lien O Neal Steel: we have first priority Bank s lien on rents was inchoate, so it wasn t enforceable until the Bank took affirmative steps to enforce it By that time, our judgment lien had already attached, so we have first priority Who has the better argument? Early Case Law [p. 375] Taylor v. Brennan an assignment of rents grants the assignee only an inchoate lien on rents That inchoate lien becomes effective only once the assignee has taken action to enforce it (which did not happen in Millette prior to bankruptcy) Under this view, O Neal s judgment lien on rents would have priority over Bank s assignment of rents Is this a sensible result? Why/why not? Millette court (properly) rejected Taylor An assignment of rents is designed to protect lender s right to collect rents that accrue in the future The Bank s lien on future rents (ones that had not yet accrued or been paid by tenants) was perfected by recording, which established the Bank s priority vs. creditors for future rents O Neal Steel may have gotten priority as to garnished rents that Ts had already paid before the Bank intervened, but not as to rents that accrue in the future, after Bank intervened 5

6 By today, most states have rejected the Taylor v. Brennan view that an assignment of rents is inchoate Uniform Assignment of Rents Act (or comparable legislation) is in effect in several states (CA, NV, UT, NM, ND, TX); the Texas statute explicitly overrules Taylor v. Brennan Other states have narrower statutes that clearly equate recording with perfected status (NC and others) Others, like Millette, have rejected this view by court decision Discussion Problem Suppose Equitable notifies tenants, after Bailey defaults, to pay rents to Equitable Equitable collects November rents Can it apply 100% of the rents to reduce the balance of the mortgage debt? Or does it have to make the rents available to Bailey to pay the expenses of operating the property? UARA 13(a) [p. 387]: if Equitable collects rent directly from tenants, it can apply 100% against the debt Equitable needs not apply rents to payment of borrower s expenses of operating property, absent contrary agreement Prudentially, however, Equitable has a strong incentive to ensure key operating costs get paid If expenses aren t paid, that may breach tenant leases, giving tenants rights to withhold rent and/or terminate their leases 6