As part of most institutions’ prudent lending practices, due diligence processes, and SBA program requirements, lenders obtain executed assignments of leases and rents from their borrowers. These agreements entitle lenders to any income derived from the CRE (from leases, rents, etc.) if the borrower defaults on the loan. However, what most lenders don’t know is what happens to the assigned rent if the borrower files for bankruptcy. A common misconception is that the assigned rent always becomes part of the bankruptcy estate to be distributed by the Trustee among the creditors. However, it is useful to know that the law typically favors those lenders who hold executed assignments of leases and rents.
The law is well settled that an assignment of leases and rents is enforceable in bankruptcy proceedings. If, prior to loan disbursement, the lender has obtained an executed assignment of leases and rents, the lender may request that the bankruptcy court issue an order to enforce the assignment and have the bankruptcy Trustee (or another custodian) turn this money over to the lender. On many SBA 7(a) loans, the proceeds from a sale following foreclosure leaves the lender with a deficiency. As such, the rule followed by most courts is that the rents collected between adjudication and the sale under foreclosure proceedings belong to the lender – under a claim of deficiency – when the proceeds of the sale are insufficient to pay the mortgage indebtedness.
Another argument presented to the court in enforcing the assignment of rents is under a theory of conversion. Upon default, an assignment of rents and leases extinguishes a borrower’s right to collect the rent, in whole or in part, meaning that the lender acquires the right to collect lease payments from its borrowers’ tenants. Because SBA loan documents require an “event of default” to occur prior to any lender’s ability to enforce the assignment of rents, SBA lenders’ loan documents should always identify bankruptcy as an “event of default.” In other words, the assignment of leases and rents may take effect conditioned upon an event of default and, if default occurs, the rents are then assigned to the lender and – arguably – do not become part of the bankruptcy estate. Unfortunately, many lenders fail to explore this option and choose to do nothing until the borrower emerges from bankruptcy or receives a formal discharge.
It is important to keep in mind that these bankruptcy enforcement options may not apply to all situations because disputes and litigation are always fact-specific. Accordingly, it is important for any institution’s special assets group to confer with bankruptcy counsel to evaluate the circumstances and determine if enforcement of the assignment of leases and rents may be appropriate and warranted to prevent conversion of funds collected by the borrower or the bankruptcy Trustee.
For more information pertaining to creditors’ rights or the enforcement of assignments of leases and rents, contact Demetri A. Braynin at firstname.lastname@example.org or at 267.470.1210.