Assignment of rents clause

This article discusses the uniform rules for enforcement of assignment of rent clauses.

The lender’s rent collection scheme

An assignment of rents clause is commonly placed in all trust deeds. The clause includes rents as additional security to the real estate described in the trust deed.

The rents clause in a trust deed transfers to the beneficiary (lender) the right to collect rental income from the income-producing real estate described in the trust deed following a default on the note, trust deed or other secured obligation held by the lender. The rents clause is legally referred to as an assignment of rents, issues and profits clause.

Two types of assignment of rents provisions exist:

1. An absolute assignment.
2. A conditional assignment.

However, the distinction between the two types of assignment of rents clauses is not of concern to the holder of a trust deed recorded on or after January 1, 1997.

A trust deed executed and delivered after 1996, containing either type of assignment of rents clause, creates a present security interest in existing and future leases, rents, issues or profits on the secured real estate, and is generally referred to as a lien. [Calif. Civil Code §2938(a)]

The 1997 statutory scheme provides for uniform enforcement of all assignment clauses, no longer leaving the details to the trust deed contract.

For assignment of rents clauses recorded before 1997, the rules regarding the distinctions between the two types of rent clauses still govern their perfection and enforcement.

Editor’s note — Unlike liens on real estate or personal property, enforcement of a security interest in rents had not been controlled by the state prior to 1997.

Like statutory schemes that control a trustee’s foreclosure sale when enforcing a power-of-sale provision in a trust deed, and the sale of personal property when used as collateral for a loan, the statutory scheme for the enforcement of assignment of rents clauses entered into after January 1, 1997, controls the procedures for perfecting the lien and enforcing the collection of rents.

Absolute assignment – pre-1997 rules

An absolute assignment of rents clause is a present transfer of all the owner’s right, title and interest in the rents generated by the real estate.

To be enforceable, the present transfer must first be perfected. The transfer of title to the rents is perfected on recording the trust deed that contains an absolute assignment clause. [CC §2938(b)]

However, the absolute assignment of rents provision reserves to the owner the right to collect and use the rents until the owner defaults on the note or trust deed, or other debt the trust deed secures.

On default, the lender can enforce its right to collect the rents. [CC §2938(c)]

Under an absolute assignment of rents, the lender is entitled to collect the rents directly from the tenants without first taking possession of the real estate or using a court-appointed receiver.

Thus, the lender can directly enforce the absolute assignment of rents clause by making a written demand on the owner or tenant for the rent.

Conditional assignment of rents – pre-1997

A conditional assignment of rents clause in a trust deed creates a lien on all rents in favor of the lender. The rents become additional security to the real estate which is liened by the trust deed.

As a lien, the conditional assignment of rents is not a present transfer of any rights to the rents. The lender merely holds a lien on the rents and has the right to enforce collection of the rents by taking possession of the real estate on a default in the trust deed. Possession can be by the lender or by a court-appointed receiver.

For conditional assignments entered into before January 1, 1997, judicial confusion as to the distinction between the terms perfection and enforcement existed.

However, for all conditional assignment of rents clauses entered into between January 1, 1993 and January 1, 1997, the lender perfected his lien right in the rents by recording the document (trust deed) that contained the conditional assignment provision. [CC §2938(b)]

Editor’s note — The two different types of assignment clauses led to chaos in perfection and enforcement.

1997 assignment of rents scheme

A trust deed executed and delivered after 1996 which contains any type of assignment of rents clause establishes a present security interest – a lien – on existing and future rents, issues or profits of the properties, regardless of whether the assignment is called absolute, absolute conditioned on default, additional security, a lien, etc. [CC §2938(a)]

The rent assignment clause may be in a separate lien agreement, but is usually placed in the trust deed recorded against the real estate involved. [See Figure 1]

Once the assignment is recorded, the assignment:

• gives constructive notice of the lender’s security interest in the rents; and
• is fully perfected even though the provision states the assignment is unenforceable until a default occurs on the note or trust deed. [CC §2938(b)]

Perfection establishes the lender’s security interest in the rents with priority over security interests in the rents subsequently acquired by other creditors or owners of the real estate.

