In re Buttermilk Towne Center, LLC, No. 10-8036, 2010 Bankr. LEXIS 4563 (B.A.P. 6th Cir. Dec. 23, 2010)
The debtor, the developer of a retail shopping center, executed: (i) a mortgage securing the property, and (ii) an assignment of all rents from the property, in favor of its lender. The assignment of rents transferred all the rents and profits derived from the shopping center to the mortgagee, but allowed the debtor to collect and use the rents, provided that the debtor was not in default of its obligations to the mortgagee. Several years later, the debtor defaulted on its mortgage obligations, and within a few months of that default, filed a chapter 11 petition. The debtor sought to use cash collateral (comprised of rents from the shopping center) to, among other things, pay professional fees. The mortgage lender objected, asserting that: (i) the rents were not property of the bankruptcy estate due to the assignment; and, (ii) the lender was not adequately protected. The Bankruptcy Appellate Panel held that the rents were estate property, and, relying primarily on an unpublished opinion, held that a replacement lien in the rents did not constitute adequate protection when the lender had an existing security interest in the rents and where the debtor had no equity cushion in the property. In doing so, it overturned the bankruptcy court order permitting the debtor’s use of cash collateral.
Buttermilk Towne Center, LLC entered into a construction financing agreement with its lender, pursuant to which it borrowed $34 million in order to purchase municipal bonds to finance its retail development. In order to maintain the tax-exempt status of the bonds, Buttermilk transferred its fee interest in the property to the issuing municipality, which, in turn, entered into a ground lease with Buttermilk. Buttermilk’s sole source of revenue was the rents collected from tenants in the center. In order to secure the amounts loaned by it, the lender obtained a mortgage securing both Buttermilk’s leasehold interest, and the municipality’s fee interest, in the real property. In addition, Buttermilk executed an assignment of rents and subleases in favor of the lender as additional security, pursuant to which Buttermilk assigned and transferred all rents and profits derived from the property to the lender. This assignment was subject to a license back to Buttermilk to collect and use such rents, provided that Buttermilk was not in default of its obligations to the lender. Both the mortgage and assignment were properly recorded by the lender.
Buttermilk failed to satisfy the obligations due under the bonds on or before their maturity date. This failure constituted a default under the mortgage and the assignment that, in turn, terminated Buttermilk’s license to collect and use rents. Following the default, the lender sent a notice to the retail center tenants directing them to pay all rents directly to lender. In response, Buttermilk filed a chapter 11 petition and sought authority to use cash collateral (i.e., the rents) to, inter alia, pay its professionals. The lender objected, arguing that the rents were not property of the bankruptcy estate, and instead belonged to the lender pursuant to the assignment of the rents. In addition, the lender objected to Buttermilk’s use of cash collateral, asserting that it was not adequately protected because there was no equity cushion in the property and no other unencumbered asset in which it could be given a replacement lien. The Bankruptcy Court disagreed and held: (i) that the rents were estate property, and (ii) that, in light of the debtor’s testimony that the anticipated rents would be sufficient to pay the lender in full, the provision of replacement liens on the rents was sufficient to adequately protect the lender’s interests. The lender appealed.
The Bankruptcy Appellate Panel’s opinion focused primarily on two issues: (i) whether the assignment of rents in favor of the lender was an absolute assignment, thus removing those funds from the bankruptcy estate; and (ii) whether the lender, having been granted a replacement lien in the rents, and despite the debtor’s lack of an equity cushion, was adequately protected.
In its briefs before the BAP, the lender characterized the assignment of rents as an “absolute assignment,” and argued that this assignment meant that the rents were not property of the estate. In contrast, the debtor argued that the assignment was a security interest, and that the rents were part of the estate. The BAP, applying Kentucky law, agreed with the debtor. In doing so, it considered the language of the assignment and determined that, when viewed as a whole, the assignment demonstrated that the intent of the parties was to grant a security interest in the rents, and not to effect an outright assignment. Specifically, the BAP found it compelling that: (i) the express terms of the assignment provided that it was a “Grant of Security Interest” that was “given to secure” payment to the lender; (ii) the assignment permitted the debtor to collect rents so long as it was not in default of the mortgage; (iii) even upon the occurrence of an event of default, the rents could only be used to reduce the debt to the lender; and (iv) the assignment of rents automatically terminated upon Buttermilk’s satisfaction of its obligations to the lender. The court concluded that these provisions evidenced the parties’ intent that the assignment serve as a security, rather than as an absolute assignment. As such, title to the rents did not transfer to the lender upon Buttermilk’s default, and the rents continued to constitute assets of Buttermilk’s bankruptcy estate as of the petition date.
Next, the BAP turned to the adequate protection issue, and considered the Bankruptcy Court’s holding that a replacement lien in the rents adequately protected the lender. In doing so, the BAP relied heavily on a 12-year-old unpublished opinion from the Sixth Circuit, Stearns Bldg. v. WHBCF Real Estate (In re Stearns Bldg.). Stearns was similar to the facts before the court, in that it dealt with a single-asset real estate debtor that, prior to the petition date, had executed an assignment of rents in favor of its lender. Following its bankruptcy filing, the debtor sought to use its cash collateral to pay expenses that were unrelated to the maintenance and operation of the subject property.
The Stearns court relied upon sections 363(a) and 552(b) of the Bankruptcy Code to conclude that rents are cash collateral, and that the lender’s pre-petition security interest in the rents continued post-petition to the extent provided in the assignment. As such, in order to use cash collateral, the debtor was obligated to adequately protect both the lender’s interest in the real property and the rents. In reviewing the facts before it, the Stearns court held that, because the debtor did not possess any unencumbered property, the debtor could not provide adequate protection of the lender’s interests in the rents. Further, the Stearns court held that the use of future rents to replace the expenditure of prior months’ rents could not constitute adequate protection. Relying principally on Stearns, the BAP overturned the Bankruptcy Court and instead held that, since a replacement lien in rents in which the lender already had a security interest could not constitute adequate protection, Buttermilk had been unable satisfy the burden necessary to entitle it to use the cash collateral. Therefore, the BAP reversed the Bankruptcy Court on this point.
This decision heightens the pressure on single-asset real estate debtors that have executed pre-petition assignments of rents, and that will require the use of cash collateral to operate. Unless they have equity in the property, it is very likely such debtors will need to obtain the lender’s permission to use the cash collateral.