The Great Recession renewed widespread use of receiverships, one of the oldest pre-judgment remedies available to creditors. What was once old has become new again, portrayed by the fact that one of the leading treatises on receiverships remains Ralph Ewing Clark’s Treatise on the Law and Practice of Receivers 3d, originally published in 1918 and last updated with a 1968-69 supplement. A creditor ordinarily seeks the appointment of a receiver in a foreclosure or similar proceeding for the purposes of liquidating its collateral while capturing the income generated by the property. In many states, a creditor must make efforts to obtain possession or control of the real estate to enforce an assignment-of-rents provision. Accordingly, receiverships are commonly sought in cases involving real estate.
There is a natural tension between a creditor’s remedy to appoint a receiver and a debtor’s right to possession of its property during its bankruptcy case. This tension is codified in § 543 of the Bankruptcy Code, which deals with turnover of property by a custodian.[1] Pursuant to § 543, a “custodian” must deliver to the debtor in possession any property of the debtor that is in its possession, custody or control when the custodian acquires knowledge of the commencement of the case.[2] A custodian who has knowledge of the commencement of a bankruptcy case is generally barred from taking any further action in the administration of the debtor’s property and must turn over any assets of the estate in its possession.[3] A receiver is a “custodian” within the meaning of § 101(11).[4]
Much of the case law and literature concerning § 543 focuses on excusing the receiver from compliance with the turnover requirements of § 543(d). Section 543(d)(1) provides that a court may excuse compliance with the turnover requirements if the interest of creditors is better served by the receiver remaining in possession of the debtor’s assets.[5] Nonetheless, the turnover requirements of § 543(a) and (b) are the rule, and excusing compliance under § 543(d) is the exception.
This article does not focus on a creditor’s ability to excuse a custodian’s compliance with the turnover requirements of § 543; rather, it is focused on whether monies collected by a receiver prepetition are property of the estate and thus subject to § 543. It is not axiomatic that a receivership account is property of the estate solely because the underlying receivership property is subject to turnover.
Determining Property of the Estate
A bankruptcy estate includes “all legal and equitable interests of the debtor in property as of the commencement of the case.”[6] Whether a prepetition receivership account constitutes property of the estate is determined by state law.[7] When a receiver is appointed prepetition, a debtor may seek to recover the prepetition rents collected by the receiver under § 543, but a debtor may only recover prepetition rents if those rents are property of the estate under applicable nonbankruptcy law.[8]
The body of law concerning receiverships is sparse in comparison to the body of federal bankruptcy law. Case law addressing whether prepetition monies collected by a receiver are property of the estate is virtually nonexistent. For instance, this was exactly the issue and property in dispute in 1518 West Chicago Avenue LLC v. South Melrose LLC,[9] but the court does not decide the ultimate issues. Rather, the dispute came before the court in the debtor’s adversary proceeding on cross-motions for summary judgment filed by the debtor and lender.[10] After discussion of the parties’ arguments, the court determined that a genuine issue of material fact existed and denied both motions.
With a lack of specific case law, it is necessary to consider the holdings of several case-specific examples addressing similar issues for guidance in determining whether a receivership account consisting of monies collected prepetition constitutes property of the estate. Here are five case-specific examples where the respective courts reached varying outcomes by interpreting and applying the respective pertinent state law to determine whether receivership funds are property of the bankruptcy estate.
Receivership Funds Are Not Property of the Estate
In Sovereign Bank v. Schwab,[11] the Third Circuit Court of Appeals considered whether the rents collected directly by a lender prepetition are property of the debtor’s bankruptcy estate. The lender held mortgages on multiple rental properties in Pennsylvania containing assignment-of-rents provisions.[12] Applying Pennsylvania state law, the court determined that the lender took title of the prepetition rents by sending notice to the debtor’s tenants that it would be collecting their rents.[13] Thereafter, the lender itself was appointed as the receiver. The trustee argued that in being appointed as the receiver, the lender became an officer of the state court with a fiduciary duty to the owners of the property, and was thus required to turn over the funds to the bankruptcy trustee.[14]
The court ultimately found in favor of the lender, holding that because the lender obtained legal title to the prepetition rents prior to its appointment as receiver, the rents were not property of the bankruptcy estate.[15] The court explained that the turnover requirements of § 543 are only triggered if (1) the custodian has possession, custody or control of the property; and (2) such property is the property of the debtor.[16] The resulting effect of obtaining legal title to the rents prepetition was that the rents were not “property of the debtor” that was subject to turnover under § 543(b)(1).[17] “When it was appointed receiver, the [lender] took only the debtor’s interest in the property, which no longer included title to the rents. The appointment did not change the debtor’s ownership rights.”[18] Therefore, the lender was not required to turn over to the trustee prepetition rents that it collected.
