March 25, 2009

With the dramatic drop in the real estate market, commercial lenders need to explore every possible avenue in recovering their non-performing loans. One such opportunity—at least in theory—is enforcing an assignment of rents. Unfortunately, the broad self-executing rights typical in an assignment of rents document are not supported by Illinois law.

Typically, an assignment of rents is executed whenever a loan is secured by a commercial mortgage. This type of contract gives the lender broad rights to the rents from and income generated by the tenant of a property—regardless of whether the borrower is in default. Most assignment documents also grant the borrower a right to collect rent until the time the lender exercises its right to collect rents.

When the underlying obligations enter into default, secured lenders understandably rely on the assignment of rents as a possible stopgap until the matter is either resolved amicably or they recover the property through a deed in lieu of foreclosure or a judicial sale at the conclusion of foreclosure. However, both federal and state courts in Illinois have found that provisions allowing a lender to collect rents without actual possession of the property are unenforceable according to the "rents and profits rule,” which prevents a mortgagee from enforcing its assignment of rents until the lender has constructive possession of the property. Illinois courts have also held that a secured party must either be placed as mortgagee in possession or appoint a receiver in order to collect the rents subject to an assignment of rents on a mortgaged property. The policy behind the "rents and profits rule" is that a party who obtains the benefit of a property's rent must also accept the burdens and responsibilities that come with possession of the property.

Case Law in Illinois

The seminal case involving assignment of rents in Illinois is Comerica Bank v. Harris Bank Hinsdale, decided in 1996. As security for a loan, Comerica took a first mortgage and an assignment of rents on a shopping center in Hillside, Illinois. After the borrower defaulted but prior to filing a foreclosure action, Comerica began to collect rents from the property (pursuant to the terms of its assignment of rents document). Ultimately, the trial and appellate courts found that despite the clear language in the assignment of rents document, Illinois common law dictates that rents belong to the party in possession of the property.

In this context, financial institutions in Illinois have looked to alternative means to collect rent from property for which they have a secured interest. In Fidelity Mutual Life Insurance Company v. Harris Trust and Savings Bank, decided in 1995, the Seventh Circuit upheld an indemnity agreement whereby the landlord was required to remit all the rents to the mortgagee after default. The court refused to view the separate indemnity agreement as an assignment of rents constrained by the "rents and profits rule" for two reasons. First, the court stated that any confusion to tenants would not exist under the separate agreement because the tenants would continue paying rent to the mortgagor. Second, as long as the mortgagor was allowed to keep the rents to the extent necessary to maintain the property, public policy would not be violated as the party in control of the property would still have the means to maintain the property.

Mortgagees who, of their own accord and on their own letterhead, direct tenants to pay rents to a third party, such as a lender, would not appear to be violating the "rents and profits rule," though no court has addressed that issue.

Lessons Learned

Illinois courts have been clear that an entity must be in possession of mortgaged real estate to utilize an assignment of rents. The "rents and profits rule," however, may not stop either commercial lenders or the courts from looking to alternative methods of collecting rents after a borrower has defaulted on a commercial loan.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.