Midwest Update - In re Town Ctr. Flats, LLC

Town Ctr. Flats, LLC v. ECP Commer. II LLC (In re Town Ctr. Flats, LLC), 855 F.3d 721 (6th Cir. 2017)

The Sixth Circuit Court of Appeals (the “Sixth Circuit” or the “Court”) overruled the lower bankruptcy court and held that Mich. Comp. Laws § 554.231 allows for transfers of ownership when (i) an agreement to assign rents (x) indicates an intention to transfer ownership and (y) has been recorded, and (ii) default has occurred.

Town Center Flats, LLC (“Debtor”) owned a 53‑unit residential complex (the “Complex”) financed with a $5.3 million loan (the “Loan”) from KeyBank that was later assigned to ECP Commercial II LLC (“ECP”). The Loan was secured with a mortgage and an agreement to assign rents to the creditor in the event of default. In the agreement to assign rents, Debtor agreed to “irrevocably, absolutely and unconditionally transfer, sell, assign and convey” to the assignee all of its right, title and interest in “income of every nature of and from the Project, including without limitation . . . minimum rents and additional rents”.  The agreement purported to be a present, absolute and executed grant of powers to the assignee while also granting a license to Debtor to collect and retain rents until an event of default, at which point the license would terminate automatically without notice to Debtor. Rents from the Complex were Debtor’s only source of income.  Debtor defaulted on its obligation to repay the Loan on December 31, 2013. On December 22, 2014, ECP sent a notice of default and a request for the payment of rents to all known tenants of the property. The following day, ECP recorded the notice documents, completing the last step required by statute to make the assignment of rents binding against both Debtor and the tenants of the property. ECP then filed a complaint alleging breach of contract, initiating foreclosure on the mortgage, and requesting the appointment of a receiver to take possession of the Debtor’s property. A week later, Debtor filed for Chapter 11 relief. At the time of Debtor’s petition, Debtor owed ECP $5,329,329 plus attorneys’ fees and costs. Debtor and ECP reached an interim agreement to allow Debtor to collect rents from the tenants of the Complex, with $15,000 per month used to pay down the debt owed to ECP.

The Bankruptcy Court and the District Court:

Debtor’s bankruptcy petition resulted in an automatic stay of the court case initiated by ECP. In February 2015, ECP filed a motion to prohibit Debtor from using rents collected after the petition was filed. Debtor opposed the motion on the grounds that it would have no income to work with in its Chapter 11 reorganization plan if the rents were not part of the bankruptcy estate. The bankruptcy court agreed with Debtor and denied ECP’s motion. The bankruptcy court determined that the assigned rents would qualify as cash collateral in the bankruptcy estate, meaning that under Chapter 11, Debtor must provide adequate protection to ECP before using the cash. ECP appealed the bankruptcy court’s ruling to the United States District Court for the Eastern District of Michigan (the “District Court”). ECP argued that Michigan law established a transfer of ownership in the assigned rents from Debtor to ECP. The District Court agreed and vacated the bankruptcy court’s decision. Debtor then appealed to the Sixth Circuit.

The Sixth Circuit:

According to the Sixth Circuit, the question on appeal was whether the assigned rents were property of ECP or part of Debtor’s bankruptcy estate. The Sixth Circuit noted that property rights are determined under the law of the state in which the real property is located, which in this case was Michigan. Once property rights have been determined under state law, federal bankruptcy law dictates to what extent that interest is property of the estate. In this case, the Sixth Circuit first analyzed the extent of property rights held by an assignor and an assignee of rents under Michigan law. The Sixth Circuit noted that the Supreme Court of Michigan had not spoken directly on the issue, and thus the Sixth Circuit would make an Erie guess as to how that court would resolve it.