Default by the owner

On a default under a trust deed, the assignment of rents clause is triggered, allowing the lender to collect the rents by taking one or more enforcement steps:

• delivering a written demand on the owner for the rents, with a copy to all persons holding a recorded interest in the rents [See Form 456 accompanying this chapter];
• delivering a written demand to the tenants with a copy to the owner and all persons holding a recorded interest in the rents, such as junior and senior trust deed holders [See Form 457 accompanying this chapter];
• having a receiver appointed judicially; or
• obtaining possession of the rents nonjudicially. [CC §2938(c)]

When the lender seeks the appointment of a receiver, takes possession of the rents or delivers a demand for rents notice, the lender has enforced his right to the rents. From the moment the lender commences enforcement of his right to collect the rents by taking one of these actions, the lender is entitled to collect and receive future rents as well as all rents accrued and unpaid from the time of  enforcement. [CC §2938(c)]

The written demand served on a tenant for collection of the rent must be made on a statutorily prescribed form, signed under penalty of perjury by the lender or the lender’s agent. [See Form 457]

Editor’s note — On an owner’s default, a lender with a pre-1997 absolute assignment (present transfer) clause may use any of the 1997 statutory enforcement procedures to properly enforce its rights to the rents.

However, for enforcement of a pre-1997 conditional assignment (lien provision), the lender must take possession of the property by:

• self-help; or
• a court-appointed receiver.

Until the lender takes physical possession or a receiver is appointed, the owner of the secured real estate remains entitled to collect and keep the rents under a pre-1997 conditional assignment provision. [Childs Real Estate Company Inc. v. Shelburne Realty Co. (1943) 23 C2d 263]

Thus, a trust deed lender with a pre-1997 conditional assignment on income-producing property should consider amending the clause in a separate, recorded document as part of any future negotiations. The post-1996 amendment, recorded after January 1, 1997, is then enforceable under the new statutory scheme.

Regardless of the method of enforcement used, be it judicial or nonjudicial, the lender’s enforcement of its collection rights under an assignment of rents clause does not constitute an action for purposes of the one-action rule. Thus, enforcement does not bar a lender from later foreclosing on the real estate or seeking a deficiency judgment. [CC §2938(e)]

Written demand on tenant

Once the lender makes a written demand on a tenant for rent, all unpaid rents due or becoming due in the future must be paid to the lender unless:

• the tenant previously received a demand for the rents from a different lender;
• the tenant has in good faith previously paid, or within 10 days following receipt of demand pays, the rent to the owner;
• a court order directs the tenant to pay rent differently; or
• the lender cancels his demand for the rents. [CC §2938(d); see Form 458 accompanying this article]

Payment of rent to the lender under the demand satisfies the tenant’s obligation to pay rent to the landlord under his lease or rental agreement.

The lender who makes a demand on a residential tenant to pay rents should at the same time make a demand on the owner to forward to the lender any rents collected after receiving the notice from the lender.

When the lender serves a demand for rents on both the residential tenant and the owner, the owner becomes personally liable for the rents if the tenant pays the rent to the owner within 10 days of receiving the demand notice.

However, nonresidential tenants remain liable to the lender for rent if they disregard the lender’s notice and continue to pay rents to the owner. [CC §2938(d)]

By noticing the owner, the lender further protects itself against the tenant’s failure to comply with the demand.

Payment of costs

Now consider a lender who enforces the assignment of rents clause by making only a written demand on the property owner to collect and hand over the rents. [See Form 456]

The lender does not seek the appointment of a receiver, does not take possession of the property or make a demand for rent on the tenants.

After receiving the lender’s demand to hand over the rents, the owner does so voluntarily. In turn, the owner may then make a written demand on the lender to pay the taxes and insurance premiums as well as operating costs on the property for repair, maintenance and security incurred by the owner.

Does the lender need to pay the ownership costs as demanded by the owner?

Yes! If rent collection by an assignment of rents clause is other than by the appointment of a receiver, the owner may make a demand on the lender to pay reasonable costs to preserve the property – including the payment of taxes and insurance premiums – which the lender is then obligated to pay from the rents collected. [CC §2938(g)(1)]

No penalties exist for the lender’s failure to pay costs on the owner’s written demand. However, the lender is liable to the owner for the costs.

Also, if the lender has a future advances clause, costs such as the payment of insurance premiums or property taxes are added to the principal owed the lender, unless they are impounded by agreement.

A future advances clause in a trust deed obligates the owner to reimburse the lender on demand for amounts advanced by the lender under provisions in the trust deed. [See first tuesday Form 450 §A5]

Any impound (escrow) account for insurance or taxes will be paid as agreed in the trust deed. [See first tuesday Forms 450 §10 and 455]

Costs which are considered reasonable to preserve and protect the property include:

• pool maintenance;
• common area maintenance (CAM), whether paid through the rents or paid by the landlord;
• repair costs, such as plumbing and roofing; and
• security patrols, if already provided by the owner before the default.

However, payment of reasonable costs under a demand from the owner does not make the lender a mortgagee-in-possession, or obligate the lender to operate or manage the property.

