Georgia court rejects “replacement lien” as adequate protection.

A federal district court in Georgia recently ruled that a financial institution creditor in a Chapter 11 case had separate, distinct security interests in both the rental property on which it had accepted a mortgage and that property’s rental income by virtue of an assignment of rents from the debtor.

In Putnal v. SunTrust Bank, the court ruled that because SunTrust Bank had two separate categories of collateral – the real property and the rents – securing its loan to the debtor, the bank was entitled to separate adequate protection for each interest under the Bankruptcy Code. The court dismissed the debtor’s argument that SunTrust could be adequately protected by offering SunTrust a “replacement lien” in future rental income to replace any use of existing income from the property. The court further held that the debtor could not use any of the rents to administer his bankruptcy or for other general purposes, but only for actual maintenance and operational expenses on the real property.1


The debtor’s obligations to SunTrust were secured by a mortgage on the property and an assignment of rents. The property in question was generating $6,966.10 in rental income per month prior to the bankruptcy filing. Those payments were put into an escrow account after the debtor filed for Chapter 11 protection. The issue arose after the debtor asked the court to approve its use some of the escrowed rental income from the subject property to cover certain costs in administering the bankruptcy.

The debtor proposed to retain about $3,000 of each month's rent to pay the costs of bankruptcy and other general expenses. Under Chapter 11 of the Bankruptcy Code, such funds are considered cash collateral that cannot be used without the consent of SunTrust or the court's authorization. Further, if the court authorized any such use of the cash collateral, SunTrust would be entitled to adequate protection.

The debtor argued that SunTrust’s security interest in the rents is subsumed by its interest in the subject property, “and that so long as the real property is not declining, all that must be protected is a lien in the rents.”2 The court disagreed and affirmed the bankruptcy court's decision, holding that SunTrust “held two distinct security interests – one in the real property, and one in the rents the property produced.”3 Therefore, SunTrust was entitled to separate adequate protection for each dollar of rental income the debtor used for general or administrative purposes.

Prior to the present case, some jurisdictions had accepted a debtor’s offer of a “replacement lien” in all future rents as adequate protection to the lender while debtor used the rents. In other words, the lender would get a new lien on each month's rents going forward, replacing the lien on the prior month’s rents. However, the Georgia court expressly rejected that option, noting that jurisdictions across the country increasingly had moved away from such practices.

Separate entity interests

The court noted that “the value of [lender's] interest in rents is measured by the rents actually generated.”4 Therefore, as the rents accrue and the “value of the rents increases each month, [lender's] security interest is in that continually increasing value.”5

In affirming the bankruptcy court, the court stated that SunTrust “has a secured interest in each dollar in rents that accumulates, and each of those dollars is entitled to adequate protection.”6 Therefore, “for each dollar in rents he spends, he [debtor] deprives [lender] of the adequate protection for that dollar.”7

Because of this, the court limited the debtor’s use of the rents limited to “expenses ‘directly related to the operation, maintenance, or preservation of the’” subject property, “or that ‘are reasonable and necessary to preserving or disposing of such property and are incurred primarily for the benefit of the secured creditor.’”8

What does this mean for lenders?

As a result of this ruling, lenders and financial institutions should ensure their interests in both the real property securing the obligation, as well as any interest in income from that property, are protected throughout the bankruptcy process. While Putnal does not completely prohibit the use of the rental income by a debtor, under this ruling lenders can ask the court to similarly limit the debtor's use of the cash collateral, including specifically prohibiting the use of the revenues to administer the debtor’s bankruptcy or for any other general purpose and requiring any escrow amounts for insurance and real estate taxes to be paid to the secured creditor. Lenders should also remember that, in bankruptcy cases involving a single real property asset, the debtor may be allowed to use rental income to pay the secured creditor interest pre-confirmation.

A complete version of the court’s decision is available here.