MCLE Article and Self-Assessment Test
New legislation resolves several contentious issues arising out of assignments of rents in real estate finance transactions
By Norma J. Williams The new year brings a new law governing the assignments of rents given by borrowers to lenders in real estate finance transactions. Comprehensive in scope, and designed to correct deficiencies and omissions in prior assignments-of-rents law, Senate Bill 947, signed by Governor Wilson on May 15, 1996, and effective January 1, 1997, sets forth the rights and requirements that apply when a lender, in making a loan, takes not only the real property but also its income stream as collateral, such as where the real property is an office building, apartment building, or shopping center.
Norma J. Williams practices with Williams & Associates in Los Angeles. She is the chair of the State Bar Real Property Section's Secured Transactions Law Reform Committee, which drafted the proposal that was introduced as Senate Bill 947 and most of the subsequent amendments.
In real estate secured transactions, the borrower gives a lender a deed of trust or mortgage on the real property securing the loan. If the borrower also seeks to assign to the lender the income that will be generated by the property, the assignment may be contained in the mortgage or the deed of trust, or in a separate document commonly called an "assignment of rents and leases." The deed of trust, as well as any separate assignment, must be recorded.
Assignments of rents generally have been characterized as "absolute," "absolute conditioned upon default," or "for additional security." In theory, an absolute assignment would operate like an assignment executed in connection with a sale of property: the assignment of the rents to the lender would occur upon the execution of the assignment by the borrower and its delivery to the lender. Thus, the lender would have the right to immediately collect the rents from the tenants directly. This scenario, however, usually is not the intent of the parties, who most often prefer that the borrower collect the rents as long as the borrower is not in default on the loan.
Thus the conditional absolute assignment is most typically used in lending transactions. In a transaction containing a conditional absolute assignment, the assignment to the lender purports to be absolute at the time of execution and delivery. However, the conditional absolute assignment is different from the absolute assignment in that the lender gives the borrower a license to collect rents so long as the borrower is not in default. Upon default, the lender in theory would have an immediate right to the rents.
Prior to the new law going into effect, it was unclear what action, if any, a lender needed to take with an absolute or conditional absolute assignment in order to enforce the right to rents after the borrower defaults.
An assignment for additional security recognizes that the assignment of rents given to the lender at the inception of the transaction creates in the lender a security interest in the rents, enforceable only if the borrower defaults. The typical method of enforcing such an assignment is by the appointment of a receiver. However, prior law was also ambiguous as to what, if any, action a lender with an assignment as additional collateral needed to take in order to enforce its rights after default.
The new law repeals prior Civil Code Sections 2938 and 2938.1, adds a new Civil Code Section 2938, and amends, in part, Code of Civil Procedure Section 564. The problems arising from the former statutes covering assignments of rents, as well as the case law applying California's one-action and security-first rules (Code of Civil Procedure Section 726) and antideficiency law in Code of Civil Procedure Section 580d to rent assignments, had been brewing for some time. Civil Code Section 2938, in its previous incarnation, governed those assignments of interests in rents that were characterized as absolute. Former Section 2938 provided that such assignments were present transfers of the assignor's interest in rents, issues, and profits that could be recorded in the real property records. Recordation, under former Section 2938, was the action that perfected the assignment, notwithstanding any provision of the assignment or other law that would preclude or defer enforcement until the occurrence of a subsequent event, such as a default of the assignor.
Former Civil Code Section 2938.1 addressed assignments that were given "as additional security" by providing that these assignments were perfected by recordation in the real property records without the necessity of the beneficiary or mortgagee obtaining possession, appointing a receiver, or taking any other action. Under Section 2938.1 the assignee could not exercise rights to collect rents until there was a default. No cases interpreted Civil Code Section 2938.1 prior to its repeal.
These statutes perpetuated the judicially created distinction between absolute assignments and assignments for additional security. Even more important, while clearly establishing recordation as a requirement for perfecting an assignment, the statutes were ambiguous as to whether or not the lender had to take any actions to enforce its rights to recover specific rents after a default of the borrower. Of the two cases that construed former Civil Code Section 2938, In re Goco Realty Fund I held that it was necessary for a lender to take steps to enforce its interest in rents under an absolute assignment of rents at the time of default in order to obtain specific rents.
