Estate Finance Notes
More on assignment of rents
We talked about what a rent is. It’s a matter of classification. But then things get more confusing. Focus on these three issues: (1) when does the assignment become effective between the mortgagor and mortgagee? (2) When does the assignment become effective (or perfected) as between the mortgagee and third parties? This is the priority issue. (3) What must be done to foreclose on the assignment of rents? In other words, when does the mortgagee get to actually start collecting the rents?
There are three types of assignments of rents: (1) The lender collects all rents from the beginning of the loan: this is called absolute assignment of rents. This is relatively rare. Many clauses that purport to create this provide that the mortgagor can maintain possession until something happens. The lender usually doesn’t care to get into the business of managing the property and collecting rents. You could have just a sale of the rents, or the right to collect the rents in a security transaction. (2) The assignment of rents becomes absolute after default. This occurs much more frequently. The language gets confusing: some documents say this is an absolute assignment of rents, except for the fact that the mortgagee appoints the mortgagor as an agent who is authorized to receive rents on the mortgagee’s behalf. The mortgagee actually gets the money, though, until default occurs. (3) The mortgagor gets to keep the rents and the mortgagee doesn’t get actual possession of them until something happens. This is usually a combination of default and some other action by the mortgagee.
The purchaser at foreclosure will get the rents because the purchaser becomes the owner of the property. The mortgage on the rents is gone, just as the mortgage on the property is gone. But who will get the rents in the interim between default and foreclosure? That’s the issue here.
The actions that can trigger an assignment include taking possession (but that often terminates the leases if the leases are junior to the mortgage), bringing an action at law to “impound” or “sequester” the rents, getting a receiver appointed, making a written demand on the tenants to give the mortgagee the right to possession of the rents, or making a written demand on the mortgagor. What if you make a demand on the mortgagor, but the tenants continue to pay the mortgagor? What is the liability of the tenants? We have a contract between landlord and tenant. The landlord is also the mortgagor. Then you have an assignment of that contract right to a third party, who is the mortgagee. The assignment becomes effective as against the obligor, the tenant, when the tenant receives actual notice of the assignment. Even though the assignment is effective just by giving notice to the mortgagor, you’ll still have to do something to actually get the rents. You must give the tenants actual notice; they are protected until that happens.
In the Matter of Millette
There are a whole gaggle of Millettes and a Fridge. They mortgage some property with assignment of rents to a lender called Eastover. Eastover assigns the mortgage to another company and appoint Security National to service the loan. What kind of assignment of rents clause was in the deed of trust? The court reads it as automatic on default. O’Neal Steel gets a judgment lien against the Millettes and brings an action to garnish rents. Security National claims that they have priority with respect to the rents. When are the rights to the rents effective? It doesn’t become operative until the mortgagee triggers it somehow. Whenever the rights become operative or effective as between the parties (when you could demand the rents), what acts are required to perfect it with respect to third parties (namely, O’Neal)? Security National is not entitled to possession of the property in a lien state. But during the pre-foreclosure period, they are entitled to possession of the rents.
The court adopts the Restatement rule, which provides that the mortgage on rents is effective against the mortgagor and third parties upon execution and delivery. What else is required to make it effective against third parties? It must be recorded. The Restatement also answers the second question: when does the mortgagee’s right to actually get the rents accrue? First, whatever conditions that are in the mortgagee must be satisfied: this mortgage says that the right accrues on default. In addition, notice must be given to the mortgagor and any subordinate mortgagees. What does that mean in this case? O’Neal already has some of the rents. Does Security National get them back? Security National wins this case. The court finds that they have a higher priority than O’Neal. But their right to possession to the rents isn’t going to arise until they get O’Neal notice that their mortgage is in default and that they are demanding the rents. It looks like O’Neal will win as to the rents it received from garnishment before it received notice. Notice that O’Neal is not a mortgagee, but will be treated as a mortgagee.
How is a mortgage on rents “perfected” as against third parties? Rents are real property, so you must record. But some courts and some parties think that rents are “just money”, meaning that you must file a Uniform Commercial Code Article 9 financing statement. This is something you file with the Secretary of State to give everyone else notice that you have a lien on someone else’s money. The best practice is to file both places—a “belt and suspenders” approach.
Receivership – Dart v. Western Savings & Loan Assocation
What’s the best way to “trigger” or “actuate” an assignment of rents? Possession is a sticky business. The best thing is receivership! Why? A receivership is easy to get. You don’t terminate junior leases. You don’t have to have a strict fiduciary accounting duty. You don’t have tort liability. You can make repairs, but don’t have to. Finally, you can evict delinquent tenants and fill vacancies.
In this case, there are two mortgages. Someone is embezzling Dart’s money! Western Savings and Inland Mortgage are both granted mortgages, and both mortgages provide that a receiver shall be appointed. Both mortgagees want a receiver appointed, but we’re not sure why. They don’t get receivers. Why not? They have security in the rents and there is no waste of the property. There was also a federal tax lien of almost $200,000. But the tax lien was junior of the other mortgages, so the purchaser at foreclosure will take free of the tax lien. So when the court evaluates the collateral as to the two mortgagees, they’re fine. It’s not the mortgagees’ problem whether Dart’s debts get paid off.
In order to get a receiver appointed in most jurisdictions, there must be inadequate security. Some courts say that the mortgagor must be insolvent. The idea is that it doesn’t matter if the property isn’t enough to secure the debt if the mortgagor has lots of other assets that could secure the debt. This makes some sense, but it arguably deprives the mortgagee of just what they bargained for: being able to rely on the property itself and not the solvency of the mortgagor. In addition, you usually must show that waste is threatened. You have to show that you’re being threatened and that you don’t have a remedy.
What is inadequate security? When is security inadequate? Why was it adequate here? What does the mortgagee bargain for? The mortgagee bargains for two different kinds of “cushions”. First, the mortgagee typically won’t loan 100% of the value of the property, but something less, like 80%, which leaves a 20% cushion. The mortgagee also bargains for the debt getting paid, meaning that the principal is reduced and the cushion gets bigger over time. So you could argue that if the value of the security is less than the lien, then security is adequate. The other way to argue it is to say that if the ratio of the amount of the outstanding lien to the value of the property is greater than originally expected, then the security is inadequate. The mortgagee typically expects that the principal will be paid down and the loan, in some sense, will become more secure as time goes on. The Restatement takes the view that you bargained for the cushion: not just the original 20%, but the rest of the cushion built into the amortization of the mortgage. If the mortgagee isn’t where they expected to be on the amortization curve, then we say that the security is inadequate.
To find out about waste, look at the Restatement § 4.6.
It is easier to get a special receiver appointed to get the rents than to have a general receiver take possession of the property. To get the rents, you must have a default, which would satisfy § 4.2(1), and a demand, as in § 4.2(2). In Dart, they’re not trying to get possession of the rents, but rather of the property itself. Not only do you have to show what you must show to get the rents, but you also have to show inadequate security, waste, and possibly the insolvency of the mortgagor. An “assignment of rents” or receivership clause in the mortgage is not binding on the court. Such a clause, however, is helpful in getting a receiver appointed.
The additional power is the right of the receiver to disaffirm leases. The problem is that a mortgagor who know that a default is threatened may do commercially unreasonable things, like rent the property out at a very low rate just to get some cash. Does the receiver have the right to disaffirm the leases? The Restatement says that the receiver has this power if three conditions are satisfied: the lease must have been made when the mortgagor was in default, it wasn’t commercially reasonable when made, and it was not consented to by the mortgagee.