The Sixth Circuit Court of Appeals in its recent decision in Town Center Flats, LLC v. ECP Commercial II LLC (In re Town Center Flats LLC), Case No. 16-1812 (6th Cir. May 2, 2017), reinforces an option that commercial lenders in certain states have as a defensive strategy in anticipation of a single-asset real estate bankruptcy involving a defaulted multi-family or hotel loans. The decision is dependent on state law regarding the effect of an absolute assignment of rents and the exercise of the lender’s rights under such an assignment clause.
In the Town Center case, the Sixth Circuit ruled that an absolute assignment of rents clause that had been fully perfected (by demanding payment from tenants to the lender and performing a related recording, in accordance with perfection of those rights under Michigan law), precluded the Chapter 11 debtor from asserting that such rents were cash collateral in bankruptcy. The Court concluded that those rents did not constitute property of the bankruptcy estate and that the debtor could not proceed with its Chapter 11 case because the debtor retained no residual rights in the rents. That Court reasoned that Michigan courts had consistently interpreted an absolute assignment of rents as a transfer of ownership of those rents to the lender if the loan was in default and certain steps were taken in accordance with Michigan law.
This Sixth Circuit decision is consistent with bankruptcy decisions that are based on similar law in a number of other states. For example, the Third Circuit Court of Appeals applied Pennsylvania law in Commerce Bank v. Mountain View Village, Inc., 5 F.3d, 34, 38 (3rd Cir. 1993), holding that rights to assigned rents properly exercised by a commercial lender did not constitute property of the estate and could not be used by the debtor as cash collateral. Similarly, application of Missouri law in the decisions of In re Northwest Commons, Inc., 136 B.R. 215, 218 (B.C.E.D. Mo. 1991); In re South Pointe Associates, 161 B.R. 224, 226 (B.C.E.D. Mo. 1993); In re Breckenridge Edison Development, LC, (unpublished opinion, Case No: 10-50558-399, B.C.E.D. Mo. 2011), resulted in bankruptcy court's holdings that properly exercised loan default rights under an assignment of rents, profits and revenues clause secured by multi-family or hotel properties, did transfer the ownership of the income streams to the commercial lender pre-petition and left nothing for the debtor to use for a reorganization.
Commercial lenders in defaulted loan workouts should examine closely the applicable state law principles surrounding (i) an absolute assignment of the rents and (ii) the proper exercise and perfection of the commercial lender’s rights under an assignment of rents, profits or revenues. Under appropriate state law, completing the perfection and exercise of the assignment of rents and profits prior to the borrower filing a Chapter 11 petition, may stymie a debtor’s attempts to use the property's income stream as cash collateral and halt a Chapter 11 before it really starts. Successful use of this option can save the commercial lender on attorney's fees and from potentially-lengthy delays in court.