Secured Interests in RentsFact or Fiction

Secured Interests in RentsFact or Fiction

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Editor's Note: This is the first article in ABI's new column on secured creditors and issues affecting them.

Undersecured creditors who hold perfected security interests in rents according to §552(b) of the Bankruptcy Code should be able to increase their secured claims (up to the amount of the debt) throughout a bankruptcy case as rents become due, and a trend in bankruptcy court opinions confirms that secured creditors who receive adequate protection payments on account of their interests in post-petition rents should be able to apply those payments to reduce unsecured deficiency claims. However, a dearth of controlling authority on the issue continues to pose significant risks to creditors who rely on rents as collateral for secured claims in bankruptcy.

The situation may evolve as follows: Secured creditors holding perfected security interests in property and the rents flowing from that property receive post-petition payments from a debtor as adequate protection for their collateral during the administration of the case. Later, at the time of confirmation of the debtor's plan, a court finds that the collateral (other than rents) has not depreciated in value during the case, and the court is faced with the question of how to allocate excess adequate protection payments.

Bankruptcy courts in the last few years have tended to find that the amount of a claim secured by property and rents increases as rents become due during the case under §552(b). Accordingly, these courts allocate any payments to the creditor in excess of the depreciation of the underlying collateral towards payment of the secured claim increased by the amount of post-petition rents. In this way, unsecured deficiency claims indirectly decrease as rent payments are made throughout the pendency of a case.

Secured creditors are awarded adequate protection payments by bankruptcy courts to protect these creditors against depreciation in their collateral pursuant to §§362, 363 or 364 and 361, which provides that periodic cash payments made by a debtor during the bankruptcy case may be a sufficient form of adequate protection. The legislative history of §361 indicates that the primary purpose of adequate protection is to ensure that secured creditors are not deprived of the benefit of their bargain" when collateral depreciates in value during the bankruptcy case. House Report No. 95-595, 95th Cong., 1st Sess. 338-40 (1977). The legislative history also emphasizes a need for judicial flexibility to provide creditors with this "benefit of their bargain." Id. Secured creditors generally take the position that rents as collateral are part of this "benefit of their bargain" that should be protected.

Because adequate protection is meant to be a prospective form of relief, the amount of adequate protection payments is determined early in a bankruptcy case, before a final determination of the secured status of a creditor. In some cases, when the value of collateral (and the amount of the secured claim) is finally determined, courts find that adequate protection payments exceed depreciation in the value of an undersecured creditor's collateral.

Courts are split regarding the appropriate application of excess adequate protection payments when the secured creditor has a perfected security interest in rents. While some courts apply the amount of these payments to a claim that includes the amount of rents, other courts have held that excess adequate protection payments must be applied to the secured claim which does not include an interest in post-petition rents. The latter group of holdings seems inconsistent with §552(b)(1) of the Bankruptcy Code which provides:

if the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, product, offspring or profits of such property, then such security interest extends to such proceeds, product, offspring or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable non-bankruptcy law, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.

11 U.S.C. §552(b)(1). Section 552 allows the creditor's security interest to "extend" to post-petition rents and profits from the underlying collateral, but does not explicitly address how the additional cash collateral in rents will increase the amount of the secured claim under §506.1 The legislative history of §552 seems to limit the rights of the secured creditor by stating that the rents "continue to be subject to the security interest, except to the extent that the estate acquired the proceeds to the prejudice of other creditors holding unsecured claims." House Report No. 95-595, 95th Cong., 1st Sess. 376-377 (1977).

Neither §552 nor §361 indicates that a secured interest in rent is an "interest in property" protected by §361, although the legislative history of §552 does state that "the section is subject to other sections of title 11." See 11 U.S.C. §§361, 506; 124 Cong. Rec. H 11,097-8 (Sept. 28, 1978); S 17,414 (Oct. 6, 1978).

Adequate Protection Payments Toward Secured Claims

In Beau Rivage in 1991, the Northern District of Georgia ruled that adequate protection payments should be applied toward an undersecured creditor's secured claim, and rejected the creditor's argument that the payments should be applied toward a secured claim that increased periodically (limited by the amount of the debt) due to the fact that the creditor held a perfected interest in rents, so that the unsecured deficiency claim would be indirectly reduced. Confederation Life Ins. Co. v. Beau Rivage Ltd. (In re Beau Rivage), 126 B.R. 632, 639 (N.D. Ga. 1991). The court in Beau Rivage cited United Savings Assoc. v. Timbers of Inwood Forest Assoc. Ltd., 484 U.S. 365 (1988), as support for its holding that if payments made to an undersecured creditor were applied to a secured claim so as to reduce the unsecured deficiency claim, such payments would be "interest payments or use value, in direct contravention of Timbers and §506." Beau Rivage, 126 B.R. at 640. The court in Beau Rivage would not acknowledge that a secured interest in rents could cause the amount of the secured claim to increase so as to reduce the unsecured deficiency claim. Id. at 640. Similar reasoning has been adopted by several bankruptcy courts that refused to increase the secured claims of creditors on account of post-petition rents, and applied adequate protection payments only to the amount of the claim secured by an interest in the underlying property.2


...it remains uncertain whether many bankruptcy courts, or any higher court on appeal, would acknowledge a creditor's secured interest in rents as part of its collateral and apply excess adequate protection payments...