Unless a receiver is appointed or the lender takes actual possession of the property, the owner still has a primary duty to operate and manage the property, even though the lender is receiving the rents and paying some of the operating and ownership expenses incurred by the owner. [CC §2938(g)(2)]

Further, the lender’s obligation on written demand from the owner to pay reasonable property operating expenses remains until:

• a receiver is appointed, in which case the receiver pays all further costs incurred to operate the property; or
• the lender ceases to enforce its assignment of rents clause. [CC §2938(g)(3)]

However, the lender is under no obligation to have a receiver appointed in order to enforce its assignment of rents clause. [CC §2938(g)(4)]

Editor’s note — When a receiver is appointed, the receiver is basically a new owner-operator of the property, managing and caring for the property for the duration of the receivership.

Most lenders secured by a rents clause on smaller rental properties have neither the administrative expertise (staff) nor the will to enforce the clause or receive a voluntary tender of the rents from the owner.

The risk of disruption

Serving the tenants with a statutory notice to now pay the rents to the lender seems to be a simple process for the secured lender.

Although initially simple, the notice to the tenant can lead to more involvement than would have occurred had the lender only made a demand on the owner or sought the appointment of a receiver.

Initially, lenders will view the statutory notice for demanding rents from the tenant as a fast and easy way to force the owner into curing the default or just protect their secured position in the rents.

Before the demand can be delivered to the tenants, the lender must, as a practical matter:

• obtain a list of tenants’ names and addresses; or
• hand deliver the demand to each tenant to get the tenant’s name, and on delivery, insert the tenant’s name on the form.

The lender must also conduct a title search for the names and addresses of the owners of record and lenders with a recorded interest in the rents. Title insurance companies will oblige for a fee.

Once made, the lender’s rent demand on the tenants will adversely affect the income flow from the property, making a cure of the default more difficult.

For example, consider an owner who defaults on a note additionally secured by an assignment of rents provision in a trust deed. The owner’s default is on a monthly payment and is the result of a simple oversight.

The lender informs the owner of the delinquency. However, before the owner cures the default, the lender, in a “knee-jerk reaction,” serves the statutory notice on the tenants.

When the tenants receive the demand for rent, the relationship between the owner and the tenants, which is often delicate, is adversely disrupted. A tenant’s confidence in the landlord is definitely diminished by the demand for rent notice.

Some tenants will consider relocating to other property, and some will do so, since the demand for rent raises concerns about the owner’s solvency and his ability to maintain the property or provide security. In essence, the tenant may believe a change of ownership is underway, a destabilizing event under the best of circumstances.

When tenants leave, the lender will experience a decrease in the flow of income from the property since replacement tenants will not be on notice to pay rent to the lender. The lender will then have to make a demand on the replacement residents and risk disrupting the landlord/tenant relationship with the replacement tenant – unless disruption is the lender’s intent.

Instead of immediately serving the demand on the tenants, the lender should first determine whether the default was merely an infrequent delinquency or a serious default which warrants the Draconian step into the collection of rents and foreclosure on the real estate.

To discover the nature of the default, the lender must contact the owner. The lender’s collection effort requires staff and analysis, not a knee-jerk, automatic foreclosure/collection reaction.

If the default is more serious than an oversight, the lender should seek to work out the default or establish a period of time for the owner to straighten out his financial affairs. Over a short period of time, the secured lender has little to lose but patience.

Property maintenance problems

Sending the notice to the tenants also weakens the lender’s relationship with the owner by taking a hostile turn.

To compound the hostilities, the owner may, in turn, correctly burden the lender with bills to be paid, whether the lender gives the demand notices for rent to the tenants or to the owner.

Further, if tenants have maintenance or security problems, the owner might refuse to correct them for lack of rental income to pay the bills, and simply refer the tenants to the lender – another example of how the tenant/landlord relationship is affected.

The lender may then feel obligated to respond as would a property manager, even though the lender is not in possession of the property, and the owner is still responsible for its operation. [CC §2938(g)(2)]

If the lender finds collecting the rents is necessary on a default, the best course of action is to seek the appointment of a receiver, usually an experienced, licensed real estate broker.

When the decision is made to collect rents through a receiver, the lender should immediately serve notice on the owner demanding the rents. The demand establishes the date of enforcement and entitlement to unpaid rents.

By making a demand on the owner, the lender promptly enforces his claims on the rents after a default occurs.

The lender can then file a specific performance action seeking a receiver. A receiver is appointed without the lender having to initiate a judicial foreclosure action or trustee’s foreclosure on the real estate involved. [Calif. Code of Civil Procedure §564(b)(11), (12)]

The lender is not liable for mismanagement of the property by a court-appointed receiver. The receiver is not considered an agent of the lender. [Tourny v. Bryan (1924) 66 CA 426]

Although having a receiver appointed is not as easy nor as inexpensive as making a demand on the tenants or owner for rents, the lender will not be burdened with accounting for rent collections or disbursement, or property management situations, all of which take time and expertise to administer.