The creditor in Goco sought to recover retainers paid to the borrower's legal counsel prior to the bankruptcy filing from cash subject to the creditor's conditional absolute assignment of rents. When its foreclosure action was filed, the creditor did not issue a demand for the debtor to turn over the rents but moved only to sequester the rents. The Goco court considered whether the creditor's interest in the rents continued after the debtor transferred the rents proceeds to third parties to pay legal retainers -- and, if so, whether that interest prevailed over the attorneys' interest in the retainers.
The court held that the creditor was not entitled to the rents collected by the debtor until the creditor made a demand for the rents or took other affirmative enforcement actions, even though the creditor had a conditional absolute assignment and its interest in the rents was perfected under Civil Code Section 2938 once the assignment was recorded. Thus the court found that an enforcement of the assignment of rents was necessary to "bring an inchoate interest to fruition." The court stated that Civil Code Section 2938 might have precluded the need for a further perfection step but the same was not true for an enforcement step. Further, former Section 2938 on its face clearly contemplated a separate enforcement action, according to the court. Thus, in Goco, the creditor acquired priority in rents only after enforcement actions were taken by the lender. The court noted that any other result would bring confusion to the marketplace regarding the issue of entitlement to monies commingled or transferred to third parties.
Goco suggested that a demand on the debtor to turn over the rents would have been a sufficient enforcement step and that the creditor would be entitled to rents starting from the time of the demand. The Goco court also stated in dicta that a demand on tenants may constitute sufficient enforcement.
The only California Court of Appeal case construing former Civil Code Section 2938 is MDFC Loan Corporation v. Greenbrier Plaza Partners. While that court held that post-default enforcement of an absolute assignment was not necessary under Section 2938, the holding emerged in a case in which the lender had taken enforcement actions -- and those actions found approval with the court. The unanswered question is whether the court would have reached the same conclusion if the lender had not taken actions to enforce its rights.
Thus, even after the enactment of the prior statutes and the decisions in the two cases that interpreted former Civil Code Section 2938, the issue of whether a lender was required to enforce an assignment still lacked a definitive resolution.
Case law was clear that the appointment of a receiver constituted adequate enforcement of an assignment of rents given as additional security, but no other method of enforcement was similarly anointed. Thus, demands to tenants or borrowers were not definitively established or rejected as methods of enforcing an assignment and giving the lender the right to the rents.
The applicability of California's one-action rule to the assignment of rents was another unresolved issue that was litigated before the passage of the new law. If a court finds that the collection of rents by a lender or a receiver pursuant to an exercise of remedies under an assignment of rents and/or the application of those rents to the indebtedness constitutes the one action that the lender is allowed to take, the lender may lose its right to foreclose on the real property collateral.
Courts were not uniform in their interpretations of the one-action rule's applicability to assignments of rents. The state court decision in Great American First Savings Bank v. Bayside Developers, a depublished decision, nevertheless became a rule of thumb for many practitioners in advising their lender clients. In Bayside, a receiver's act of applying sales proceeds to the indebtedness prior to foreclosure caused the lender to lose its security interest in the underlying real property because of the one-action rule contained in Code of Civil Procedure Section 726. While the federal line of cases reached a different result, their precedential value is not clear in state court actions. Thus, lender clients frequently were advised that rents should not be applied to debt incurred before foreclosure but, instead, should be held and used to reduce the amount of a credit bid and applied to debt only after the completion of the foreclosure sale.
In re Sunnymead 13 is one case that demonstrates the extreme concern of lenders about the one-action rule. In Sunnymead, a secured creditor refused to accept cash collateral consisting of rents and profits from real property from the debtor's bankruptcy trustee as adequate protection payments for fear that such acceptance would violate the one-action or security-first principles of Code of Civil Procedure Section 726. The court held, however, that acceptance of the cash collateral would not have violated Section 726.
