Sixth Circuit Court of Appeals Sharpens the “Teeth” of Assignments of Rents by Excluding Them From Defaulted Borrower’s Bankruptcy Estate

When a defaulted borrower files a bankruptcy petition, two important events occur: (1) a bankruptcy “estate” comprised of certain assets of the debtor is created; and (2) all collection efforts (and pending litigation) against the debtor or its assets are automatically stayed. Accordingly, the court’s determination of whether items are or are not property of the debtor and of the bankruptcy estate is of critical importance to the creditor’s ability to collect on its debt. In the real estate context, a bankruptcy filing will delay—or even preclude (under certain circumstances)—a lender’s ability to foreclosure on its mortgage. However, a recent decision from the Sixth Circuit Court of Appeals significantly improves a lender’s ability to collect on its debt notwithstanding a bankruptcy filing by holding that a properly perfected assignment of rents (“AOR”) related to real property in Michigan is not a part of the debtor’s bankruptcy estate. See Town Center Flats, LLC v ECP Commercial II LLC (In re Town Ctr Flats, LLC, 855 F3d 721, 722 (CA 6, 2017)).

In Town Center, the debtor, a single asset real estate holding company (the “Borrower”), owned a multi-unit residential complex in Michigan, which was financed with a $5.3 million loan held by ECP Commercial II LLC (the “Lender”). The Lender’s loan was secured by a mortgage and a broadly written AOR, which provided that the Borrower “irrevocably, absolutely and unconditionally [agreed to] transfer, sell, assign, pledge and convey to [the Lender], its successors and assigns, all of the right, title and interest of [the Borrower] in income of every nature of and from the Project, including, without limitation, minimum rents [and] additional rents.” The AOR also provided that it was a “present, absolute and executed grant of the powers herein granted to Assignee,” and granted a license to [the Borrower] to collect and retain rents until an event of default, at which point the license would “automatically terminate without notice to [the Borrower].”

The Borrower defaulted on its loan and the Lender then completed the remaining steps to “perfect” its interest in the AOR (steps to perfecting an AOR in Michigan are discussed below). The Lender then filed an action in Michigan state court claiming breach of contract, initiating foreclosure, and requesting that a receivership be established to manage the Borrower’s property. Shortly after the lawsuit was initiated, the Borrower filed for Chapter 11 bankruptcy relief. The Lender then sought an order from the bankruptcy court prohibiting the Borrower from using any rents collected after the filing of the bankruptcy petition due to the Lender’s perfected AOR. The bankruptcy court denied the Lender’s request and the Lender appealed the decision by arguing that, under Michigan law, a perfected AOR constitutes a transfer of ownership of the right to collect rents and not a mere security interest in the rents. The United States District Court and Sixth Circuit Court of Appeals agreed with the Lender and held that the rents must be excluded from the Borrower’s bankruptcy estate based on the “broad language of the [AOR] [which] evidenced an intention to transfer ownership” and the language in MCL 554.231, which “allows for an ownership transfer in these circumstances….”

The Sixth Circuit summarized its holding as follows:

In summary, Michigan law treats a completed assignment of rents as a change of ownership and the assignor of those rents does not retain residual property rights in the assigned rents.

Although the Sixth Circuit’s holding in Town Center certainly sharpens the “teeth” of a properly perfected AOR as a means for lenders to collect from a defaulted borrower, lenders should be mindful that this holding will have limited applicability throughout the country as it was decided under the unique real properly laws of Michigan (e.g., MCL 554.231 – 554.232 and case law cited in the Town Center opinion). Therefore, a prudent lender will be sure to fully understand how a given state treats AOR and will include language in the AOR which maximizes the lender’s rights under that state’s real property laws. The Town Center opinion also highlights the importance of “perfecting” the AOR before the borrower’s bankruptcy petition is filed. In Michigan, the five steps to properly perfect an AOR are set forth in MCL 554.231 – 554.232 and can be summarized as: (1) entering into a signed AOR; (2) recording the AOR; (3) the occurrence of an event of default by the borrower; (4) recording a notice of default; and (5) serving the tenant(s) with a copy of the recorded AOR and notice of default.

One other important implication of Town Center is its potential impact on a borrower’s ability to restructure through Chapter 11 bankruptcy when the borrower is a single asset entity, as was the case in Town Center. As the rents received from a single asset entity’s property are typically the sole source of income for the borrower, excluding the AOR from the borrower’s bankruptcy estate will effectively leave most borrowers with no income and thus no ability to restructure the business with a court-approved plan to repay its creditors. The Sixth Circuit recognized this concern but ultimately held that, “Michigan law, however, is clear on the matter and governs despite other policy concerns.”

Dykema will continue to monitor these issues as the Town Center opinion is interpreted and applied in Michigan and throughout the country. If you have questions about the matters raised in this alert, you may contact Michael Vogt at 248-203-0739, Michael Rothstein at 312-627-2280, or your Dykema relationship contact.