In these days of economic uncertainty, even the most basic commercial transactions deserve renewed scrutiny if parties to a deal want to protect themselves against the other's bankruptcy.

Along these lines, lenders should be aware of potential threats to collateral. Among the transactions that have received significant scrutiny by the courts are real estate-based loan transactions in which a lender requires as security an assignment of leases and rents.

In many instances, rents generated by a mortgaged property play a significant role in a lender's decision to make a loan. As a result, protection of such rents upon a borrower's default or bankruptcy is of the utmost importance.

Usual Arrangement

Customarily, collateral assignments of leases and rents are recorded as separate documents with appropriate county or other local recording officers or, in some cases, are incorporated within real estate mortgage documents.

Recent bankruptcy court cases nationwide, however, have called into question the manner in which security interests in lease rents are "perfected" and have focused on the additional enforcement steps, if any, that need to be taken by lenders to create and continue the "perfection" of such security interests upon a borrower's default or bankruptcy.

("Perfecting" a security interest under the Uniform Commercial Code is a process that establishes a secured party's priority in the collateral as against other claimants to the same collateral.)

Interpreting the Law

The initial issue regarding security interests in leases and rents is whether the filing of an assignment of leases (or including appropriate assignment language within a real estate mortgage) is sufficient to perfect the security interest granted in such documents.

Since the Uniform Commercial Code generally excludes from secured transactions the creation or transfer of interests in or liens on real estate, including interests in leases or rents, lenders normally look to state law to determine how real estate-based security interests, including interests in leases and rents, are perfected.

Notwithstanding the foregoing, however, some bankruptcy courts have concluded that in certain circumstances the interests granted to a lender are, in fact, not real property interests in rents.

Categorizing Rent Income

For example, some courts have held that rents or receivables generated from hotel rooms and nursing home rooms are actually accounts receivable or "personalty", and that the proper perfection of such security interests is accomplished only by filing Uniform Commercial Code financing statements, not by filing traditional lease assignment documents.

It is easy to envision circumstances in which, for example, a lender may be financing the acquisition of a hotel and in which the lender will seek security in the form of room receipt revenues (which may be deemed "personalty"), together with concession rents from shops and restaurants (which fall within the common category of "realty" based rents).

Such a hybrid situation may result in true real estate lease assignments (for the shop and restaurant leases), which should be perfected under state law by filing an assignment of leases with the appropriate county or local recording officer, and a grant of a security interest in accounts receivable (for hotel room receipts), which should be perfected by filing financing statements.

What Prudence Demands

Since different courts have reached different findings in analyzing the nature of the asset in which a security interest is granted, a prudent lender would be well advised to consult with legal counsel as to the status of the law in its jurisdiction and may, in some circumstances, be best advised to file both a real estate assignment of leases and financing statements.

Unfortunately, the analysis regarding a lender's rights to rents does not end with the discussion of proper security interest perfection.

Bankruptcy courts in some jurisdictions take the analysis a step further and have raised the issue of whether the filing of an assignment of leases or a financing statement is sufficient when the lender has not diligently pursued its rights in such rents and leases after a default by the borrower.

Danger of Inaction

Some courts have gone so far as to deem a lender's interests unperfected if the lender has not taken action to realize upon the rights granted to it in the respective security documents. Examples of such actions to be taken include seeking the appointment of a rent receiver or taking action to collect rents itself upon a borrower's default.

The foregoing determinations concerning a lender's inaction have led some courts to make a corollary distinction between whether an assignment of leases and rents is a "collateral" assignment or an "outright" assignment.

A collateral assignment is one that gives lenders certain rights on a default, whereas an outright assignment gives lenders rights immediately upon execution of the loan documentation.

A determination that an assignment is "collateral" has been used by some courts as a basis for concluding that a lender's interest is "unperfected."

Certain bankruptcy courts have therefore accorded significant importance to a secured party's ability to evidence its control over the rents in which it seeks to retain an interest, whether as a result of its having an outright assignment originally or as a result of its having taken action to collect rents itself, or to have a rent receiver appointed in "collateral" situations when a borrower has defaulted.

Post-Default, Pre-Bankruptcy

Since loan defaults may occur before a borrower seeks bankruptcy protection, a lender's actions post-default and pre-bankruptcy have become critical to certain courts.

In current loan situations, lenders should therefore be careful to exercise rights they may have if defaults occur.

In situations where lenders are about to enter into loans or modify existing loans, lenders may want to consider requiring an outright assignment of rents pursuant to which the lender, or a receiver appointed on behalf of the lender, collects all rents at all times, not only after the occurrence of a default.

Such collateral mechanisms may vary depending upon the situation, and may include "lockbox" arrangements pursuant to which tenants are instructed to remit all rent payments directly to the lender, or some other escrow arrangement in which ultimate control as to application of the proceeds of such rent payments may be applied at the lender's discretion.

If appropriately documented, such outright assignments may give a lender actual possession of rents and may be effective in keeping such rents and proceeds outside of the bankruptcy estate in the event a borrower seeks bankruptcy court protection.

In structuring such escrow or lockbox arrangements, however, lenders should be mindful that borrowers may need access to the rent proceeds on an ongoing basis for working capital.

If properly crafted, the lender may have access to the rents if an event of default were to occur, but otherwise permit the borrower to have access to its cash flow.

While lockbox or escrow mechanisms may be an attractive solution for lenders as protection in case a borrower goes bankrupt, lenders should always be mindful of potential lender liability issues that may arise under such schemes.

Lender Liability

For example, if it is a lender's responsibility to collect rents on time and to be sure that tenants are paying on time, and if a lender does not discharge such responsibility adequately, the lender may expose itself to legal action by the borrower.

Similarly, certain risks will be borne by a lender if rent payments are misapplied or not applied in compliance with the rent collection and disbursement mechanisms that have been established, or if rent receipts are improperly commingled with other funds, or if good accounting practices are not maintained during the lockbox arrangement.

Any discretion granted to the lender in disbursing rent proceeds to a borrower may also expose a lender to legal action if such discretion is not exercised in a prude fashion.

Know the Law

As in all situations in which laws are emerging, lenders and borrowers alike should bear in mind that it is extremely important to fully understand the status of the law in their own jurisdictions.

It is equally advisable for lenders to take the opportunity to reevaluate their lending and collateral policies in light of changing laws. Such review is equally important and is equally applicable to new loans as well as to loan modifications.

Borrowers should have a clear understanding of the controls they need to maintain over cash flow from rents during the administration of a loan before a default or bankruptcy, and should be aware that a well-advised lender may seek greater control over its rent receipts before and after a loan default.

And while lenders may resist the added risks and responsibilities of rent-receiver or lockbox arrangements, the rewards of greater collateral protection may be more than sufficient compensation.

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