Avoiding the “Lender as Landlord” Scenario
December 21, 2011
Unfortunately, as we all know, foreclosures are necessary. But foreclosures, by their nature, involve a certain degree of unpleasantness and challenges.
A particularly thorny set of challenges arises when the foreclosure involves income producing property, especially residential rental property.
Imagine this all too familiar real world scenario: as security for a loan, the borrower grants the bank a deed of trust lien against the borrower’s apartment building. As additional security for the loan, the borrower grants the bank an assignment of leases and rents. After a period of time, the borrower defaults on the loan. The bank exercises its rights under the assignment of leases and rents and notifies the borrower’s tenants that all rent coming due should be paid to the bank until further notice. Unfortunately, pursuant to the terms of leases entered into by and between the borrower and his tenants, the cost of utilities such as electricity, water and natural gas were included in the monthly rent. Now effectively cut off from the income stream that the borrower used to pay for the utilities (assuming, of course, that the borrower actually was paying the utilities in the first place) by virtue of the bank exercising its rights under the assignment of leases and rents, the borrower allows the utilities to become delinquent. Shut-off notices are issued. Through no fault of their own, nor the bank’s, the building’s tenants face the loss of some of their most basic utilities. Winter will soon be upon us, and the tenants are looking for someone to step up and remedy the situation. The tenants do not want to hear that that the utilities were established in the name of their landlord, and that the bank is simply exercising its contractual rights under the assignment of leases and rents. They want answers. They want their lights back on.
A Potential Solution.
What is the bank to do in this situation? How does the bank enforce its contractual rights against a recalcitrant debtor while at the same time avoiding the nightmare “lender as landlord” scenario? While it may not be a magic wand (and can be expensive), the appointment of a receiver to take control of the collateral may be a viable solution. “Single-asset” real estate businesses, with loans secured by the real estate, are particularly well suited to receivership. Many deeds of trust expressly provide for the appointment of a receiver upon default by the borrower, and courts are amenable to honoring these provisions. Receivers are appointed by the court, and therefore, are agents of the court, not beholden to the debtor or any one creditor. That stated, often, the party seeking the appointment of a receiver, usually the senior secured party, will suggest one or more candidates to serve as a receiver. State court judges frequently are receptive to lienholders designating receivers, and often they will enter an order appointing the receiver suggested by the moving party.
A receiver’s duties are derived from state law. In many states, a special receiver may only be appointed in a pending lawsuit. In other words, an action does not lie for the sole purpose of appointing a receiver. The court must have jurisdiction over the action upon some other ground, such as a suit to collect on the loan, before it can make the appointment. Additionally, before a receiver can be appointed, the court must first determine that “there is danger of the loss or misappropriation” of “funds or property of a corporation, firm or person.” Finally, the courts generally require that the receivers give bond in an amount set by the court.
Receivership Coupled With Injunctive Relief.
States vary on the degree of notice required before a receiver may be appointed. In West Virginia receivership statutes provide that “no such receiver shall be appointed of any real estate, or of the rents, issues and profits thereof, until reasonable notice of the application therefore has been given to the owner or tenant thereof.” This, in and of itself, may present its own unique set of challenges. For example, will notice to the borrower create an opportunity for mischief, such as the mass exodus of fixtures from the real estate? For states requiring significant notice, a lender seeking the appointment of a receiver is well advised also to seek injunctive relief against the borrower enjoining him from entering upon the property and interfering with the receiver’s management of the property.
How Does the Receiver Get Paid?
No individual or organization in its right mind would take on the burden of managing an apartment building, or some other operating collateral, without some assurance of compensation. Court appointed receivers are no different. The particular terms of a receiver’s compensation are subject to negotiation. Often, the receiver is to be paid a reasonable fee out of the income derived from the property being managed (i.e., the rents). If, after paying the costs and expenses associated with the operation and maintenance of the property, the rental income is insufficient to compensate the receiver, the senior secured lender may wish to advance to the receiver such funds as may be necessary to satisfy the costs and expenses of the receivership. The amounts paid to the receiver by the lender may be deemed secured advances and added to the outstanding balance due under the note secured by the deed of trust. This can be embodied within the order appointing the receiver entered by the court.
A lender faced with a nonperforming loan secured by income producing property, particularly residential rental property, is faced with the unenviable position of “lender as landlord” if the lender elects to invoke its contractual rights under an assignment of rents and leases. Fortunately, single-asset real estate businesses are particularly amenable to the appointment of a receiver to take control of and to manage the property, thus relieving the lender from being bombarded by calls from angry tenants whose hot water tank is on the fritz.
The above is not, nor is intended to be, an exhaustive discussion of the advantages and risks of receivership. Please feel free to contact any one of the attorneys practicing in Spilman’s Community Banking Group to discuss any particular issues you may be facing.