Case law had also raised the specter that application of rents to the debt could later result in a loss of the lender's right to a deficiency judgment. The primary case raising this risk was In re 500 Ygnacio Associates, in which the lender had an assignment of rents designated as absolute conditioned upon default. After the borrower's default, the lender made a direct demand on tenants and collected approximately $200,000. The case is not clear as to whether the rents were applied to the debt.
In response to the one-action issue raised by the borrower, the Ygnacio court ruled that enforcement of the interest in rents prior to foreclosure of the real property did not cause the lender to lose its right to foreclose because the rents were additional collateral. Turning to the antideficiency argument, the court said that the lender may lose its right to a deficiency judgment if the assignment of rents is viewed as a chattel mortgage, and application of rents to debt is viewed as a nonjudicial foreclosure of that chattel mortgage. No deficiency judgment would be permitted after that nonjudicial foreclosure.
An assignment of rents also could provoke litigation over who is entitled to the proceeds of real property rents if the lender had validly enforced its assignment but the borrower nevertheless obtained the rents and used them for other purposes. Could the lender move to recover those rents once they were paid out or used by the borrower? The courts gave conflicting answers. The Goco court, for example, stated in dicta that the lender could not recover the proceeds because it could not trace them. On the other hand, in In re Scottsdale Medical Pavilion, the court held that the rents were the lender's cash collateral even though the rents had been converted to checks and deposit accounts.
The drafters of the new assignment-of-rents legislation -- the Secured Transactions Law Reform Committee, which was appointed by the Executive Committee of the State Bar Real Property Section -- determined that the new law would meet all these conflicts head on:
- New Civil Code Section 2938(a) establishes that all assignments will operate as additional security, thus allowing parties to discard the fiction of the absolute assignment.
- Section 2938(b) requires perfection and enforcement of the assignment prior to the lender's entitlement to collect rents.
- Section 2938(c) and (d) delineate the permissible methods of enforcement, as well as their consequences.
- Section 2938(e)(2) and (3) provide that enforcement, collection, and application of rents to indebtedness do not constitute violations of Code of Civil Procedure Sections 726 or 580d, California's one-action and anti-deficiency statutes.
- Section 2938(f)(1) establishes that lenders may recover the proceeds of rents obtained 1) by the borrower after the lender's enforcement, either directly from the borrower or its agent; and 2) by third parties with an interest in the rents, if the rents can be traced in accordance with the relevant rules.
One of the most significant conceptual dilemmas raised by the former law was its perpetuation of the distinction between absolute assignments and assignments as additional security. New Civil Code Section 2938(a) could not be more clear in its abolition of the absolute assignment:
A written assignment of an interest in leases, rents, issue or profits... irrespective of whether the assignment is denoted as absolute, absolute conditioned upon default, additional security for an obligation, or otherwise, shall... be effective to create a present security interest....
The absolute assignment had been relied upon by bankruptcy courts in order to find that a lender had an immediate present interest in rents that could not be lost even if a debtor filed bankruptcy after a loan default but prior to the time a lender took action to enforce its interest. In re Ventura Louise Properties was the leading Ninth Circuit decision reaching this result. However, since assignments most often arose in the context of lending transactions, it has been difficult to maintain that an absolute assignment of the rents and leases (as in a purchase transaction) was the real intention of the parties. Thus, courts have strained to apply the absolute assignment concept to validate the lender's intention or have simply ignored the characterization and stated that only a collateral assignment was intended.
In taking the position that an absolute assignment was a fiction in the lender-borrower context, the drafting committee determined that all assignments should be treated as additional security. This treatment assures borrowers that they remain entitled to rents until they are in default and lenders enforce the assignment. The statute is consistent with the revisions to the Bankruptcy Reform Act of 1994, which treats assignments of rents as assignments as additional security.
