A recent decision by the Sixth Circuit Court of Appeals may have muddied the question of the impact of collateral rent assignments on a debtor’s ability to re-organize under chapter 11.

Town Center Flats LLC v. ECP Commercial II LLC involved a fairly standard real estate finance transaction for a multi-unit residential complex in Michigan. The loan used to finance the complex was secured by a mortgage and an assignment of rents.  The assignment of rents was structured as an absolute transfer, coupled with a license for the debtor to utilize the rents until the occurrence of an event of default.  Upon default, the agreement provided that the license would automatically terminate, thus re-vesting the rents in the secured party assignee.

Following a default by the debtor, the secured party provided a notice of default and request for payment to the tenants in the property. The secured party also recorded the notice in the real property records, completing the last step required by the statute to make the assignment binding against both the debtor and the tenants.

Subsequently, after a foreclosure case was begun by the secured party, the debtor filed a petition under chapter 11 and sought to recover the possession and use of rentals from the property. In response, the secured party filed a motion to prohibit the debtor from utilization of the rent collected post-petition.  The bankruptcy court determined that the rentals were assets of the estate, thus subject to use by the debtor upon provision of “adequate protection.” The secured party appealed the decision to the district court, which agreed with the creditor and vacated the bankruptcy court’s decision.  The debtor then appealed to the Sixth Circuit.

Citing Butner v. United States, 440 U.S.  48 (1979), the Sixth Circuit panel found the property rights are determined by virtue of state law.  It then made and “Erie guess” that Michigan courts would determine that a completed assignment of rents would qualify as a complete transfer of ownership.  The decision also rejected arguments by the debtor regarding the effect of residual cure rights and statutory limitations on the creditor’s use of the proceeds.  The court concluded: “ . . . Michigan law treats a completed assignment of rents as a change of ownership and the assignor of those rents does not retain residual property rights in the assigned rents.”

While the court considered the broad reach of the bankruptcy estate created under section 541 of the Bankruptcy Code, it concluded that since the debtor retained no rights under state law, accruing rents were not property of the estate.

Two factors seem to color the decision of the Sixth Circuit in this regard. First, the debtor did not act to commence its Chapter 11 case until after the secured creditor had completed all of the actions contemplated by statute to fully perfect the rental assignment.  In addition, the court did not cite an important Supreme Court decision that impacts the Butner ruling on use of state law.  In Barnhill v. Johnson, the Supreme Court acknowledged the relevance of state law to concepts of “property” and “interest in property.” Nonetheless, the court noted that, in the context of a preference dispute, that what constitutes a transfer and when the transfer is complete is a matter of federal law rather than state law.  Had federal bankruptcy principles, rather than state law, been used to evaluate the effect of the debtors residual rights following the default, a different outcome may have resulted.

Once again, a case involving fairly extreme facts has given rise to a ruling which may have applicability well beyond the scope of the particular situation. The effect of this decision, at least for debtors in Michigan, may be to drastically reduce the potential use of Chapter 11 by real estate debtors whose revenues are principally comprised of rentals subject to a collateral assignment.