An underutilized remedy for California lenders: Section 2938 rent demands
Mortgage lenders in California typically take an “assignment of rents” from the borrower when they originate loans. However, if the borrower fails to pay timely, many California lenders are quick to start trustee’s sale or foreclosure proceedings but are reluctant to make rent demands as allowed by their assignments of rents. Why?
I think some of the reluctance is historical, because the relevant law was significantly changed in 1996. Even though that seems a long time ago, the California real property markets were so buoyant from 1996 through 2006 (but for a relatively small hiccup in 2001 or so) that many practitioners have never really learned the new laws, which are much more favorable to lenders.
First, some background: in California, when a lender makes a loan secured by real property, it is entitled to foreclose on the real property (either judicially – through a court action -- or through a trustee’s sale). What’s more, the lender’s rights are limited: the lender must enforce the loan against the collateral for the loan (other than in a few very limited circumstances), and does not have the ability to sue the borrower directly and to ignore the real property collateral. (I’ve discussed these “one-action” and “anti-deficiency” rules in earlier blogs.)
A lender with a mortgage or deed of trust encumbering real property collateral does not have the right to take the rents from the property – which are considered personal property, not real property -- unless it has a valid assignment of rents from the borrower. If a lender doesn’t have an effective assignment of rents, it has no right to the rents generated by the property from the time of the borrower’s default until it completes its foreclosure. Since this process takes some time – around 4 months as a minimum – lenders understandably can get fed up with borrowers collecting and keeping the rents from the real property while failing to pay their loans.
But if the lender has an effective assignment of rents, and makes the right moves to enfoce it, the lender may collect the rents from the property (even before a foreclosure or trustee’s sale is completed) if the borrower defaults under its obligation. (The rents must be applied to the obligation by the lender, and some other rules must be carefully followed.)
Assignments of rents must be in writing and signed by the borrower to be enforceable in California. California Civil Code Section 2938 is the key statute governing assignments of rents. Section 2938 was extensively rewritten in 1996 to clarify inconsistent earlier case law about how and when a lender’s interest in rents was created, perfected and enforced. To get priority against other folks claiming a right to the rents from the property, an assignment of rents must be recorded. These provisions may be included in deeds of trust or mortgages, or drafted and recorded as separate documents, or included in both the mortgage or deed of trust and as a separate document.
The biggest gift of the California legislature to lenders in the 1996 revisions to Section 2938 was amending the statute to provide that upon a default by a borrower who has provided an assignment of rents, its lender is entitled to enforce the assignment of rents in one or more of the following ways:
(a) by obtaining the appointment of a receiver;
(b) by delivery to any one or more of the tenants (with copies to the assignor and certain other required parties) of a written demand for turnover of rents, issues, and profits in the statutory form specified in Cal. Civ. Code Section 2938 (k);
(c) by delivery to the assignor (with copies to certain other required parties) of a written demand for the rents, issues, or profits.
While obtaining a receiver is a worthwhile remedy (the right to which was also changed in the late 1990s to fix some problems with inconsistent case law), as a practical matter, Section 2938 allows lenders to make demands directly to the tenants of the real property collateral, or to the borrower, or both, that they pay over all rents to the lender. This can be done in a matter of days after the borrower defaults!
These sorts of rent demands were virtually never done in the last (late 1980’s – early 1990’s) serious real estate lending recession because case law suggested that making such a direct demand for the rents might violate the one-action rule, and therefore might result in a lender losing its lien against the real property. No lender wanted to take that risk!
Now, however, revised Cal. Civil Code Section 2938(e) expressly provides that neither such rent demands, nor any collection, distribution, or application of rents, issues, or profits by the lender after such an enforcement action will constitute an action, render the obligation unenforceable, violate Section 726 of the Code of Civil Procedure, or otherwise limit any rights available to the assignee with respect to its security (other than with respect to marshaling requirements).
Further, Cal. Civil Code Section 2938(e) expressly provides that such rent demands do not make the lender/assignee a mortgagee in possession of the property, or any agent of the assignor, except if the assignee obtains actual possession of the real property. Nor does such a rent demand bar a deficiency judgment against the borrower. As noted above, the revised statute places some limitations on the lender: it must apply the rents collected to the secured obligation, and must, if requested by the borrower, pay certain expenses of the property out of the collected rents. Other restrictions are spelled out in Section 2938. Also, using Section 2938 rent demands is not completely without risk: the revised statute has not been fully tested in the courts, so some borrower may convince some court to construe it more narrowly than its plain language would suggest.
However, rent demands are (relatively) cheap, and can be done quickly, as they don’t require court approval.
Strategically, making rent demands can quickly cut off a defaulting borrower’s access to the money generated by the real property collateral – and that may bring a borrower to the table to negotiate a consensual resolution more quickly, since it may be blocked from using the lender’s collateral to build a war chest to pay its counsel to fight foreclosure or to file bankruptcy. These are great tools for lenders seeking to enforce defaulted commercial real estate loans in California.