Can Assigned Rents Be Excluded From a Debtor’s Estate? In Michigan, Absolutely.

The recent decision from the United States District Court for the Eastern District of Michigan, ECP Commercial II LLC v. Town Center Flats, LLC (In re Town Center Flats, LLC), gives us at the Weil Bankruptcy Blog a reason to revisit the issue of “absolute” assignments of rent.  As we have reported before, in our posts Actions Speak Louder Than Words: Assignments of Rent and Property of the Estate, and Another Look at “Absolute” Assignments of Rent Under New York Law, determining the exact interests a debtor or creditor may have in rents can be contentious.  These rents are often particularly important in single asset real estate cases—either protecting lenders against further losses from a defaulting borrower, or helping carry a debtor through a much needed reorganization.
In this latest chapter of the assigned rents saga, the district court chalked up a win for prudent lenders. Stressing the importance of state law in deciding certain bankruptcy matters, the court held that the debtor no longer had any property interest in the assigned rents.  At least in Michigan, when a creditor has validly enforced and perfected its interest in assigned rents prepetition, absolute really means absolute.
The Facts
The debtor owned a residential townhouse and apartment complex, which was subject to a mortgage. Importantly, the debtor and the mortgagee were also parties to a certain Assignment of Leases and Rents Agreement, pursuant to which the mortgagee had the right to collect rents directly from the debtor’s tenants if the debtor defaulted on its payment obligations.
On December 31, 2013, the debtor defaulted. The mortgagee responded by exercising its rights under the Assignment of Leases and Rents Agreement, issuing a notice of default and sending payment instructions to the debtor’s tenants.  On January 23, 2015 the mortgagee followed up by filing a complaint against the debtor in state court for breach of contract and foreclosure on the mortgage, as well as a motion for appointment of a receiver.  However, before the motions were heard, the debtor filed for a chapter 11 petition.  The mortgagee responded with a motion seeking either an order confirming that the assigned rents were not subject to the stay, or an order prohibiting the debtor from using the rents.
The Law
In this case, the district court reversed a bankruptcy court order holding that the assigned rents were property of the estate and were therefore protected by the automatic stay.
First, the district court noted that the governing law was that of the state where the property was located—in this case Michigan. Next, the court looked to Michigan common law in order to interpret the proper scope of the relevant statute. The court relied largely on Otis Elevator Co. v. Mid-Am. Realty Inv’rs, a seminal Michigan decision involving the assignment of rents.  Otis Elevator dealt with the question of whether a judgment creditor could garnish rents from the debtor’s property where a separate creditor had already secured and perfected an interest in those rents.  There, the court determined that the judgment creditor was prohibited from doing so, asserting that the debtor “no longer had a valid property interest in the rents after its default on its mortgage.”
Reading that language, the district court found Otis Elevators to stand for the proposition that, under Michigan law, rents do not constitute property of the debtor’s estate where an assignee has perfected and enforced the assignment of rents prepetition and after an event of default.  Consequently, the district court vacated the bankruptcy court’s decision and remanded the matter for further proceedings.
Predominance of State Law
Interestingly, the district court took pains to emphasize the importance of state law in determining whether assigned rents constitute property of the estate. Acknowledging a split among bankruptcy courts’ decisions on the treatment of assigned rents in Michigan, the court asserted that the split resulted from bankruptcy courts inappropriately straying from Michigan law.  Recognizing the validity of competing business interests implicated in the matter, the court nonetheless found itself bound by Michigan law precedent, in accordance with the Supreme Court’s decision in Butner v. U.S., discussed further in our post, Bankruptcy 101Back to Basics with Butner.
Aside from providing clarity on whether Michigan allows for an absolute assignment of rents, Town Center Flats serves as a helpful reminder of the importance of state law under the federal bankruptcy regime.  Particularly where debts are secured by real property, lenders must be cognizant of the different legal contours from state to state.  What constitutes property of the estate in one part of the country may not be property of the estate elsewhere.