Accounting for rents received

All rents received by the lender must first be applied to the debt and credited for purposes of curing the default and reinstating the debt, except to the extent the lender complies with the owner’s demand to cover reasonable costs. [CC §2938(c)]

However, failure of the lender to apply rents to the debt will not:

• result in a loss of the lender’s security interest;
• render the debt unenforceable; or
• constitute an action which would bar a foreclosure under the one-action rule. [CC §2938(c)]

Editor’s note — No statutory sanctions exist to penalize a lender who does not follow the accounting rules.

 An owner could face a situation where he must contest a judicial foreclosure action or litigate a nonjudicial foreclosure to compel a foreclosing lender to account for the rents received and not properly applied to the debt.

Priority between competing lenders

Now consider property encumbered by both a first and second trust deed. Both trust deeds contain assignment of rents clauses.

On the owner’s default in payment, the junior lender promptly enforces its assignment of rents clause by making a demand for the rents on both the tenants and the owner.

Later, the senior lender enforces its assignment of rents clause by making a demand for the rents on both the tenants and the owner.

The senior lender then claims the junior lienholder must pay to him all the rents he collected after the  owner defaulted on the first trust deed, even though the senior lender did not enforce his right to the rents until later.

The junior lender claims the senior lender may only collect the rents from the time the senior lender first served rents demands on the tenants or the owner.

Is the senior lender entitled to all the rents from the time of the default?

No! A junior lender with an assignment of rents is entitled to collect the rents until the senior lender enforces its right to collect the rents.

All rents collected by the junior lender prior to the time the senior lender enforces its clause are uncollectible by the senior lender as a source of funds to cure the default on its loan. [CC §2938(h)]

Should the junior lender who has enforced his assignment of rents receive notice of the senior’s enforcement, the junior lender must:

• cease collecting the rents; and
• sends notice to the tenants cancelling his demand for rents. [CC §2938(h); see Form 458]

The junior lender’s failure to send the cancellation notice will not result in any penalties.

However, the junior lender will be liable to the senior lender for any rents collected after the senior lender enforces its clause.

Receiving rents after notice

If the owner or a junior lender receives rents after a notice of demand for rents from a senior lender has been served on the owner or tenant, the senior lender is entitled to the rents collected.

To recover rents improperly received and withheld by the owner or a junior lender, the senior lender has the right to bring an action against the owner or the junior lender.

The senior lender’s action to recover the rents collected by the owner or junior lender after the senior lender’s demand is not a violation of the one-action rule.

Thus, the dispute over rents is unrelated to the foreclosure of the trust deed lien on the real estate, except for the amount of the debt remaining unpaid (which will require an underbid at a foreclosure sale).

Further, if a dispute arises between the senior lender and another person claiming an interest in the cash proceeds – such as in bankruptcy – the senior lender has a continuously perfected security interest in the cash proceeds from the rents which remain identifiable.

To remain identifiable, the cash proceeds must be in a segregated account or traceable if commingled with the owner’s or junior lender’s other accounts.

Owner files bankruptcy

If the owner files bankruptcy before the lender enforces the assignment of rents clause, the lender still has a security interest in post-petition rents since they are considered cash collateral. [11 United States Code §363(a)]

Cash collateral can be used by the owner in bankruptcy only in limited circumstances, and then only  with the consent of the lender holding the security interest. [11 USC §363(c)(2)]

Before the statutory scheme for assignment of rents clauses was enacted, conflicting bankruptcy decisions turned on whether the lender who enforced the assignment of rents clause post-petition was entitled to control pre-petition rents collected by the owner.

A court held the lender who enforced the assignment clause after the bankruptcy petition was filed was entitled to the rents paid pre-petition as cash collateral, even though the lender did not enforce the assignment clause until after the filing. [In re Scottsdale Medical Pavilion (9th Cir. BAP 1993) 159 BR 295]

Another court held the lender only had a security interest in unpaid rents when enforcement occurred post-petition. Thus, the lender could not collect rents paid after the default but collect the rents before the lender enforced the assignment of rents clause. [In re Goco Realty Fund I (1993) 151 BR 241]

The new California statute should clear up the confusion created by conflicting cases.

The Goco Realty Fund I case is the codified rule for post-1997 assignment of rents clause enforcement.

Under the statutory assignment of rents scheme, the lender is now only entitled to rents which are paid after the lender enforces the assignment of rents clause, regardless of whether the rents accrued or became unpaid before enforcement.

Thus, if the owner files a bankruptcy petition, cash collateral also includes those rents which were due pre-petition if:

• the rents were paid post-petition; and
• after the assignment clause is enforced.