One of the bankruptcy court opinions that followed the reasoning of Beau Rivage is In re Reddington/Sunarrow, 119 B.R. 809, 813 (Bankr. D. N.M. 1990). The court in Reddington/Sunarrow held that a creditor with a secured interest in real property and the rents flowing from that real property should have the amount of its secured claim set at the petition date, and would not acknowledge an increase in the amount of collateral, and thus an increase in the secured claim, when rents became due post-petition. Id. at 814. The Reddington/Sunarrow court held further that in order to avoid improving the position of the secured creditor with an interest in rents in relation to other creditors, as that court believed was forbidden by Timbers, post-petition payments must be applied to the amount of the claim secured by the underlying property only. Id. at 814.

Adequate Protection Payments to Reduce Deficiency Claims

A trend has developed in more recent bankruptcy court opinions rejecting the reasoning of Beau Rivage regarding creditors with perfected secured interests in rents and applying adequate protection payments to the secured claim including the amount of post-petition rents.3 One of the first of these cases was In re Flagler-At-First, in which the court decided that §552(b) requires a creditor's perfected4 security interest in rents to be part of the collateral that must be adequately protected under §§361 and 506. In re Flagler-At-First Assoc. Ltd., 114 B.R. 297, 304 (Bankr. S.D. Fla. 1990). In Flagler-At-First, a creditor had a secured interest in property and in rental revenues flowing from that property. Id. at 298. The court held that adequate protection payments need not be applied to the creditor's claim on account of the underlying property, which had not depreciated in value during the case. Id. at 300. Instead, the court held that such payments may be applied to the increased secured claim, which included the amount of the "rents as cash collateral," in order to produce a "wash." Id. at 301. Therefore, as rents became due and were paid to the secured creditor as adequate protection, the amount of the unsecured deficiency claim diminished. The court in Flagler-At-First cited Timbers as support for its holding because the "rents as cash collateral" were depleted during the case, entitling the creditor to adequate protection. Id. at 303.5

In In re Gramercy Twins, the court held that an application of excess adequate protection payments to produce a "wash" is also consistent with the Supreme Court's proposition in Dewsnup v. Timm, that "any increase over the judicially determined valuation [of collateral] during bankruptcy rightly accrues to the benefit of the creditor, not to the benefit of the debtor and not to the benefit of the other unsecured creditors." In re Gramercy Twins Associates, 187 B.R. 112, 121 (Bankr. S.D.N.Y. 1995), citing, Dewsnup v. Timm, 502 U.S. 410, 417 (1992).

The bankruptcy court for the District of Columbia followed the reasoning of Flagler-At-First in In re Vermont Investment and additionally put forth an equitable reason for applying excess adequate protection payments to an increased secured claim. In re Vermont Investment L.P., 142 B.R. 571, 574 (Bankr. D. D.C. 1992):

application of the bank's bargained for collateral to create an "equity cushion"...would create a dramatic incentive for any secured creditor to bring a single asset reorganization case to a halt at the earliest possible moment, and would create a similar incentive on the part of the debtors to delay the case as long as possible in order to reduce the amount of the creditor's secured claim. Such a result would be contrary to the spirit and policy of the Code, which contemplates the protection of secured interests in property and that debtors should have a reasonable period of time to reorganize.

In 1995, the bankruptcy court for the Eastern District of Pennsylvania in In re Union Meeting Partners supported a holding consistent with Flagler-At-First with a thorough analysis of "Subtraction Cases" and "Addition Cases." In re Union Meeting Partners, 178 B.R. 664, 677 (Bankr. E.D. Pa. 1995). "Subtraction Cases" were defined as cases holding that excess adequate protection payments must be applied toward the secured claim on account of the creditor's interest in the underlying property, with no increase in that claim due to a secured interest in rents. Id. at 677. "Addition Cases" are those which hold that an interest in rents increases the amount of a secured claim and that excess adequate protection payments should be applied toward the increased amount so as to reduce the unsecured deficiency claim. Id. at 677. Based on this analysis and an interpretation of Timbers, the court in Union Meeting Partners aligned itself with the "Addition Cases," holding that payments of rent are not "interest payments on the secured portion of an undersecured creditor's claim, but instead are analogous to a liquidation of the rent portion of the creditor's collateral." Union Meeting Partners, 178 B.R. at 676.6

Practice Tips

Despite the increasing tendency in bankruptcy court decisions to include post-petition rents in the secured claim of a creditor with a perfected interest in those rents and to apply adequate protection payments toward the increased claim, it remains uncertain whether many bankruptcy courts, or any higher court on appeal, would acknowledge a creditor's secured interest in rents as part of its collateral and apply excess adequate protection payments toward that portion of a secured creditor's claim so as to reduce the deficiency claim.

