Assignment of Rents in Bankruptcy - July 1995 Update

A landmark opinion has just been issued by the Third Circuit which is a major victory for lenders. The Court held that under New Jersey law, an absolute assignment of rents vests title to the rents in the secured lender leaving the borrower with no interest in the rents. Thus, when the borrower filed a petition under Chapter 11 of the Bankruptcy Code, the rents were held not to be property of the estate and were not available to fund the debtor's proposed plan of reorganization.

First Fidelity Bank, N.A. v. Jason Realty, L.P. (In re Jason Realty, L.P.), 1995 U.S. App. Lexis 16527 (3d Cir. 1995) involved a single asset real estate debtor which owned a retail and office building in New Jersey. The lender held a mortgage and a separate assignment of rents. The debtor was given a license to collect the rents so long as there was no default on the mortgage. After the borrower went into default, the bank sent a notice to the tenants demanding payment of the rent directly to the bank. Subsequently, the bank initiated a foreclosure action and sought the appointment of a receiver. Before the return date of the receiver motion, the debtor filed a Chapter 11 petition.

The Bankruptcy Court had held that the assignment of rents was a security device which perfected the lender's lien on the rents, but that the debtor, nevertheless, retained a property interest in the rents. Therefore, the Bankruptcy Court found the rents to be property of the estate and cash collateral. The Bankruptcy Court permitted the debtor to use cash collateral to pay the operating expenses of the property and ordered adequate protection payments to the lender. On appeal, the District Court reversed and held that the rents were not property of the estate. Thus, the rents were not cash collateral and were not available to fund the debtor's plan of reorganization. In re Jason Realty, L.P., 1994 WL 774537 (D.N.J. 1994). The debtor appealed to the Third Circuit which affirmed the District Court. The Third Circuit gave a detailed recital of the history of New Jersey law regarding assignments of rents. The Court concluded that the assignment document in this case was an absolute assignment leaving the debtor no interest in the rents and no ability to use the rents to fund a plan of reorganization.

This is the second major opinion issued by the Third Circuit in favor of lenders. In Commerce Bank v. Mountain View Village, Inc., 5 F. 3d 34 (3d Cir. 1993), the Court found that an assignment of rents under Pennsylvania law left the debtor with no property interest at the time of the bankruptcy petition. Pennsylvania is a title theory state, whereas New Jersey is a lien theory state. Therefore, it was not clear that the same result would obtain under New Jersey law. However, the Third Circuit has now settled all questions in favor of lenders.

Connell Foley LLP is recommending that the commercial lending documents of the firm's bank clients be reviewed to make sure that there is a separate assignment of rents document, that the assignment language is absolute and that the borrower be given a mere license to collect the rents prior to default.

For further information about assignments of rents in commercial lending documents and related matters, please contact Steven V. Falanga.