The Bankruptcy Appellate Panel for the Sixth Circuit (BAP) recently held that a mortgagee that held a collateral assignment of rents on property in which the debtor had no equity was not adequately protected by cash collateral orders entered by the bankruptcy court that granted the lender a "replacement lien" on post-petition rents. The BAP relied upon a 12-year old unpublished decision of the Sixth Circuit Court of Appeals to find that the debtor could not grant adequate protection by giving a replacement lien in the post-petition rents where the creditor already had a secured interest in them.
The debtor in In re Buttermilk Towne Center, LLC1 was the owner and operator of a commercial real estate development (the project). The debtor sublet space in the project to tenants, and the rent generated was the debtor's sole source of revenue.
Years prior to its bankruptcy, the debtor had entered into a financing agreement with the predecessor to Bank of America (the bank) to fund the purchase of $34 million of taxable industrial revenue bonds (bonds). The bank held 100 percent of the bonds, which were issued to finance the project. In order to maintain the tax-exempt status of the bonds, the debtor conveyed the fee interest in the project to the municipality, which then leased the project back to the debtor under a ground lease. The debtor's obligations under the financing agreement were secured by a mortgage, granting the bank a lien on both the underlying property and the debtor's interest in the ground lease. The debtor also executed an assignment of rents and subleases (assignment) assigning and transferring to the bank all rents and profits derived from the project, but retaining in the debtor a license to collect and use such rents, so long as the debtor was not in default.
The debtor's license to collect and use the rents was to terminate automatically and without notice upon a default. The debtor failed to repurchase the bonds at maturity, thereby defaulting under the mortgage. Soon thereafter, the debtor filed a petition under Chapter 11 of the Bankruptcy Code.
The debtor filed a motion (cash collateral motion) seeking to place $260,000 from the rent collections in escrow for payment of professional fees. The bank filed two separate objections to the use of the rents, arguing both that the rents were not property of the debtor's bankruptcy estate due to the assignment and that the bank would not be adequately protected because there was no equity cushion in the property and the bank already held a lien on the rents. The bankruptcy court overruled the bank's objections, entering an order that permitted the debtor to use the rents and found that the bank was adequately protected.2
The bank argued that under the assignment and applicable Kentucky law, it was the owner of the rents, which, accordingly, were not property of the estate. Under applicable Kentucky contract law, the bank contended, contracts must be enforced to effectuate the intent of the parties, and the parties intended that the bank would have an "absolute assignment" under which the bank became the owner of the rents. The debtor argued that the assignment was for security purposes only. The bankruptcy court agreed with the debtor that the assignment was for security purposes and therefore the rents were property of the estate.
The BAP affirmed the holding of the bankruptcy court that the rents were property of the estate, looking to three features of the assignment for support. First, the debtor retained the right to collect the rents so long as it was not in default under the mortgage. Second, even after a default occurred, giving the bank the right to collect rents, the rents could only be used to reduce the debtor's debt to the bank. Third, the assignment automatically terminated when the debtor's debt to the bank was satisfied. The BAP found that these provisions did not support an interpretation that the bank became an owner of the rents, but rather that the assignment was intended only to serve as security. The BAP distinguished the Third Circuit's decision in Jason Realty, L.P. v. First Fidelity Bank, N.A. (In re Jason Realty, L.P.),3 which held that an assignment of rents conveyed absolute ownership to the secured lender, reasoning that the Third Circuit's decision interpreted New Jersey law and finding that Kentucky law would not require the same result.
The BAP also rejected the bank's argument that the rents were not property of the estate because the bank had taken prepetition possession of the rents. While there was a dispute about whether the bank had taken possession, the BAP found it did not have to resolve this issue because the assignment did not give the bank absolute ownership of the rents. Without an absolute right of ownership, mere possession could not divest the debtor of its ownership interest. The rents were therefore property of the estate.
The BAP then turned to the bank's argument that the bankruptcy court erred in approving the cash collateral motion because the bank was not given adequate protection by a replacement lien in the rents because the debtor did not hold any equity in the property and the bank already held a lien on the rents. In agreeing with the bank and reversing the bankruptcy court on this issue, the BAP relied upon an unpublished decision from the Sixth Circuit that held that a debtor that had no unencumbered assets could not use cash collateral in which a secured lender already held a lien to provide adequate protection.
In In re Stearns Bldg.,4 the debtor owned and derived its income from the rents received from an apartment complex. The debtor was indebted to a lender that held an assignment of rents. The debtor sought authority from the bankruptcy court to use the rents to pay Chapter 11 administrative expenses unrelated to the maintenance and operation of the complex, including the fees and expenses of the debtor's lawyers and consultants. As adequate protection for the use of the rents, the debtor proposed to grant the lender a replacement lien "in all types and descriptions of collateral which may have been secured."
The Sixth Circuit found that under sections 362 and 552(b) of the Bankruptcy Code, the rents constituted cash collateral and the lender's pre-petition security interest in the rents extended to post-petition rents. Therefore, the debtor was required to provide adequate protection in order to use the "net" rents (i.e., the funds remaining after paying operating expenses). Because the record did not indicate that the debtor possessed any unencumbered assets, the Sixth Circuit found that the debtor could not provide adequate protection.
The debtor argued that the Stearns Bldg. decision was not binding on the BAP because it was an unpublished decision. The BAP rejected this argument, holding that it would not disregard a Sixth Circuit decision directly on point merely because it was unpublished. Because there was no other Sixth Circuit law directly on point, the BAP determined it would follow Stearns Bldg.
The Buttermilk Towne decision represents an important development in single-asset real estate bankruptcy cases. The rent received from a single-asset real estate project likely constitutes substantially all of the debtor's income. Under Buttermilk Towne, if the debtor grants a lender an assignment of rents that extends to post-petition rent collections and has no other unencumbered assets by which to grant adequate protection, the debtor may be precluded from using the rents without the lender's consent.
The Buttermilk Towne decision relied solely on the Sixth Circuit's unpublished decision. It remains to be seen whether the decision will be followed in other circuits. It also may be significant that the debtor in Buttermilk Towne sought to use the rents to pay administrative expenses unrelated to the operation and maintenance of the property, i.e., professional fees. Query whether using the rents solely for the maintenance and operation of the property would pass adequate protection muster, either because the lender's lien is deemed to attach only to "net" rents or because appropriate use of cash collateral for the benefit of the real property collateral constitutes adequate protection.
In addition, as noted above, under the cash collateral orders entered in Buttermilk Towne, the bank was granted adequate protection in two forms: a replacement lien on future rents and interest payments from the rent collections. Therefore, the BAP's holding appears to be that, given that the debtor had no equity in the property, the debtor could not provide adequate protection by using that property, whether by granting a "replacement lien" or by making periodic payments to the secured party from the rent collections on which the secured party already held a lien.
Footnotes
1 No. 10-8036, 2010 Bankr. LEXIS 4563 (B.A.P. 6th Cir. Dec. 23, 2010).
2 Although not stated in the BAP opinion, a review of the cash collateral orders entered by the bankruptcy court reveals that the bank was granted adequate protection in two forms: (i) a "replacement lien" on future rent collections and (ii) monthly payments of interest from the rent collections.
3 59 F.3d 423 (3rd Cir. 1995).
4 Stearns Bldg. v. WHBCF Real Estate (In re Stearns Bldg.), 165 F.3d 28 (table), 1998 WL 661071 (6th Cir. 1998).
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