In a significant ruling impacting commercial real estate lenders in Michigan, the Sixth Circuit Court of Appeals has ruled that an absolute assignment of rents that had been fully perfected (by demanding payment from tenants to the lender and related recording) precludes a debtor from asserting that such rents can be used as cash collateral in bankruptcy. The reasoning is that these rents do not constitute property of the bankruptcy estate. As such, the debtor could not use the rents to fund its operations during its chapter 11 case.

Background

The borrower Town Center Flats, LLC owned a 51-unit multifamily complex in Michigan. The mortgagee ECP Commercial II, LLC had an assignment of rents as part of the collateral for a $5.3 million loan made to Town Center. The assignment of rents provided that Town Center “irrevocably, absolutely, and unconditionally [agreed to] transfer, sell, assign, pledge, and convey” the rents to ECP. Town Center retained a license to collect the rents so long as an event of default had not occurred. The rents were the only income Town Center generated in its business operations.

On December 31, 2013, the borrower defaulted on its obligations to ECP, and ECP subsequently sent a notice of default and directed tenants to pay their rents to ECP directly. ECP also recorded the notice of default with the Register of Deeds, which made the assignment binding on both Town Center and the tenants. On January 23, 2015, ECP filed a judicial foreclosure action against Town Center.

To stave off foreclosure, Town Center filed for bankruptcy under Chapter 11. ECP requested that the bankruptcy court prohibit Town Center from using postpetition rents, because Town Center no longer had an ownership interest in the rents. The bankruptcy court disagreed and allowed Town Center to use postpetition rents as cash collateral in its bankruptcy case. In doing so, the bankruptcy court reasoned that: (1) the rents constituted cash collateral because ECP had a security interest (rather than ownership interest) in such rents and (2) if Town Center could not collect the rents, it would have no income to reorganize. ECP appealed and the district court vacated the bankruptcy court’s opinion. The appeal to the Sixth Circuit Court of Appeals followed.

Analysis

The Sixth Circuit rejected the bankruptcy court’s reasoning and found in favor of ECP. The Court noted that Michigan courts had consistently interpreted an assignment of rents as a transfer of ownership in the rents, and that was particularly true in this case where the language of the assignment was broad and where the mortgagee had followed all of the steps to perfect its assignment of rents.¹

Town Center then argued that even if ownership of the rents had transferred to ECP, Town Center retained a residual “contingent future interest” in the rents if and when Town Center cured its default. The Court also rejected this argument, concluding that ECP has the sole interest in the rents even if Town Center later cured its default.

Finally, Town Center noted that because Michigan law restricts how an assignee can use rents (that is, rents must be applied to the mortgage debt), then Town Center still retained a residual right in the rents. The Sixth Circuit declared, “Neither the Michigan Supreme Court nor the Michigan Court of Appeals has concluded that these restrictions on the assignee’s use of rent money create a property right vested in the assignor. We decline to create a new rule of Michigan property law on this issue . . . .”

The Sixth Circuit acknowledged the Bankruptcy Court’s public policy concern that a ruling in favor of the mortgagee would deprive single asset real estate debtors of funds necessary to reorganize. However, the Court concluded that Michigan law was clear on the issue and governed – despite other public policy concerns.

Takeaway

Michigan law allows for transfers of ownership in rents from the borrower to the lender when: (1) an agreement to assign rents indicates an intention to transfer such ownership; (2) a default has occurred; and (3) to the extent the lender wishes the assignment of rents to be effective against the tenants, the requisite notices have been recorded under state law and properly served on each tenant. When such requirements have been satisfied, a borrower may no longer claim an ownership interest in the rents. As a result, such rents are not property of the borrower’s bankruptcy estate and may not be treated as cash collateral in the bankruptcy case. 11 U.S. C. § 541; 11 U.S.C. § 363. As a result, commercial lenders in Michigan should carefully consider invoking their rights under an assignment of rents clause as a potential means of forestalling single asset real estate bankruptcy cases.

The case is Town Center Flats, LLC v. ECP Commercial II LLC (In re Town Center Flats, LLC), Case No. 16-1812 (6th Cir. May 2, 2017).

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