Wednesday, August 11, 2010

Judge Isgur Takes on the "Absolute" Assignment of Rents

The absolute assignment of rents was a trendy lender's argument during the 1980s. The lender could claim that its loan documents granted it ownership of the rents to be received by the debtor. The lender would magnanimously allow the debtor to use its rents so long as the debtor was not in default. However, upon default, the lender would take back "its" rents. Without ownership of the rents, the debtor would have nothing to fund a plan of reorganization with and thus no hope of reorganization.

The absolute assignment of rents was largely discredited during the 1980s. However, like Jason or Freddy Krueger in a cheap horror movie, it keeps coming back. In a thoughtful opinion, Judge Marvin Isgur explains why it might work outside of bankruptcy, but that the mighty Code has the power to unravel the assignment, no matter how absolute it might claim to be. In re Amaravathi Limited Partnership, 416 B.R. 618 (Bankr. S.D. Tex. 2009).

What Happened

In Amaravathi Limited Partnership, the Debtors owned four apartment properties in the Greater Austin area. They were supposed to pay their rents into a lock box. The lender would make the debt payments and remit the balance to the debtors. This did not leave the debtors with enough money to operate their properties, so the debtors stopped sending their money to the lock box. The lender filed suit and obtained appointment of a receiver. The debtors then filed bankruptcy and asked for permission to use cash collateral. The lender objected contending that the absolute assignment of rents meant that they were not property of the estate.

Section 541(a)(6) Spells It Out

Judge Isgur (in a lengthy opinion) found an elegantly simple answer. Under Section 541(a)(6), property of the estate includes "proceeds, product, offspring, rents or profits of or from property of the estate. . . " Therefore, regardless of whether you have a collateral assignment of rents or an absolute assignment of rents, the post-petition rents are property of the estate.

Judge Isgur found that this straightforward reading of the Code would control unless it would lead to an absurd result. He found that it did not.

The Code provisions dealing with post-petition rents maintain a balance. Section 541(a)(6) brings the rents into the estate; Sec. 552(b) extends the lender's lien to post-petition rents and Sec. 363 requires adequate protection in order to use rents. This structure "incentivizes debtors and creditors to behave efficiently."

C1 Trust seeks to seprate the rental income from the assets and individuals that produce the rental income. Permitting such separation creates inefficient incentives that could greatly impede any debtor's ability to successfully reorganize. It is a fundamental principal of a capitalist society that when the owners of productive assets cannot benefit from the income produced by the assets , the incentive to produce income is eliminated. Without any prospect to generate rental income, the business's prospects for success are minimal at best.
In re Amavarathi Limited Partnership, at 624.

In concluding his statutory reading, he said:

The Court therefore follows the unambiguous text of Sec. 541(a)(6) and declines C1 Trust's request to choke the Debtors out of bankruptcy.
Id. at 626.

You Can Call It Mickey Mouse But It's Still a Lien

Having decided the issue, he went on to offer several additional rationales. First, he argued that the term "absolute" assignment of rents is a misnomer. Regardless of what you call it, it is still a security device. He quoted In re Foundry of Barrington Partnership, 129 B.R. 550, 557 (Bankr. N.D. Ill. 1991) for the proposition that:

The lender can call this arrangement an "absolute" assignment or, more appropriately "Mickey Mouse." It's still a lien.
Id. at 631.

The Court noted that the Fifth Circuit used the term "contingent present assignment" to describe the so-called absolute assignment of rents.

Why It's Different Outside Bankruptcy

Judge Isgur further explained that under Texas law, an absolute assignment of rents grants the lender legal but not equitable title to the rents. Outside of bankruptcy, the lender's legal title to the rents controls. However, inside bankruptcy, the retained equitable interest passes to the estate.

Synthesizing Whiting Pools with International Property leads to the conclusion that the post-petition rents at issue in this case are property of the estate. This conclusion is unmistakable despite the fact that the International Property lender was was permitted to retain the "absolutely" assigned rents. They key difference between the ostensibly inconsistent outcomes in this case and International Property is the bankruptcy framework. Outside of bankruptcy, International Properties stands for the proposition that once default occurs, the lender immediately has rights to the "absolutely" assigned rents. The debtor cannot keep rents received post-default. Upon receiving the rents, the lender must then take the cash from those rents and apply it to the mortgage debt. In doing so, the lender becomes both the equitable and the legal title holder of the cash from the rents. It is not until the cash is applied to the debt that the equitable title transfers from the debtor to the lender.

This case would follow the outcome of International Property if the Debtors had not filed bankruptcy. Upon the Debtors' bankruptcy filing, however, Sec. 541(a)(1) brings all property in which the Debtors hold an equitable interest into the estate. At the time of the filing of the bankruptcy petition, the Debtors held equitable title to all future rents, despite the lender's right to the rents under the "absolute" assignment.

Id. at 633.

This is a thoughtful opinion and well worth the time to read it. Judge Isgur has done an admirable job of reconciling the labels, the state court doctrine and the Bankruptcy Code's effect on these rights. Not only that, his opinion is based on basic capitalist principles.

1 comment:

Anonymous said...

Nice post, kind of drawn out though. Really good subject matter though.