Assignment of rent: an effective remedy against defaulting borrowers?
The property market is still volatile despite rising property prices, and it remains a tricky time for lenders.
The property market is still volatile despite rising property prices, and it remains a tricky time for lenders. For those lenders struggling to keep debts serviced until property values rise again, the assignment of rental income by way of security can provide an effective remedy against defaulting borrowers.
Through such an assignment, lenders can demand that rent is paid to them directly from tenants which can then be used to discharge outstanding loan or interest payments as an alternative to repossession and sale.
For those properties in negative equity, where the current value is less than the amount secured on it, the assignment route enables lenders to keep loans serviced until property values increase again when the land can be sold to repay the lender in full.
Whilst lenders are commonly entitled under their standard mortgage terms to appoint Law of Property Act 1925 Receivers to collect rent directly from tenants, the main benefit of using the assignment by way of security route rather than relying on the receiver is that with the latter:
- receivers charge a fee or commission by the receiver for any rent collected;
- receivers have a discretion to exercise wider powers than simply rent collection, potentially increasing costs and depleting available funds from the property; and
- receivers may be unwilling to accept the appointment if they feel it is too minor, such as where only one low value property is involved.
Using the assignment method, there are no costs to the lender whose security entitles them to gain direct control over rental income without the need for a receiver appointment, as the lender is empowered to take all necessary steps themselves.
Under lenders’ standard legal mortgages, there is often a provision requiring landlords to hold any rent received upon trust for the lender. However this provision is ineffective against a defaulting or insolvent landlord since unlike assignments it does not confer rights of ‘appropriation’ of the money. An assignment gives powers for the lender to pursue the money directly.
To take advantage of this type of security, lenders should ask the borrower to sign a form of assignment containing a fixed charge over the rental account held by the landlord together with an assignment of the borrower’s right to receive rent from the tenant
Once this document is entered into, the borrower is prevented from using or releasing the money held in the rental account because it is charged to the lender, and is additionally unable to collect rent directly from tenants since this right is conferred on the lender as a direct assignment. Lenders are also entitled to sue tenants directly for non-payment of rent.
It would be prudent for lenders to require this type of security in every case where rental income from the property is to be the borrower’s main or only source of repayment of the mortgage loan. Otherwise, if prices have fallen and the borrower directs the tenant to pay its rent elsewhere, lenders will be left in the cold with no immediate remedy except the more expensive receiver route.
The status of the lender’s security over the rental account will depend on the level of control it exerts over that money. If the lender does not allow funds to be released without their express consent, it will usually be a fixed charge. However if lenders allow the borrower freedom to use and release money without reverting back to them in every case, it is more likely to be construed as a floating charge.
If the rental account is held by another lender, that other lender should be asked to confirm that it will not exercise any right of set-off or counterclaim against the money standing to the credit of the rental account.
To be binding on liquidators, the security assignment must be registered at Companies House. It is not registrable at the Land Registry.
Also, notice of the assignment must be given to all affected tenants in order to reserve priority over the rental money. The notice explains to tenants that they must make rent payments directly to the lender if they are asked to do so at any time in the future. It goes on to say that the tenant need not contact the landlord to enquire as to the justification of any request it receives from the lender, and will not be penalised by the landlord at a later dated for following the lender’s instructions.
The tenant signs a counter-notice confirming its understanding of those rights and verifies that it has not already received a similar request from another lender.
If no notice is served, the assignment will still confer the same rights over the rent but the lender could lose priority to another lender who took an equivalent assignment and served notice on the affected tenants. Priority over the rent between competing lenders is determined by the date notice is served and not by the date of the assignment.
The main advantage of the assignment is that it provides lenders with a more direct route to obtaining critical funds to service debts. This route is quicker and often cheaper than appointing a receiver, as the lender may carry out the work itself. The assignment gives lenders powers of appropriation not normally found in standard legal mortgages, and if the money has already been paid to the borrower’s rental account it is effectively frozen in favour of the lender.
Sixth Circuit Determines that an Absolute Assignment of Rents Perfected Under Michigan State Law Takes Property out of a Bankruptcy Estate (In Re Town Center Flats, LLC, Case No. 16-1812 — Decided May 2, 2017)
If under state law perfection of an absolute assignment of rents is a transfer of property, then such rents could be excluded from property of a debtor’s bankruptcy estate. Debtor Town Center Flats, LLC owns a 53-unit residential apartment complex in Shelby Township, Michigan. Town Center financed construction of the building with a $5.3 million loan from ECP Commercial II LLC. The loan was secured by a mortgage, as well as an agreement to assign rents to the creditor in the event of default (the “Agreement”). Pursuant to the terms of the Agreement, Town Center “irrevocably, absolutely and unconditionally [agreed to] transfer, sell, assign, pledge and convey to Assignee, its successors and assigns, all of the right, title and interest of [Town Center] in … income of every nature of and from the Project, including, without limitation, minimum rents [and] additional rents….” The Agreement purported to be a “present, absolute and executed grant of the powers herein granted to Assignee,” while simultaneously granting a license to Town Center to collect and retain rents until an event of default, at which point the license would “automatically terminate without notice to [Town Center].”
