Sixth Circuit: A Perfected Assignment of Rents is Not Property of Bankruptcy Estate | Practical Law

Sixth Circuit: A Perfected Assignment of Rents is Not Property of Bankruptcy Estate | Practical Law

The Sixth Circuit Court of Appeals recently held that a perfected assignment of rents from a borrower to a lender constitutes a transfer of ownership under Michigan law. Because the rents became property of the lender, the court held that the rents are not property of the borrower's bankruptcy estate.

Sixth Circuit: A Perfected Assignment of Rents is Not Property of Bankruptcy Estate

Practical Law Legal Update w-008-4162 (Approx. 5 pages)

Sixth Circuit: A Perfected Assignment of Rents is Not Property of Bankruptcy Estate

by Practical Law Real Estate
Published on 14 Jun 2017Michigan, USA (National/Federal)
The Sixth Circuit Court of Appeals recently held that a perfected assignment of rents from a borrower to a lender constitutes a transfer of ownership under Michigan law. Because the rents became property of the lender, the court held that the rents are not property of the borrower's bankruptcy estate.
On May 2, 2017, in Town Center Flats, LLC v. ECP Commercial II LLC (In re Town Center Flats) (855 F.3d 721 (6th Cir. 2017)), the US Court of Appeals for the Sixth Circuit held that:
  • A properly perfected assignment of rents that complies with the Michigan assignment of rents statute (MCL § 554.231) acts to transfer ownership of the rents to the lender.
  • Because the rents are property of the lender, the rents are not property of the borrower's bankruptcy estate and may not be used as cash collateral in the bankruptcy case.

Background

Town Center Flats, LLC (Town Center) financed the construction of a residential complex (Property) with a $5.3 million loan from ECP Commercial II LLC (ECP). To secure the loan, Town Center signed an assignment of rents (Assignment) in favor of ECP. The Assignment was written to "irrevocably, absolutely, and unconditionally . . . transfer, sell, assign, pledge, and convey" all rents from the Property to ECP, with a license granted to Town Center to collect the rents until the occurrence of a default, when the license would automatically terminate. The rents were Town Center's lone source of income.
In December 2013, Town Center defaulted on its obligation to repay the loan. In December 2014, ECP:
  • Notified all tenants of the Property of Town Center's default.
  • Recorded the notice of default with the Register of Deeds.
  • Sent all tenants of the Property a request to pay their rents directly to ECP.
ECP then filed a foreclosure action in state court against Town Center. Shortly thereafter, Town Center filed for bankruptcy.
ECP then filed a motion with the Bankruptcy Court to prohibit Town Center from using rents collected after its bankruptcy, arguing that Town Center transferred ownership of the rents to ECP under the Assignment. The Bankruptcy Court rejected ECP's motion, reasoning that:
  • A perfected assignment of rents grants the assignee only a security interest in the rents, not an ownership interest.
  • Excluding perfected rents from the property of the bankruptcy estate would prevent Chapter 11 relief for single-asset real estate companies whose sole source of income is rent payments from that asset.
ECP appealed and the US District Court for the Eastern District of Michigan vacated the Bankruptcy Court's decision, holding that Michigan law treats a perfected assignment of rents as a transfer of ownership. Town Center appealed to the Sixth Circuit.

Outcome

In applying Michigan law, the Sixth Circuit reversed the Bankruptcy Court's decision, holding that:
  • Michigan law treats a perfected assignment of rents as a transfer of ownership. An assignee perfects its rights to the rents when:
    • an agreement indicates the assignor's intention to transfer ownership in the event of a default;
    • a default has occurred;
    • the assignee has filed a notice of default with the register of deeds; and
    • the assignee has sent a copy of the notice of default to each tenant of the property.
  • Town Center transferred ownership of the rents to ECP before the bankruptcy filing. The court found that the broad language in the Assignment indicated Town Center's intention to "irrevocably, absolutely, and unconditionally" transfer ownership of the rents upon default.
  • Because Town Center retained no residual rights in the rents, the rents were not property of Town Center’s bankruptcy estate. Both Town Center and the Bankruptcy Court expressed concern that excluding the rents from the bankruptcy estate would foreclose Chapter 11 relief for single-property real estate companies whose only source of income is rents from the property. The Sixth Circuit disagreed, explaining that Michigan law governs the matter despite policy concerns.

Practical Implications

This case highlights what may be a little-known split among courts in the treatment of assignments of rents. Although assignments are almost all written the same way as the one in this case, as an absolute assignment to the lender with a license to the borrower to collect rents prior to a loan default, whether they are actually treated as absolute assignments or collateral assignments depends on the state law governing the agreement. How courts interpret state law can depend on whether a state is a "title theory" state, "lien theory" state, or "intermediate theory" state.
Counsel for both borrowers and lenders should carefully review the language of assignments of rents to ensure that the parties' intent is properly reflected, depending on the governing state law.
For assignments of rent subject to Michigan law, lenders should ensure they comply with MCL § 554.231 to perfect their interests after a borrower default.
For an example of a jurisdictionally-neutral form of assignment of rents, see Standard Document, Assignment of Leases and Rents (Pro-Lender).