Contributed by Rich Mullen
For debtors, especially those in single asset real estate cases, rents from real property can be an essential lifeline. Lenders, too, know the importance of these rents and, very often, will obtain an “absolute” assignment as part of their agreements to lend money prepetition. The integral nature of rents to both the single assert real estate debtor and its lender sets the stage for contentious litigation that features rents from real property being tugged at from two sides – the debtor arguing that rents are property of the estate and the lender’s cash collateral, and the lender arguing that its bargained-for assignment grants it an absolute right to the rents. We have blogged about two recent cases, In re Soho 25 Retail, LLC and In re HT Pueblo Properties, LLC, that adjudicated and decided these issues.
Here, we examine an even more recent opinion arising from In re South Side House, a case pending before Judge Stong of the United States Bankruptcy Court for the Eastern District of New York. In South Side House, Judge Stong concluded that: (i) under New York law, rental income from certain real property was property of the debtor’s estate and the secured lender’s cash collateral despite a purported “absolute” assignment of rents from the debtor to the lender and the lender’s affirmative steps to initiate a foreclosure proceeding and to obtain the appointment of a receiver; and (ii) the debtor’s monthly payments to the lender should be applied first to the unsecured portion of the lender’s claim (until that portion is reduced to zero), then to postpetition interest, fees, costs, and charges allowed under section 506(c) of the Bankruptcy Code, and finally applied to principal.
The dispute in South Side House arose when the debtor’s lender objected to confirmation of the debtor’s plan of reorganization arguing, among other things, that the debtor could not use the rents to fund its plan because they were not property of the estate and that postpetition payments made from the rents did not reduce the lender’s claim.
Rents as Property of the Estate and the Lender’s Cash Collateral
As to the first issue, whether the rents were property of the debtor’s estate and the lender’s cash collateral, the debtor argued that, under New York law, it retained a property interest in the rents sufficient to make the rents property of the estate and that the rents were property of the estate under section 541 of the Bankruptcy Code and the terms of the Court’s previously entered cash collateral order. The lender argued that the rents were not property of the estate, under New York law, because, prepetition, it had obtained from the debtor an “absolute” assignment of rents and, in any event, the lender’s “affirmative steps” to initiate a foreclosure proceeding and appoint a receiver left the debtor with only a “reversionary interest” in the rents, i.e., a right to the rents only if the loan was paid in full. The lender also argued that, in stipulating to the use of cash collateral, it reserved its rights as to whether the rents were property of the estate. With respect to the lender’s “affirmative steps” argument, the debtor countered that In re Soho 25 Retail, upon which the lender relied, was wrongly decided, and courts have held that the appointment of a receiver does not take rents out of a debtor’s estate.
Judge Stong observed that the majority of courts have determined that New York law does not allow absolute assignment of rents (despite clear contractual language suggesting otherwise) because New York law operates under a “lien” theory of mortgages, and under this theory, a rent assignment clause acts merely as a “pledge of rents” for additional security and “not as a direct conveyance.”
Applying this framework to the contract at hand, Judge Stong concluded that the assignment of rents was in the “nature of a pledge of additional security” notwithstanding contradictory contractual language stating that it was an “absolute assignment and not an assignment for additional security only.” In making this determination, Judge Stong emphasized that the assignment (i) was found within a mortgage securing a commercial real estate loan, (ii) did not bind the lender to any of the covenants or other obligations in the leases, and (iii) provided that the rents reverted back to the debtor once the mortgage is satisfied.
As to “affirmative steps,” Judge Stong concluded that the foreclosure proceedings and appointment of a receiver did not prevent the rents from coming into the estate. Judge Stong found that these events only gave the lender an enforceable interest in the rents. The debtor’s prepetition reversionary interest was sufficient to make the rents property of the estate. While not adopting the debtor’s argument that In re Soho 25 Retail was wrongly decided, Judge Stong’s conclusion appears to contradict In re Soho 25 Retail, which held that under New York law, the commencement of a foreclosure action and appointment of a referee, together with the lender’s application to seek relief from the automatic stay, were sufficient “affirmative steps” that prevented rents from becoming property of the estate.
Application of Postpetition Payments to the Lender’s Claim
With respect to application of the debtor’s postpetition payments from the rents to the lender, Judge Stong concluded that the debtor’s monthly payments to the lender should first be applied to the unsecured portion of the lender’s claim (until that portion is reduced to zero), then to postpetition interest, fees, costs, and charges allowed under section 506(c) of the Bankruptcy Code, and finally applied to principal.
Judge Stong reasoned that the debtor’s payments from rents first should be applied to the unsecured portion of the lender’s claim because a creditor cannot receive more than its allowed claim, and an undersecured creditor is not entitled to receive postpetition interest under section 506(b). For these same reasons, Judge Stong concluded that the aggregate rents collected by the debtor and paid to the lender could not be added to the value of the collateral when determining the value of the lender’s claim.
Notably, Judge Stong rejected the lender’s argument that section 362(d)(3) of the Bankruptcy Code, which (under some circumstances) requires a single asset real estate debtor to make payments to its secured creditor from, among other things, rents generated by real property securing the creditor’s claim, grants an undersecured creditor the right to pendency interest. Judge Stong stated that her reading of section 362(d)(3) did not undermine Congressional intent to expedite single asset real estate cases, and that payments made under section 362(d)(3) should be applied in the same way as are adequate protection payments.
For lenders, South Side House is a blow to favorable precedent. Not only did Judge Stong find that the foreclosure proceedings and appointment of a receiver were not sufficient “affirmative steps” to prevent the debtor’s rents from becoming property of the estate, but she also answered the “murky legal question” left open by Judge Lane in Soho 25 Retail by concluding that a very strongly worded “absolute” assignment of rents was a pledge of additional security as opposed to a conveyance. One very important question is whether bankruptcy judges in the Southern District of New York will follow the reasoning of South Side House, a reasoned opinion coming from across the river in the Eastern District of New York, when Soho 25 Retail serves as very recent precedent for the Southern District of New York. We will be sure to report back on any new developments.