On December 31, 2013, Town Center defaulted on its obligation to repay the loan. On December 22, 2014, ECP sent a notice of default and a request for the payment of rents to all known tenants of the Town Center property. The notice complied with the terms of the Agreement and with section 554.231 of the Michigan Complied Laws, which allows creditors to collect rents directly from tenants of certain mortgaged properties. The following day, ECP recorded the notice documents in Macomb County, Michigan, completing the last step required by the statute to make the assignment of rents binding against both Town Center and the tenants of the property. On January 23, 2015, ECP filed a complaint in the Circuit Court for Macomb County, Michigan, seeking foreclosure and requesting the appointment of a receiver to take possession of the Town Center property. Subsequently, on January 31, 2015, Town Center filed a petition for relief under chapter 11 of the Bankruptcy Code. On the petition date, Town Center owed ECP $5,329,329, plus attorney’s fees and costs.
At the commencement of the chapter 11 case, ECP and Town Center entered into interim agreement to allow Town Center to continue to collect rent from tenants of the complex, with $15,000 per month used to pay down the debt owed to EPC, and the remainder of the rents to be used for authorized expenses. Town Center defaulted on the interim agreement almost immediately. Consequently, in February 2015, ECP filed a motion to prohibit Town Center from using rents collected after the chapter 11 petition was filed. The bankruptcy court denied the motion, finding that the rents were property of Town Center’s bankruptcy estate because an assignment of rents creates a security interest, but does not change ownership. Simply stated, Town Center still had an interest in the rents. On appeal, the district court vacated the order of the bankruptcy court, finding that an assignment of rents is a transfer of ownership under Michigan law, and thus the rents should not be included in the chapter 11 estate. Appeal was then taken to the Sixth Circuit.
Property of an estate in bankruptcy is broadly defined by section 541 of the Bankruptcy Code as all legal or equitable interests of the debtor in property as of the commencement of the case. The Sixth Circuit, citing the Supreme Court’s decision in Butner v. United States, noted that property rights of a debtor in bankruptcy are determined under the law of the state in which the property is located, which in Town Center is Michigan. Turning to Michigan law, the Court cited section 554.231 of the Michigan Compiled Statutes, which provides, in pertinent part:
[I[n or in connection with any mortgage on commercial or industrial property … it shall be lawful to assign the rents, or any portion thereof, under any oral or written leases upon the mortgaged property to the mortgagee, as security in addition to the property described in such mortgage. Such assignment of rents shall be binding upon such assignor only in the event of default in the terms and conditions of said mortgage, and shall operate against and be binding upon the occupiers of the premises from the date of filing by the mortgagee in the office of the register of deeds for the county in which the property is located of a notice of default in the terms and conditions of the mortgage and service of a copy of such notice upon the occupiers of the mortgaged premises.”
Relying on a number of Michigan state court decisions that generally discuss assignment of rents under section 554.231 as ownership transfers, the Court held the rents generated by Town Center’s property were not property of its bankruptcy estate because perfection of the assignment of rents by ECP had transferred ownership to ECP.
Two key supplemental points were additionally addressed by the Court. First, the Court determined that Town Center’s right to receive rents once the mortgage is paid is not a residual property right that would serve to somehow supersede ECP’s present ownership interest and bring the rents into the bankruptcy estate. Second, the Court distinguished the Supreme Court’s decision in United States v. Whiting Pools. In that case, personal property had been seized by the Internal Revenue Service in satisfaction of a tax lien was determined to be part of the bankruptcy estate because the debtor retained an ownership interest until sale to a bona fide purchaser. The Sixth Circuit concluded by finding that the bankruptcy court’s decision was motivated by a policy concern that excluding the assigned rents from the estate would effectively foreclose chapter 11 relief for companies like Town Center that own a single property and receive their sole stream of revenue from rents of that property. “We recognize the concern of Town Center—and the bankruptcy court—that single-asset real estate entities may have limited options under [c]hapter 11 in this situation. Michigan law, however, is clear on the matter and governs despite other policy concerns.”