As in Sovereign Bank v. Schwab, the court in Soho 25 Retail LLC v. Bank of America[19] reached a similar conclusion based on different reasoning. Under New York state law, a lender is entitled to rents if it takes sufficient steps toward asserting its interest under an assignment of rents.[20] The court determined that the lender in this case took sufficient affirmative steps to sequester the rents.[21] The court further opined that the debtor only has an interest in the rents to the extent that the mortgage and note are ever satisfied, and the cash flow from the rents is not property of the estate until the mortgage and note are satisfied.[22] Since the lender took sufficient affirmative action to enforce its interest in the rents, the rents were not property of the estate. The court explained that (1) the debtor had, at most, a revocable license in the rents, which was revoked by the lender prepetition; and (2) the mortgage and note remain unsatisfied.[23] As with Sovereign Bank v. Schwab, under application of the relevant state laws, the lender’s prepetition actions effectuated a transfer of ownership interest in the rents that were generated from the property.
Receivership Funds Found to Be Property of the Estate
The court in In re South Side House LLC[24] also applied New York state law to determine whether postpetition rents constituted property of the estate. In evaluating this issue, the court addressed the prepetition actions taken by the lender and whether those actions affected a transfer in the debtor’s interest in the rents. In dicta, the court stated that “courts in this Circuit regularly conclude that prepetition rents are property of the estate, even when the debtor has lost possession of the rents to a receiver.”[25] Unlike the court in Soho 25 Retail LLC v. Bank of America, the In re South Side House court found that although a lender has an enforceable interest in the rents, the debtor retains a prepetition interest in the rents sufficient to bring them into the bankruptcy estate.[26]
Similar to In re South Side House in considering the prepetition actions by a lender in obtaining the appointment of a receiver, the court in In re Willows of Coventry Ltd. Partnership[27]determined that rents collected by a receiver prepetition are property of the estate. The court determined that under Indiana state law, the appointment of a receiver effects no change in title to the property over which the receiver is given authority, and that “the receiver only ‘holds possession of the property for the benefit of the party or parties ultimately determined to be entitled thereto. His custody is considered to be custody of the court.’”[28] The rents remained property of the bankruptcy estate despite the fact that under Indiana state law, the receiver had the right to possession of both the rents and the underlying real estate.[29]
The court further explained its holding by citing the U.S. Supreme Court’s decision in United States v. Whiting Pools Inc.[30] that turnover was appropriate under § 542(a). The bankruptcy court found that § 542(a) is “functionally identical” to § 543 and the case at hand. Therefore, consistent with Whiting Pools, the court in essence found that § 543 modifies the procedural rights available to creditors to protect their liens, and further granted the estate a possessory interest in certain property of the debtor that was not held by the debtor at the time the petition was filed.[31] “The Bankruptcy Code provides secured creditors various rights, including the right to adequate protection, and these rights replace the protection afforded by possession.”[32]
Receivership Funds Consisting of Property Other Than Rents
Each of these cases involved collection of rents by a receiver or other custodian and the effect of the prepetition actions of the lender on the debtors’ interest in the rents. While rents derived from real property may be the most common funds comprising receivership accounts, there are instances whereby a receivership account may consist of other funds, such as business income, insurance proceeds or proceeds from a receiver sale. For example, the court in In re Flores[33] considered the motion of a debtor seeking turnover of property from a creditor under §§ 542 and 543.[34] The creditor obtained a prepetition turnover order from the state court for funds that had been levied pursuant to a writ of execution. Shortly thereafter, the debtor filed her bankruptcy petition.
Following the filing of the debtor’s petition, the debtor’s bank turned over the levied funds pursuant to the state court’s turnover order.[35] The debtor moved for a turnover of the levied funds under both §§ 542 and 543. In applying New Jersey state law, the court found that the levied funds were not property of the estate. The state court turnover proceeding marked the final judicial determination of the debtor’s interest in the account.[36] Under New Jersey state law, the state court turnover order cut off the debtor’s legal and equitable interest in the account prior to the debtor filing her petition.[37] Consequently, the funds were not property of the bankruptcy estate and were not subject to turnover under either §§ 542 or 543.
Conclusion
Property in the possession, custody or control of a receiver at the initiation of a bankruptcy case may be subject to the turnover requirements of § 543. However, a receiver’s deposit account of funds collected prepetition are not necessarily property of the bankruptcy estate solely due to the underlying receivership property being subject to a turnover. The determination of whether a receivership account is property of the estate will be subject to applicable state law and will be a fact-specific inquiry based on a variety of factors.
