Real
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.