Rents as Security [pages 389-413]
• Mortgage lenders underwrite commercial mortgage loans
based on project leases and rents from those leases
• Key Issues:
– 1) What rights does the mortgagee have to collect rents (and
apply them to the debt) as against the mortgagor?
– 2) What is the priority of the mortgagee’s right to rents as
against other creditors, such junior lienholders or the trustee in
bankruptcy (if borrower files for bankruptcy)?
• Problem: in states with long foreclosure times, defaulting
mortgagor may engage in “rent-skimming” (or “milking”)
– E.g., Borrower stops making its mortgage payment, but collects the
rents and uses them for other purposes
• Lender wants rents applied to reduce the debt
– Especially where the loan is nonrecourse (i.e., borrower would not
be liable for deficiency judgment after foreclosure sale)
– Problem: under lien theory, lender doesn’t have inherent right (as
mortgagee) to collect rents prior to foreclosure sale
• Thus, mortgage typically includes an “assignment of rents
and leases” that grants the lender a separate lien in the rents
The Foreclosure Process
• In about ½ of the states, foreclosure happens by
nonjudicial sale (no court proceeding/supervision)
– In these states, the foreclosure process takes anywhere from
30-120 days total (MO: approximately 45 days)
• In the remaining states, foreclosure can occur only by
judicial foreclosure
– In some of these states, average time from default to
completed foreclosure sale exceeds 2 years
§ 9-203(f). The attachment of a security interest in collateral gives the
secured party the right to proceeds provided by Section 9-315 ....
§ 9-315(a). Except as otherwise provided in this article and in Section 2403(2): …
(2) a security interest attaches to any identifiable proceeds of
collateral.
§ 9-102(a)(64). Proceeds ... means the following property:
(A) whatever is acquired upon the sale, lease, license, exchange or
other disposition of collateral; …
Personal Property vs. Real Property
• Under UCC Article 9, a lender’s SI in collateral
automatically extends to proceeds of that collateral
– E.g., Bank’s security interest in Uphoff’s crane would extend
automatically to rents, if Uphoff leased the crane to Contractor
• Should the same concept apply under the law of real
property, if the mortgage is silent (if it says nothing about
rents and leases)?
“Lien Theory v. Title Theory”
• UARA essentially codifies the “title theory” approach to rents
• But, most states are lien theory states
– Under lien theory, until foreclosure, mortgagee’s right to the land is not
possessory
– Thus mortgagee (as mortgagee) has no implicit right to collect rents
absent (1) mortgagor consent, or (2) abandonment by mortgagor
• Thus, in a lien theory state, to obtain a lien on rents that accrue prior to
foreclosure, mortgagee must do so by additional contract (e.g., by
taking an “assignment of rents”)
• Personal property has a short productive life (e.g., use of
a car or bulldozer will consume a portion of its economic
value via depreciation)
• Improved real estate also has a “limited” economic life
(e.g., apartment building must be “refurbished” every so
often; buildings need new roofs, etc.)
– Some portion of “rents” reflects a return on the original investment,
which must be reinvested into the land over time to preserve land’s
productive or “going-concern” value
• Uniform Assignment of Rents Act [p. 404]: rents are
analogous to “proceeds,” mortgage lien should cover
rents, unless mortgage says otherwise
• This is why in most mortgage transactions today, it doesn’t really
matter whether the state is a “title” or “lien” theory state
• Reason: by executing an “Assignment of Leases and Rents,” the
mortgagor expressly “assigns” leases of the mortgaged property
(and rents arising from the leases) to the mortgagee
– Thus, mortgagor and mortgagee contract themselves into the
“intermediate” position
– Pre-default: mortgagor can collect rents, spend them as it wishes, even
in “title theory” states
– Post-default: mortgagee can take steps to enforce its security interest in
rents, collect them, and apply them to the debt, even in “lien theory”
states
Assignment of Rents
• Many forms explicitly create a “lien” or “security
interest” in rents
• Others explicitly purport to create an “absolute”
assignment of rents
– Note, however, that even an “absolute” assignment is really
just for security purposes (mortgagee does not “own” the
rents outright, but must apply them to mortgage debt)
“Mortgagee in Possession”
• Lender can become a “mortgagee in possession” of the
mortgaged property prior to foreclosure, if either:
– (1) Mortgagor consents; or
– (2) Mortgagor abandons the property (putting property at risk of
harm due to vandalism/lack of maintenance)
• Upon taking possession, mortgagee can operate
property, collect rents from tenants, apply them to
mortgage debt
Discussion Problem
• Bailey owns Tiger Shopping Center (“Center”) with 10
tenants, financed by a mortgage from Equitable
• Bailey has defaulted on the mortgage
• Equitable files a judicial foreclosure proceeding (assume
judicial foreclosure takes 18 months to complete)
• Why wouldn’t Equitable just take possession and
operate the Center itself during foreclosure?