[1] See 11 U.S.C. § 543. Compare § 543(a) and (b) with § 543(d).
[2] In re South Side House LLC, 474 B.R. 391, 405 (Bankr. E.D.N.Y. 2012).
[3] 11 U.S.C. § 543(a) and (b); In re Lizeric Realty Corp., 188 B.R. 499, 506-07 (Bankr. S.D.N.Y. 1995).
[4] 11 U.S.C. § 101(11); see Paren v. Noneman (In re Paren), 158 B.R. 447, 450 (Bankr. N.D. Ohio 1993); In re Snergy Props. Inc., 130 Bankr. 700, 703 (Bankr. S.D.N.Y. 1991); Foundry of Barrington P’ship v. Barrett (In re Foundry of Barrington P’ship), 129 B.R. 550, 557 (Bankr. N.D. Ill. 1991).
[5] 11 U.S.C. § 543(d)(1); see In re Poplar Springs Apartments of Atlanta Ltd., 103 B.R. 146, 150 (Bankr. S.D. Ohio 1989); In re Falconridge LLC, 2007 Bankr. LEXIS 3755, at *21 - 22 (Bankr. N.D. Ill. 2007) (citations omitted); Dill v. Dime Sav. Bank FSB (In re Dill), 163 B.R. 221, 225 (E.D.N.Y. 1994) (citations omitted).
[6] 11 U.S.C. § 541(a)(1).
[7] Butner v. United States, 440 U.S. 48, 54, 99 S. Ct. 914, 915, 59 L. Ed. 2d 136 (1979); see also In re Buttermilk Towne Ctr. LLC, 442 B.R. 558, 562 (B.A.P. 6th Cir. 2010); Oakland Gin Co. v. Marlow (In re Julien Co.), 44 F.3d 426, 428 (6th Cir. 1995) (citing In re White, 851 F.2d 170, 173 (6th Cir. 1988)).
[8] In re South Side House LLC, 474 B.R. at 405.
[9] In re 1518 W. Chicago Ave. LLC, 427 B.R. 439 (N.D. Ill. 2010).
[10] Id. at 440. The lender argued that the receivership account consisting of primarily rents collected prepetition was not property of the estate, and therefore not subject to the turnover requirements of § 543. In contrast, the debtor argued that the receivership account was property of the debtor’s estate and constituted cash collateral that was subject to a lien.
[11] 414 F.3d 450 (3d Cir. 2005).
[12] Id. at 451.
[13] Id. at 453 (“In doing so, the bank enforced its rights under the mortgage, and obtained constructive possession of the properties and title to the rents.” (citations omitted)).
[14] Id. at 454.
[15] Id.
[16] Id. (citing 11 U.S.C. § 543(b)(1)).
[17] Id. at 454.
[18] Id. at 455.
[19] In re Soho 25 Retail LLC v. Bank of Am., No. 11-1286, 2011 WL 1333084 (Bankr. S.D.N.Y. March 31, 2011).
[20] Id. at *22 (citing 641 Ave. of the Arms Ltd. P’ship v. 641 Assocs., 189 B.R. 583, 591 (S.D.N.Y. 1995)).
[21] Id. at *21.
[22] Id. at *26-27. (citations omitted).
[23] Id. at *27.
[24] 474 B.R. 391 (Bankr. E.D.N.Y. 2012).
[25] Id. at 406 (citing Temple Court Assocs., 1996 WL 537886, at *4-5 (affirming part of bankruptcy court’s decision that held that debtor “retains an ownership interest in prepetition rents until after a foreclosure sale has occurred”)).
[26] 474 B.R. at 411-12 (414).
[27] 154 B.R. 959 (Bankr. N.D. Ind. 1993).
[28] Id. at 962 (citing Parfenoff v. Kozlowski, 218 Ind. 154, 161, 31 N.E.2d 206, 208 (1941)).
[29] 154 B.R. at 965.
[30] 462 U.S. 198 (1983).
[31] In re Willows of Coventry Ltd. P’ship, 154 B.R. at 965.
[32] Id. (quoting Whiting Pools, 462 U.S. at 207).
[33] No. 10-34546, 2011 WL 44910 (Bankr. D.N.J. 2011).
[34] Id. at *1.
[35] Id. at *2-4.
[36] Id. at *6 (citing Sylvan Equip. Rental Corp. v. C. Washington & Son Inc., 292 N.J. Super. 568, 573 (1995)).
[37] Id. at *7-8.