The treatment of perfection in former Civil Code Sections 2938 and 2938.1 is unchanged in the new law: the recording of an assignment still constitutes perfection, under new Civil Code Section 2938(b). The new law then explicitly deals with enforcement in Section 2938(c), which lists the four permissible methods of enforcement after default by the borrower:
1) The appointment of a receiver.
2) Obtaining possession of the rents.
3) Delivering a written demand, in the form set forth in the statute, to one or more tenants for the turn over of rents, with copies to the named borrower and all other assignees of record of the rents.
4) Delivering a written demand for the rents to the assignor/borrower, with a copy to all other assignees of record of the rents.
Lenders should find a more simplified enforcement process as a result of these clear methods. Also, the enforcement requirement is consistent with designating all assignments as for additional collateral since under California law, when an assignment is for additional security, the borrower/assignor is entitled to collect and use the rents until the lender/assignee takes some action to obtain possession of the rents upon the default of the borrower. New Civil Code Sections 2938(c) and (e) specifically address the concerns of lenders expressed in the Bayside, In re 500 Ygnacio Associates, and Sunnymead cases. The intention was to clarify the interaction between a creditor's enforcement actions pursuant to its assignment of rents and the one-action and antideficiency rules. As part of its enforcement procedures, subdivision (c) provides for the allocation of funds received as a result of the assignee's enforcement actions:
Moneys received by the assignee pursuant to this subdivision, net of amounts paid pursuant to subdivision (g), if any, shall be applied by the assignee to the debt or otherwise in accordance with the assignment or the promissory note, deed of trust, or other instrument evidencing the obligation; provided, however, that neither the application nor the failure to so apply the rents, issues, or profits shall result in a loss of any lien or security interest which the assignee may have in the underlying real property or any other collateral, render the obligation unenforceable, constitute a violation of Section 726 of the Code of Civil Procedure, or otherwise limit any right available to the assignee with respect to its security.
Subdivision (e) reaffirms subdivision (c) by listing the ways in which the enforcement of an assignment of rents will not jeopardize an assignee's security rights and interests. This includes an explicit statement that enforcement actions will not constitute a violation of Code of Civil Procedure Section 726 or be construed as a bar to a deficiency judgment. The courts should get the message loud and clear that the legislative intent behind the new law is to overrule the residual effects of Bayside, disapprove In re 500 Ygnacio Associates regarding antideficiency implications, and allay the fears of lenders similar to those in Sunnymead.
In response to the dicta in Goco about the lender's right to the proceeds of rents, the drafting committee concluded that a proceeds doctrine would be a necessary component of any legislation that sought to address the rents issue comprehensively. New Civil Code Section 2938 (f)(1) and (2), plus the definitions found in subdivision (a), come into play when the lender has validly enforced its interest but the funds nevertheless are received by either the borrower or third parties, directly or indirectly.
An analysis of the proceeds issue begins with the characterization of rent proceeds as real or as personal property. Next is the determination of the interest of the creditor in the proceeds once they have been commingled and used by the debtor, as well as the rights of third parties.
Commercial Code Section 9104(j) excludes from the coverage of Article 9 of the Commercial Code the creation or transfer of an interest in or lien on real estate, including a lease or rents and any interest of a lessor and lessee in the lease or rents. However, some courts have distinguished between the lender's interest in rents excluded from the Uniform Commercial Code under Section 9104(j) and the proceeds of the rents, noting that proceeds consisting of cash, checks, instruments, and deposit accounts are items of personal property governed by the Uniform Commercial Code.
The drafting committee differed with Goco as to the characterization of rent proceeds. New Civil Code Section 2938(a) provides that the execution and delivery of an assignment of rents includes the cash proceeds of the rents. The term "cash proceeds" covers cash, checks, instruments, deposit accounts, and the like. Support for the new law's characterization may be found in cases such as In re Scottsdale Medical Pavilion, in which the court rejected the characterization of rents as real property and proceeds as personal property. The Scottsdale court held that such a distinction would render all assignments of rents illusory because paid rents would always be converted to items that would be covered by the Commercial Code.