• Problem: In lien theory states, lender can’t take possession if
borrower doesn’t abandon property and doesn’t consent
• Also, mortgage lenders are very reluctant to take actual
possession of land prior to foreclosure
– Potential premises liability (in tort) to 3rd parties (e.g., Coleman v.
Hoffman, p. 408)
– Duty to account for rents collected (“in the quasi character of a trustee,”
p. 378, note 4)
– Duty of care to mortgagor (lender can’t act solely to protect its own
interest)
• Lenders want to be able to collect rents and apply them to the
debt without taking possession of land
“Collection” of Rents
• The two most common methods for a lender to enforce an
assignment of rents are:
– (1) Getting the court to appoint a receiver (receiver operates and
manages the property as agent of court, collects rents from
tenants)
– (2) Notifying tenants of the assignment of rents and directing them
to pay their rent directly to the lender (assignee of rents)
• Once T receives such a notice, T can ONLY satisfy its rent obligation by
paying the lender, not by paying the borrower (the landlord)
• Once tenants pay their rents, the cash proceeds of those
rents is personal property (money)
• At common law, money is negotiable; someone who
takes money for value in good faith takes it free of any
conflicting interest in the money
– Thus, Equitable can’t enforce its lien on that money as against
Lambert Paving (absent proof of collusion with Bailey)
– Rationale: how was Lambert Paving supposed to know the
cash was proceeds of rents? We wouldn’t expect Lambert
Paving to search the real estate records before accepting cash
in payment!
• Suppose that Bailey collects January rents from his
tenants ($30,000 total), but instead of paying his
mortgage payment, Bailey uses the money to pay
Lambert Paving to resurface the parking lot
• Equitable sues Bailey and Lambert Paving, claiming
– (a) Bailey “converted” the lender’s rents, and
– (b) Lambert Paving also “converted” those rents, in
violation of Equitable’s prior lien right, so that Lambert
Paving should turn over the money to Equitable (to be
applied against the debt)
• As judge, how would you rule in that case?
The Trustee’s Avoiding Power
• Bankruptcy trustee (in Ch. 7 liquidation) or bankrupt debtor
(in Ch. 11 reorganization) has the power to avoid:
– Transfers of interests in personal property that could be avoided
by a lien creditor
– Transfers of interests in real estate that could be avoided by a
bona fide purchaser
• This power permits trustee to invalidate unperfected
security interests or unrecorded mortgages in bankruptcy
Bankruptcy Code § 544(a)
• In bankruptcy, the bankruptcy trustee can invalidate an
unperfected security interest in the debtor’s property under
its “strong-arm” power
– Trustee is deemed to have the status of a “lien creditor” of
debtor’s personal property (lien creditor has priority over an
unperfected Article 9 security interest) [§ 9-317(a)(2)]
– Trustee is deemed to have the status of a BFP of debtor’s
land (BFP would take land free of an unrecorded mortgage,
under a state’s recording act)
In re Millette Chronology
• 8/92: Borrowers obtained $445K loan from Bank
– Bank recorded mortgage and assignment of rents
• 11/93: O’Neal Steel got $165K judgment against the Borrowers,
which became a lien on the mortgaged building
• 5/94: Borrowers leased office space to County
• O’Neal Steel brought garnishment action against County (to
garnish the rent payments it owed to Borrowers)
• Bank later intervenes in garnishment action
• Millette (one of the Borrowers) files for bankruptcy
• Problem 2(c): after defaulting on mortgage, Bailey files
bankruptcy petition
• Prior to bankruptcy, Equitable had recorded its assignment
of rents, but it had not yet starting collecting rents (i.e., it had
not obtained a receiver or sent notification letters to tenants
directing them to pay rent to Equitable)
• Trustee argues: Equitable had not “perfected” its lien on
rents, so I can avoid its lien on the rents (and use the rents
accruing during bankruptcy to pay unsecured creditors)
• Should this argument succeed?
