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A consequence of the COVID-19 pandemic is that many companiesare unable to operate their businesses partially or completely. Asa result, they have been compelled to seek relief from theirlandlords, vendors and lenders.

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This has imposed tremendous strain on property owners whichthemselves have debt to service. In order to preserve preciousliquidity, property owners may need relief (deferral, forbearance,restructuring, extension) from their lenders and real propertyowners may consider withholding payment on their mortgageindebtedness.

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Now is the time for owners of real estate to review theirmortgage documentation, especially with regard to the assignment ofrents. Defaulting on mortgage indebtedness can divest the owner ofthe ability to use the rental income and place the owner in aweaker bargaining position with its lender. Furthermore, it maymake a Chapter 11 reorganization more difficult.

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A commercial mortgage lender often obtains a direct interest inthe rents flowing from income producing property [that it hasfinanced] to itself in the event of the borrower's default. Anassignment of rents – a standard loan document or component of themortgage or security agreement – assigns the property's leases andall rent and other income to the mortgagee. In addition, it is alsocommon for all rent and other income to be required to be depositedinto a dedicated lockbox account that is pledged to the lender. Inmany instances, the assignment is automatic and default notice isnot required.

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There are three general types of rental assignments: (a)absolute assignment, (b) absolute assignment conditional upondefault, and (c) assignment for security purposes. However, onlyabsolute assignments commonly are used in commercial mortgagestoday.

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The absolute assignment is an assignment ofall leases and rents that immediately transfers to the lender theright to receive rents from the encumbered property for the term ofthe mortgage. When an absolute assignment is used, the lendertypically grants the borrower a license to collect the property'srental income until some triggering event.

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The mortgagee's rights under an assignment of rents clausedepends upon, among other things, the state's interpretation ofmortgage law, which will determine to what extent the agreementnegotiated by the parties will be enforced and to what extent themortgagee will be able to reach the rents of the encumberedproperty.

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Does the mortgage loan provide for cash management provisionsthat require tenants to pay rent into a dedicated lockbox, and, ifso, does the lender have the right to cut off the borrower's accessto those funds in the event of a mortgage default? Commercialmortgage loans often include hard or springing lockbox protectionsfor the lenders. A hard lockbox prohibits the borrower from havingunfettered access to the rents and other income on day one of theloan, a springing lockbox cuts off the borrower's access upon theoccurrence of a trigger event, like a payment default or a breachof a financial covenant.

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The majority of states take the approach that the parties maybargain for a provision granting the mortgagee a right to rents andprofits upon default. Examples of triggers are:

  • Failure to make any payment.
  • Failure to perform or observe any term or condition of themortgage, the note or any other loan document.
  • Any representation, statement or warranty made by or on behalfof Mortgagor to Mortgagee at any time shall be materiallyincorrect, incomplete or misleading when made in any respect
  • Judgments, warrants or tax liens.
  • Casualty.
  • Any spill, discharge, disposal, seepage or release of anyRegulated Substances.
  • Impermissible encumbrance.
  • Covenant breach.
  • Any other typical default.

In Chapter 11, a debtor (borrower) typically will seekpermission of the bankruptcy court to use the income (rents)generated by the property for maintenance and operation of theproperty. However, if the license to use rents was terminated priorto bankruptcy because of the type of trigger described above, therental income no longer is considered property of the debtor.Therefore, the bankruptcy court is not able to permit its use overthe objection of the lender.

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Chapter 11 provides powerful tools to a borrower. It is a toolthat a prudent borrower should never inadvertently surrender.

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Commencement of a chapter 11 case requires advance planning.Moreover, the borrower must anticipate and prepare for the reliefthat the lender is likely to seek from the bankruptcy court. Beingequipped to commence a well thought out chapter 11 case is avaluable tool to avoid chapter 11.

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Chapter 11 is not necessarily a panacea for either side. Forlenders Chapter 11 may foreclose the ability to receive currentinterest or principal payments. Bankruptcy judges also mayrecognize the inequity of granting relief to lenders to enable themto foreclose at a low point in the market. For borrowers, it is arace against time that can be contentious and expensive- especiallyif the market recovery or property recovery takes an extendedperiod of time.

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In coping with Covid19, property owners need to be knowledgeableof their applicable loan documentation – including a rentassignment agreement- before developing a negotiating strategy withthe lender. The borrower also should assure that no triggeringevent occurs without proper planning. Otherwise, the outcome may bevery negative.

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Kenneth A. Rosen and Ted Hunter are chairs of thebankruptcy and real estate practices, respectively, and Stuart S.Yusem is counsel in the real estate practice, at Lowenstein SandlerLLP. The views expressed herein are those of the authors and maynot be shared by other persons employed by Lowenstein Sandler LLP.Each case is unique. The law is subject tointerpretation.

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