Of course, the only way to avoid such uncertainty is to require collateral in secured lending transactions that would fully secure the debt even if rents were not taken into account. Another possible way to limit uncertainty regarding the effect of a secured interest in rents in some jurisdictions could be to structure transactions to include absolute assignments of rents rather than perfected interests in rents. Some bankruptcy courts in certain jurisdictions have held that an absolute assignment of rents pre-petition takes the rents completely out of a debtor's estate.7 However, transactions should only be structured in this fashion if it can be ascertained that the assignment of rents will be considered absolute in a bankruptcy proceeding according to prevailing state law. Another option for the secured creditor may be to create a bankruptcy-remote facility for the receipt of rents paid directly from lessees to be held for the benefit of the creditor. The risks involved in creating such a facility also may be determined largely by state law.


Footnotes

1Section 506(a) defines an allowed secured claim by providing:

An allowed secured claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under õ553 of this title, is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor's interest or the amount so subject to setoff is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor's interest. [Return to Text]

2 See, e.g., Matter of IPC Atlanta L.P., 142 B.R. 547, 558 (Bankr. N.D. Ga. 1992); In re Oaks Partners, 135 B.R. 440, 449 (Bankr. N.D. Ga. 1991); In re Kalian, 169 B.R. 503, 506 (Bankr. D. R.I. 1994); In re Reddington/Sunarrow Ltd. Partnership, 119 B.R. 809, 811(Bankr. D. N.M. 1990). [Return to Text]

3See, e.g., Flagler-At-First, 114 B.R. 297, 304 (Bankr. S.D. Fla. 1990); In re Vermont Investment LP, 142 B.R. 571, 574 (Bankr. D.C. 1992); In re Birdneck Apartment Assoc., II LP, 156 B.R. 499, 505 (Bankr. E.D. Va. 1993); In re Bloomingdale Partners, 155 B.R. 961, 976 (Bankr. N.D. Ill., E.D. 1993); In re 354 East 66th Street Realty, 177 B.R. 776, 782 (Bankr. E.D.N.Y. 1995); In re Gramercy Twins Assoc., 187 B.R. 112, 122 (S.D.N.Y. 1995); In re Columbia Office Assoc., LP, 175 B.R. 199, 204 (Bankr. D. Md. 1994); In re Union Meeting Partners, 178 B.R. 664, 667 (Bankr. E.D. Pa. 1995). [Return to Text]

4Although this article does not contain a detailed discussion of unperfected security interests in rents, generally courts have not acknowledged such interests as part of a secured claim. See, e.g., In re Multi-Group III Ltd. Partnership, 99 B.R. 5 (Bankr. D. Ariz. 1989); In re Association Center Ltd. Partnership, 87 B.R. 142 (Bankr. W.D. Wash. 1988); In re TM Carlton House Partners Ltd., 91 B.R. 349 (Bankr. E.D. Pa. 1988); In re Metro Square, 93 B.R. 990 (Bankr. D. Minn. 1988); 140 Congr. Rec. H 10,768 (October 4, 1994). [Return to Text]

5The court in In re 354 East 66th Street Realty reached a similar holding to that of In re Flagler-At-First, stating that the "wash" that results when a court applies excess adequate protection payments to an increasing secured claim of a party with an interest in rents is consistent with the Supreme Court's holding in Timbers, because the Supreme Court stated that parties with an interest in rents have greater rights than those that merely have an interest in the underlying property. 354 East 66th Street Realty, 177 B.R. at 781. [Return to Text]

6The Eastern District of Pennsylvania later criticized the "Subtraction Theory" because that theory assumes a "single valuation" approach for determining the value of a secured claim. In re Duval Manor Associates, 191 B.R. 622, 632 (Bankr. E.D. Pa. 1996); see In re Addison Properties LP, 185 B.R. 766 (Bankr. N.D. Ill. 1995), for a more detailed discussion of approaches toward timing of valuations of secured claims and the impact on application of payments. The court in Duval Manor adopted the "dual valuation approach," which also allowed for an increase in the secured claim to produce a "wash" for post-petition payments. In re Duval Manor Associates, 191 B.R. at 634, citing, Addison Properties, 185 B.R. 766 and In re Landing Associates Ltd., 122 B.R. 288 (Bankr. W.D. Tex. 1990). [Return to Text]

7See First Fidelity Bank N.A. v. Jason Realty L.P. (In re Jason Realty L.P.), 59 F.3d 423 (3d Cir. 1995); see, also, In re Wheaton Oaks Office Partners Ltd., 27 F.3d 1234 (7th Cir. 1994) (holding that despite the fact that an assignment of rents was not an absolute assignment of rents under state law, the creditor had taken steps pre-petition that took the property out of the estate); Federal Deposit Insurance Corporation v. International Property Management Inc., 929 F.2d 1033, 1034 (5th Cir. 1991). [Return to Text]

Journal Date: 
Monday, December 1, 1997