• Bank’s argument: we have first priority
– Our mortgage/assignment of rents was recorded (“perfected”)
before O’Neal Steel obtained its judgment lien
• O’Neal Steel: we have first priority
– Bank’s lien on rents was “inchoate,” so it wasn’t enforceable
until the Bank took affirmative steps to enforce it
– By that time, our judgment lien had already attached, so we
have first priority
• Who has the better argument?
Early Case Law [p. 393, 398]
• Taylor v. Brennan — an assignment of rents grants the assignee
only an “inchoate” lien on rents
• That inchoate lien becomes effective only once the assignee has
taken action to enforce it (which did not happen in Millette prior to
bankruptcy)
• Under this view, O’Neal’s judgment lien on rents would have
priority over Bank’s assignment of rents
• Is this a sensible result? Why/why not?
• Today, nearly all states have rejected the Taylor v.
Brennan view that an assignment of rents is “inchoate”
– Uniform Assignment of Rents Act (or comparable legislation)
is in effect in several states (CA, NV, UT, NM, ND, TX); the
Texas statute explicitly overrules Taylor v. Brennan
– Other states have narrower statutes that clearly equate
recording with “perfected” status (e.g., NC) and hold that a
recorded assignment of rents creates a perfected lien on the
rents
– Others, like Millette, have rejected this view by court decision
• Millette decision properly rejected Taylor (the “American
common law rule”)
– Assignment of rents is designed to protect lender’s right to collect
rents that accrue in the future, during foreclosure process
– Bank’s lien on future rents (ones not yet accrued) was “perfected”
by recording of the assignment, which established Bank’s priority
vs. creditors (like O’Neal Steel) for future rents
– Any garnished rents that Tenant (State) had already paid into court
before the Bank intervened could be applied to O’Neal’s judgment;
but for all rents State paid after Bank intervened (i.e., after it took
action to collect rents), Bank had priority over O’Neal
• Suppose Equitable notifies tenants,
after Bailey has defaulted, to pay
rents to Equitable
• Equitable collects February rents
– Can it apply 100% of the rents to
reduce the balance of the mortgage
debt?
– Or does Equitable have to make the
rents available to Bailey to pay the
expenses of operating the property?
Problem 2(d)
• UARA § 13(a) [p. 407]: if Equitable collects rent directly
from tenants, it can apply 100% of the collected rents
against the debt
– Equitable need not apply rents to payment of borrower’s
expenses of operating property, absent contrary agreement
– As Landlord, Bailey certainly has responsibilities to the tenants
under the tenant leases
– As mortgagee, though, Equitable is not bound by these unless
it buys the property at the foreclosure sale (at which time, it
would be bound by Landlord covenants in Bailey’s leases)
• Prudentially, though, Equitable has a strong incentive to
ensure important operating costs get paid
– If expenses aren’t paid, that may breach tenant leases, which
may give Ts rights to withhold rent or terminate their leases
– Plus, Equitable doesn’t want the property to deteriorate
• Thus, direct collection of rents is usually designed to
“force” a settlement/resolution on mortgagor like Bailey
– Once Bailey no longer has control of the rent stream, Bailey is
more likely to (1) voluntarily cooperate with foreclosure or (2)
file for bankruptcy