The Sixth Circuit noted that historically, in Michigan, an assignment of rents was unenforceable because it would interfere with a mortgagor’s right of redemption. However, a 1925 statute created a right to assign rents for properties subject to trust mortgages. Important to this case, the Sixth Circuit noted that Mich. Comp. Laws § 554.231, a 1953 statute titled “Assignment of Rents to Accrue from Leases as Additional Mortgage Security,” extended the ability to assign rents to additional categories of property. Section 554.232 also solidified the validity of the assignment.  According to the Sixth Circuit, § 554.231 puts the assignee in the shoes of the mortgagor until the debt is paid, with all his rights to the rents and profits as long as he, under the general law of mortgages, could enjoy them. The Sixth Circuit noted that Michigan courts generally discuss assignments of rents under § 554.231 as ownership transfers once the agreement has been completed and recorded and a default has occurred. Further, an assignor loses any right to collect the rents after the assignee has perfected its rights following an event of default. The Sixth Circuit therefore predicted that, under Erie v. Tompkins, the Supreme Court of Michigan would treat a completed assignment of rents as a transfer of ownership.

The Sixth Circuit noted Debtor’s argument that the title and language of the Michigan statute made it clear that only a security interest, not an ownership interest, is assigned under this law. Debtor reasoned that the statute allows only for a security interest in the assigned rents, so any attempt to transfer ownership of the rents would be blocked by the default rule that an assignment of rents is unenforceable. The Sixth Circuit disagreed finding that the language of the statute that the assignment is “as security” does not foreclose an ownership transfer. The Court noted that Michigan courts have consistently read § 554.231 as allowing for assignments of rents to be transfers of ownership once the statutory steps for perfection have been completed. The Sixth Circuit decided to follow those Michigan courts in interpreting the language of § 554.231 as allowing for ownership interests to be transferred with an assignment of rents. The Court then found that the agreement in this case used broad language to unconditionally transfer its right in an executed assignment of the rents from the Debtor’s property. The Court concluded that the only fair reading of the language is that Debtor assigned the rents to the maximum extent permitted by Michigan law. Thus, because the Court held that § 554.231 allows for an ownership transfer in these circumstances, Debtor transferred ownership in the assigned rents to ECP before the bankruptcy petition was filed. Essentially, the broad language of the agreement evidenced an intention to transfer ownership.

Debtor argued that even with a transfer of ownership under § 554.231, it still retained some rights in the rents under Michigan law. In regards to a residual right, Michigan law states that if an assignor cures the default according to the agreement’s terms, then the assignor is able to start collecting rents again. Debtor argued that if the rents from the property are thought of as a stream of money, then it continued to hold a contingent future interest in collecting those rents. The future interest is realized, according to Debtor, if and when it cures the default. However, as the Sixth Circuit explained, if the rents are thought of as payments that occur during the discrete time period between the event of default and a potential future cure, then ECP has the sole interest in those payments and Debtor has no interest in them. This would hold true even if the Debtor later cures the default. The Sixth Circuit found the latter conceptualization of a discrete period to be more aligned with the text of the statute.  Debtor also pointed to a second residual right: Michigan courts have created restrictions on how the assignee can use rents collected under the law. However, the Sixth Circuit noted that neither the Supreme Court of Michigan nor the Michigan Court of Appeals has concluded that these restrictions on the assignee’s use of rent money create a property right vested in the assignor. The Court declined to create a new rule of Michigan property law on the issue.

The Sixth Circuit then answered whether the rights retained by the assignor were sufficient for those rents to be included in the bankruptcy estate. Again, federal law determines the scope of the bankruptcy estate. Despite the broad scope of Chapter 11 bankruptcy estates, the Court found that the assigned rents in this case were not properly included in Debtor’s estate. Debtor did not retain ownership of the rents and did not hold residual property rights in those rents. Instead, the rents belonged to ECP. In making this determination, the Court noted that its holding was in line with the majority of bankruptcy court decisions that have addressed the issue.  The Sixth Circuit concluded by noting that the bankruptcy court was motivated by a policy concern that excluding the assigned rents from the estate would effectively foreclose Chapter 11 relief for companies like Debtor that own a single property and receive their sole stream of revenue from rents of that property. The Court recognized the concern of the Debtor and the bankruptcy court that single‑asset real estate entities may have limited options under Chapter 11 in this situation. The Court concluded that Michigan law, however, is clear on the matter and governs despite policy concerns. Thus, § 554.231 allows for transfers of ownership when an agreement to assign rents indicates an intention to do that and has been recorded, and default has occurred. Since Debtor did not retain rights under Michigan law in the perfected assignment of rents, such rents were not included in the bankruptcy estate.