Perfecting an assignment of rents under Michigan law takes that income out of the estate and can render reorganization impossible, according to a May 2 decision from the Sixth Circuit.
The holding means that an owner of real estate in Michigan or in states with similar laws cannot wait until the last minute before filing a chapter 11 petition.
The case involved a defaulted mortgage on a multi-family residential project. According to the opinion by Circuit Judge Jane B. Stranch, the loan was secured by a mortgage on the property and an absolute assignment of rents.
After giving notice of default, Judge Stranch said the lender gave additional notices and took all steps necessary under Michigan law “to make the assignment of rents binding on both [the debtor] and the tenants.” Among other things, the lender gave notice to the tenants that they must pay rent to the lender, not the debtor.
Later, the debtor filed a chapter 11 petition and negotiated a cash collateral order allowing the debtor to use some of the rents to operate the property. A month later, the lender filed a motion to prohibit the debtor from using rent. The bankruptcy court denied the motion, saying the lender had cash collateral and was entitled to adequate protection.
On appeal, the district court reversed and held that the rent was not property of the estate. In her opinion for the Sixth Circuit, Judge Stranch affirmed.
Citing Butner, she said that property rights are determined by state law. After surveying the history of the Michigan statute, she made an Erie guess and held that “a completed assignment of rents [is] a transfer of ownership.” Michigan courts, she said, consistently hold that ownership of rent transfers once the lender has taken all the steps to perfection required by statute.
The debtor argued, unsuccessfully, that Whiting Pools justified the bankruptcy court’s ruling. In that case, the Supreme Court held that property seized by the Internal Revenue Service before bankruptcy under a tax lien was part of the bankruptcy estate because the debtor had an ownership interest until a tax sale to a bona fide purchaser had taken place.
“Despite the broad scope of chapter 11 bankruptcy estates,” Judge Stranch concluded that Whiting Pools was not controlling because “assigned rents in this case are not properly included in” the estate.
Judge Stranch cited several lower court opinions reaching the same result under Michigan law and holding that assigned rents are not property of the estate. In one of the opinions, a bankruptcy judge in New York refused to confirm a plan because, under Michigan law, the debtor lost ownership of the rent and could not fund a plan.
Although Michigan law can benefit a lender whose borrower is headed toward bankruptcy, the statute can also work against the lender. According to authority cited by Judge Stranch, a judgment creditor can obtain an interest in rent ahead of the lender if the lender has not taken all steps necessary for perfection.