In In re Town Center Flats LLC,[1] the Sixth Circuit Court of Appeals addressed the extent of a debtor’s interest in an assigned stream of rents. The court held that the debtor did not retain sufficient rights in the assigned rents under Michigan law such that the rents were not included in the bankruptcy estate.
Debtor Town Center Flats, LLC owned a 53-unit residential apartment complex. Rent from the complex’s residents was Town Center’s sole source of income. As part of the construction financing, Town Center executed a mortgage and an agreement to assign rents to the lender in the event of a default. The language of the assignment of rents provided that 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 from the Project, including, without limitation, minimum rents [and] additional rents.…” The agreement granted Town Center a license to collect and retain rents until the occurrence of an event of default, at which time the license would automatically expire.
Town Center ultimately defaulted on the loan. The lender (an assignee of the original lender), in compliance with Michigan law, sent a notice of default to Town Center and notified tenants that rents owed to Town Center should be paid to it. It also recorded the notice documents as required under Michigan law to make the assignment of rents binding against both Town Center and the tenants. Shortly thereafter, the lender instituted a mortgage foreclosure action and requested the appointment of a receiver to take possession of the apartment complex. In response, Town Center filed its chapter 11 petition.
Soon after the filing, the lender filed a motion in the bankruptcy court seeking to prohibit Town Center from using rents collected after the petition date. In opposing the motion, Town Center argued that without the rents, it lacked any income with which to propose and fund a plan of reorganization. The bankruptcy court determined that the rents were cash collateral and available for Town Center’s use, subject to the lender receiving adequate protection. The lender appealed, and the district court overruled and vacated the bankruptcy court’s decision. Town Center then appealed to the Sixth Circuit.
The court of appeals analyzed the assignment of rents under Michigan law. A 1925 statute overturned an earlier “default rule” that assignments of rents were unenforceable and created a right to assign rents for properties subject to trust mortgages, which was later determined by the Michigan Supreme Court to be a distinct remedy and additional security for the mortgage lender.[2] Reviewing the statutory language and history, the court of appeals determined that Michigan law allows for a transfer of ownership of rents when an agreement to assign rents indicates an intention to do that and has been recorded, and default has occurred. The Sixth Circuit rejected Town Center’s arguments that it retained residual rights in the rents and held that under Michigan law, the assignment effectuated a change of ownership of the rents from Town Center to the lender. Turning to the scope of the bankruptcy estate, the court of appeals further held that despite the broad scope of chapter 11 bankruptcy estates, the assigned rents were not property of Town Center’s estate and instead belonged to the lender.
The court recognized that its ruling could limit — even foreclose — the ability of a single-asset real estate debtor to propose a plan of reorganization. The court determined that although the policy concern was valid — and was in fact the basis for the bankruptcy court’s decision that the rents were cash collateral — it was overruled by the clear language of governing Michigan law on the issue of assigned rents