A lender can generally assure that its lien on a borrower's real estate has priority over later creditors by simply recording the mortgage or deed of trust.
The action a lender must take to obtain similar priority for a lien on rents arising from that real estate, however, varies widely among the states.
In some states, recording a mortgage that contains an "assignment of rents" provision is all that needs to be done, while other states require lenders to record a mortgage and take additional action, such as commencing a foreclosure proceeding or having a receiver appointed for the property.
Still other states have unclear requirements, leaving lenders without adequate guidance on what steps to take.
Rulings Hard to Predict
This lack of clarity is worsened when a borrower enters bankruptcy. That's because bankruptcy courts may apply and interpret state law requirements differently from state court judges. Indeed, two bankruptcy judges interpreting the same state's law may come to completely different conclusions.
All of this leaves lenders in a tenuous position.
If the lender has failed to take appropriate action, it might be cut off from its right to rents should a borrower file for bankruptcy. Yet precisely what action a lender is supposed to take to prevent this may not be ascertainable, or even achievable.
This is hard to figure.
How is it that a commercial lender and a real estate developer, two sophisticated parties commonly represented by high-powered counsel, can agree on a contract clearly reflecting the understanding that the lender is entitled to rents after the borrower's default (including as a result of bankruptcy), yet have no certainty that the contract will be upheld?
To make matters worse, developers do not even need to file for bankruptcy to benefit from this confusion.
Knowing that lenders run a risk should developers file, many developers use this undeserved leverage to squeeze concessions from lenders by threatening to declare bankruptcy.
As a consequence, one of the principal points of confrontation in many real estate workouts and bankruptcies today is over who should receive the rents: the lender in accordance with the business arrangement, or the borrower despite it?
Because the stakes are so high -- the right to potentially millions of dollars of rents often is at issue -- this is a major battleground over which endless hours of needless debate and negotiation occur.
Attempts at a Solution
To date, the response to the problem has been telling. A handful of states, including Florida and Tennessee, have enacted statutes upholding a lender's priority in rents after it records a mortgage containing the assignment-of-rents language, sends notice to its borrower demanding a turnover of rents, or takes other specified acts.
In certain cases, bankruptcy judges interpreting state law have strained to come up with creative techniques that a lender can take to preserve its right to rents after the borrower enters bankruptcy.
Unfortunately, this patch-work quilt of solutions does not solve the problem nationally or even within some states.
Law in the Works
In June, on a 97-to-0 vote, the U.S. Senate passed a bankruptcy reform bill with a provision intended to end the rents problem nationwide. It seeks to enact a federal standard for bankruptcy cases by protecting a lender that has a recorded lien on rents.
This approach would avoid unnecessary and unintended losses by lenders and create consistency in real estate lending transactions, thereby encouraging lenders to make credit more available.
Unfortunately, it is unclear whether the bankruptcy reform bill under consideration in the House of Representatives will even address the issue, let alone follow the approach taken by the Senate. It should.
Mr. Edelstein is a partner in the bankruptcy and workout department of the law firm of Milbank, Tweed, Hadley & McCloy, New York, and a co-head of the firm's real estate workout and bankruptcy group.