New Civil Code Section 2938(f) also sets forth the specific rules that govern the different rights of the creditor, on the one hand, and the borrower/assignor or third parties, on the other. The creditor is entitled to immediate turnover of rents collected by the borrower; if the rents are in the possession of third parties, the creditor is entitled to them both if the money is segregated or, if commingled, can be traced using "the lowest intermediate principle." This doctrine results in recovery of an amount equal to the lowest balance that existed between the date of deposit and the date the lender's interest in the account is established.
Applying the lowest intermediate balance principle does not always result in the recovery of the exact amount of deposited funds. Further, the use of the principle does not carry an assumption that funds deposited by the assignor/borrower after withdrawing the funds in which the lender had an interest were deposited with an intent to replenish the withdrawn funds.
New Civil Code Section 2938(g) addresses the obligations of the lender who has been successful in collecting rents pursuant to its enforcement efforts. Subdivision (g) establishes that the borrower or any other lender with an interest in the rents may make a written demand on the lender who has collected the rents to use the rents, to the extent collected, for the reasonable costs of protecting and preserving the property, including the payment of taxes and insurance and compliance with building and housing codes. After the demand is received, the lender is obli-gated to use the rents in the indicated manner, but these actions do not make the lender a mortgagee in possession; the obligation to operate and manage the property remains that of the borrower. The lender remains obligated under the demand until it obtains an appointment of a receiver or it ceases its enforcement of the assignment of rents -- whichever happens first.
It is not uncommon for borrowers to grant interests in rents to more than one lender. For a determination of priority, new Civil Code Section 2938(b) continues California's race-notice rule -- the first party to perfect by recording has priority. However, if a junior priority lender nevertheless enforces its right to specific rents after a default under the new law and a lender with senior priority later enforces, new Civil Code Section 2938(h) states that the senior perfected, later enforcing creditor will be able to displace the junior perfected, first enforcing creditor as to rents accrued and unpaid as of the date of the senior's enforcement action as well as rents accruing thereafter.
The senior perfected creditor will not be entitled to rents that were paid prior to the date of its enforcement action. Once the senior perfected creditor takes its enforcement action, the junior creditor will be obligated to cancel any demand that it has made and will no longer be entitled to receive any of the rents. Rents received by a junior perfected creditor after the date of the enforcement action by the senior will be subject to turnover by the junior under new Civil Code Section 2938(f)(1).
The new law is effective for contracts entered on or after January 1, 1997. The text of former Civil Code Sections 2938 and 2938.1 that was in effect prior to January 1, 1996, will govern contracts entered into prior to January 1, 1997, and actions and proceedings initiated on the basis of pre-January 1, 1997 contracts. The date of January 1, 1996, rather than January 1, 1997, was designated for the operation of the code sections since the bill that led to the new law was introduced in 1995. As a practical matter, this designation is probably irrelevant since there were no changes to former Sections 2938 and 2938.1 between 1995 and 1996. Although the new law is not retroactive, parties entering into loan-modification transactions may elect to have the new law govern.
1. See S.B. 947, 1996 Cal. Stat. Chapter 49.
2. The new law sought to address deficiencies and omissions in the law governing assignments of rents in effect at the time it was introduced: see former Civ. Code §2938 (1991), former Civ. Code §2938.1 (1992), and case law. See also RTC v. Bayside Developers, 232 Cal. App. 3d 1546 (1991), depublished, Mar. 12, 1992, vacated sub nom., Resolution Trust Corporation as Conservator for Great American First Savings Bank v. Bayside Developers, 817 F. Supp. 822 (N.D. Cal. 1993), aff'd, 43 F. 3d 1230 (9th Cir. 1994); In re 500 Ygnacio Associates, 141 B.R. 191 (Bankr. N.D. Cal. 1992).
3. Except where the context otherwise requires, the new statute refers throughout to "leases, rents, issues, and profits." In this article, only the term "rents" will be used to refer to rents, issues, or profits.
4. See Kinnison v. Guaranty Liquidating Corp., 18 Cal. 2d 256 (1941); In re Ventura-Louise Properties, 490 F. 2d 1141 (9th Cir. 1974).
