To anyone practicing bankruptcy law more than a month, the scenario of a lender secured by a lien against real property, as well as an assignment of rents (“AOR”) is pretty standard fare. Default on the debt occurs, threats (and counter threats) are tossed about, notices of foreclosure are filed (and perhaps receivership proceedings were begun), and the borrower files the inevitable bankruptcy proceeding where all is stayed to be dealt with under the watchful eye of the bankruptcy court. Cash collateral skirmishes start at the very beginning and may culminate in cram-down litigation at the end of the case.
For purposes of this article, let’s assume a straightforward factual situation. Secured lender (the “Lender”) makes a loan of $1000, secured by a lien against real estate used by the borrower as an apartment complex, with the lender also having an AOR on the rents from the property (the “Rents”), all of which are properly perfected under state law. Default occurs on the loan; Lender utilizes its state law right and notifies the tenants in the apartment complex to pay the Rents directly to Lender or its agent. Borrower files bankruptcy shortly after those notices go out to prevent the foreclosure.r
The time-honored dance between Lender and Borrower now has a new tune! On May 2, 2017, the Sixth Circuit Court of Appeals, using Michigan law, ruled that a lienholder’s AOR (once the lienholder notifies tenants to pay rents to the lender) creates an ownership interest in the rents, not collateral or security interest. Hence, in the borrower’s bankruptcy post-notification, the rents are not a cash collateral issue—the rents are not even estate property under Bankruptcy Code § 541. Complete victory for the secured lender! Ahhhh….not so fast. Let the games begin!
True to the age-old adage “Be careful what you ask for”, logically (and legally speaking), the host of (likely) unintended consequences that flow from this bit of jurisprudence from the Sixth Circuit may amaze. At least in the minds of the authors, at least six consequences flow from this decision.
In no particular order of prevalence, the following are likely to be raised to level the proverbial playing field in the bankruptcy proceeding:
If indeed ownership of the Rents passed upon the notification of the tenants, doesn’t this open the Lender up to an adversary proceeding for fraudulent transfer under either (or both) Bankruptcy Code §§ 544 and/or 548? Assuming a loan of $1000 as posited above, then legally, even after the Lender collected $1000 in rents, it gets to continue to keep all the remaining Rents (presumably into perpetuity as it is the legal owner). So, if the Lender collects another $1000, or even $1 million, it’s theirs. This is indeed a great country!
But why isn’t this a fraudulent transfer? Lender “paid” $1000 in consideration for the AOR, and got back property worth substantially much, much more than $1000—all to the detriment of the unsecured creditors, and ultimately the equityholders in the debtor. This issue would not come up in an AOR construed as being for collateral purposes, of course, since the assignment is not of all rents—just enough to repay the loan. Valuation hearings would ensue, with financial wizards valuing the cash stream into the future. Although payment of an antecedent debt is considered “value” under fraudulent transfer laws, can there be too much of a good thing? When the mismatch between consideration given and value received is so exorbitant, it may open the door to this type of litigation in cases where borrowers (or trustees) are left with little else!
To be sure, the valuation issues are not simple in this context for sure. What value does income producing property have separate and apart from the income stream? What is the fair market value of a future stream of rent separated from the bricks and mortar? What would an arm’s length buyer pay for just the right to collect rent without access to the bricks and mortar to make tenant improvements, or fix the structure, or even give access to the structure? Likely not much, but it is just such issues that lawyers latch onto to bring litigation.
Under many state laws, guarantors are entitled to a defense based on a valuation of collateral taken back by a Lender. Guarantees are usually important to the Lender as they preserve a means to exert pressure on the principals of a borrower. If the tenant notification acts to transfer ownership of all the Rents and depending upon the valuation that would be the hallmark of the fraudulent transfer litigation discussed above, would the Lender ultimately be deemed to have waived the guarantee rights?
If the Lender is now the owner of the Rents, is the Lender possibly also saddled with the responsibilities of a landlord under state law? The borrower cannot very well keep the apartment building maintained, and pay the common area utilities and other such expenses when the Lender, as the owner of the rents, has all the money. Will this create successor liability for the Lender? What duties to the tenants would state law impose on the Lender as the de facto or de jure landlord? Does it make the Lender a non-statutory insider?
Many states have adopted usury laws that, in commercial settings appear lax but have some strictly enforced limits. In a commercial loan setting in many states, the parties are free to agree to whatever rate of interest they want to, but should the lender charge more than the agreed amount, the statutes impose (in some instances) strict liability for the lender. In Arizona, for example, the penalty for charging more than the agreed upon rate of interest is forfeiture of all interest—not just the “overcharged” interest. Could it be argued that the transfer of ownership in the Rents, if applied to the loan balances, constitutes an interest charge in excess of the loan agreement? If the loan agreement called for 7% interest and applying a valuation to the Rents now “owned” by the Lender, the resulting economics would result in an effective interest rate of 40 or 50%, it could implicate state usury laws.
It is axiomatic in bankruptcy cases that a secured creditor is entitled to be paid its debt (if over secured, with interest, costs and fees)—no more. After that, the “waterfall” of the Bankruptcy Code expressly dictates who gets what. If state law has the effect of essentially providing that a Lender could get 300 or 400% return on its debt (after payment of its principal, interest, fees and costs), that would contravene the fundamental priority regime of the Bankruptcy Code. It could (or indeed should) be preempted.
If the Rents are in fact owned by the Lender pre-filing, is it possible that it may prevent the debtor from being characterized as a Single Asset Real Estate (“SARE”) because the debtor generates no gross income from the property, so the debtor can try to hold the brick and mortar hostage under normal chapter 11 deadlines, subject only to adequate protection arguments about collateral of highly debatable value
Seasoned practitioners may recall that a version of this issue used to be raised as part of the perfection debate before the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”). Debtors would say that a Lender did not have a properly perfected (or “choate”) lien in Rents unless/until the Lender notified the tenants to pay rents to the lender and/or got a receiver. Lenders countered that perfection occurred upon recordation/filing of the instrument in the real property records and a UCC 1. BAPCPA ended the debate in favor of the Lender. Of course, the amendments to §552(b) (2) in BAPCPA only addressed one side of the AOR issue – whether the lender was “perfected” on rents if the debtor beat the lender to the courthouse.
In all events, pre-BAPCPA, debtors always wanted to file before the tenant notification/receivership was put in place to preserve this perfection argument. Looks like timing will be everything once again at least in Michigan—file before the Lender notifies tenants to pay Rents to the Lender or lose all rents. Restructuring based on future cash flows? You snooze, you lose.
These are but a few of the issues that arise given the Sixth Circuit decision. While many lenders do not try to be as aggressive as the Town Center Flats lender because they are willing to let a debtor use the rents subject to an acceptable cash collateral order, this new decision may indeed embolden them. While it is possible that borrowers could attempt to put limiting language in AORs related to the “ownership” issue at the negotiation stage of the loan relationship, many of the loans secured by AORs are not as highly negotiated as other commercial loans.
The list of questions that Town Center Flats raises greatly exceeds the question it answered. “Be careful what you ask for.” Indeed.
Thomas Salerno brings thirty-five years' experience to resolving complex issues in commercial corporate restructurings and recapitalizations, advising lenders, distressed companies, committees and acquirers of assets in both out of court restructurings and in bankruptcy cases.
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