5. In describing the acts that were not necessary to perfect an assignment, the statutes mentioned acts that are actually methods of enforcement. This confusion emerged from the numerous cases, arising primarily in bankruptcy, where acts such as the appointment of a receiver were described as methods of perfection. See, e.g., Matter of Gotta, 47 B.R. 198 (Bankr. W.D. Wisc. 1985); In re Association Center Ltd. Partnership, 87 B.R. 142 (Bankr. W.D. Wash. 1988). Former Civ. Code §§2938 and 2938.1 clearly stated that these acts were not necessary to perfect but left open whether these acts or any others were necessary to enforce the assignment upon default.
6. In re Goco Realty Fund I, 151 B.R. 241, 248 (Bankr. N.D. Cal. 1993).
7. Id. at 248.
9. MDFC Loan Corporation v. Greenbrier Plaza Partners, 21 Cal. App. 4th 1045 (1994).
10. See Bernhardt, California Mortgage and Deed of Trust Practice ¤5.12 (discussion), at 249 (CEB, 1990 and Supplement).
11. See Lee v. Ski Run Apartments Assn., 249 Cal. App. 2d 293 (1967); Malsman v. Brandler, 230 Cal. App. 2d 922 (1964); Childs Real Estate Co. v. Shelburne Realty Co., 23 Cal. 2d 263 (1943); and Snyder v. Western Loan and Bldg. Co., 1 Cal. 2d 697 (1934).
12. Bayside Developers, 232 Cal. App. 3d 1546 (depublished).
13. In re Sunnymead, 178 B.R. 809 (B.A.P. 9th Cir. 1993).
14. 500 Ygnacio Associates, 141 B.R. 191.
15. Goco, 151 B.R. at 250.
16. In re Scottsdale Medical Pavilion, 159 B.R. 295 (B.A.P. 9th Cir. 1993).
17. Ventura-Louise Properties, 490 F. 2d 1141.
18. Cases that are critical of Ventura-Louise Properties include In re Charles D. Stapp of Nevada, Inc., 641 F. 2d 737 (9th Cir. 1991); FDIC v. International Property Management, Inc., 929 F. 2d 1033 (9th Cir. 1991); Goco, 151 B.R. 241. See also 500 Ygnacio Associates, 141 B.R. at 195-96 (criticism of absolute assignment characterization).
19. 11 U.S.C. §552(b)(2). However, the Reform Act does not state explicitly that all assignments are for additional security. Instead, it treats all assignments of rents as assignments for additional security. Thus some cases have stated that there is an open question whether the Reform Act provisions were intended to apply to absolute assignments. Compare First Federal v. Metroplex, 190 B.R. 510 (Bankr. S.D. N.Y. 1995) with In re Geary's Bottled Liquor, 184 B.R. 408 (Bankr. D. Mass. 1995).
20. Civ. Code §2938(c)(1) (1996).
21. Civ. Code §2938(c)(2) (1996).
22. Civ. Code §2938(k) (1996).
23. Civ. Code §2938(c)(3) (1996).
24. Civ. Code §2938(c)(4) (1996).
25. See Lee, 249 Cal. App. 2d 293.
26. In re Bristol Associates, Inc., 505 F. 2d 1056 (3rd Cir. 1974); In re Standard Conveyor Co., 773 F. 2d 198 (8th Cir., 1985).
27. Goco, 151 B.R. at 250 n.8.
28. Scottsdale Medical Pavilion, 159 B.R. 295 (interpreting Arizona law).
29. Id. at 298.
30. See Universal C.I.T. Corporation v. Farmer's Bank, 58 F. Supp. 317, 13 U.C.C. Rep. Serv. 109 (E.D. Mo. 1973); Chrysler Credit Corp. v. Superior Court, 17 Cal. App. 4th 1303 (1993). See also Code Civ. Proc. ¤703.080.
|EARN CLE CREDIT|| ||By reading this article and answering the accompanying test questions, you can earn one CLE credit.|