Land Mines for Real Estate Lawyers
 
June 1, 1999
 

The New Hampshire Supreme Court has ruled that a real estate lender that collects rents under an assignment of rents will be bound to observe the repair covenants in a lease demising the secured real property. The case should give a secured lender pause before exercising its rights to collect rents from tenants of the secured property prior to foreclosure.

The facts of the case, Touma v. St. Mary's Bank, 712 A.2d 619 (N.H. 1998), are fairly straightforward. When the owner of the secured property defaulted on the mortgage, the lender initiated foreclosure proceedings and exercised its right to collect rents from the single tenant of the property under the lender's assignment of rents. The assignment provided that the mortgagor would perform all of mortgagor's obligations under the lease and also provided that the assignment would not impose any obligation of any nature on the mortgagee to take any actions. The tenant argued that that the lender was obligated to maintain the roof of the premises during the period of time that the lender was collecting rents as assignee. The trial court ruled in favor of the lender.

The appellate court held that when the lender foreclosed and exercised its rights under the assignment, it stepped into the landlord's shoes vis-a-vis the tenant, at least insofar as the owner's duty to repair under the lease.

The Touma case may be precedent shattering since it appears to impose liability on the lender for asserting its claim on rents. The majority of cases that have dealt with this issue have supported the notion that a lender can collect rents without becoming a mortgagee in possession. However, the Touma court chose to follow the minority view. The court noted that, if the lender is allowed to collect rents without undertaking the responsibilities of management and operation, it "would in effect have the [landlord] act as an indentured servant acting for the [lender] in operation of the business while allowing the [lender] to take the fruits of the [landlord's] continuing efforts without any of the liabilities."

Although the facts of the Touma case deal specifically with the lender's failure to repair a roof, the court's reasoning contains a disturbing ambiguity that may leave lenders open to even greater liability: the case is unclear whether the lender's liability arises solely from asserting its claim on the rents or because lender becomes a mortgagee-in-possession of the property when it exercises its claim to the rents. Based on the holdings of the cases upon which the Touma court relies, it appears that the Touma court's holding must stand for the proposition that a lender cannot seize rents without becoming a mortgagee-in-possession.

This reading of the Touma case holds several landmines for the real estate lender. First, if the lender is viewed as a mortgagee-in-possession for simply exercising its rights to rents, the lender may not only be liable to tenants for the rents it collects but also for complying with lease obligations that may greatly exceed the rents collected. Second, by exercising its rights to collect rents the lender may become liable to unrelated third parties with tort claims against the owner of the real property. Third, if a lender decides to comply with lease covenants to avoid claims by tenants, it may be viewed as an operator of the real property for purposes of imposing liability under federal environmental statutes.

Many lenders are already reluctant to collect rents or have questioned the wisdom of collecting rents prior to a foreclosure sale for exactly the reasons raised in the Touma decision. This is especially true since the last spate of commercial real estate bankruptcies. In response to some surprising rulings from the bankruptcy courts regarding when a security interest in rents is perfected, many states passed statutes providing that a security interest in rents is perfected once an assignment of rents is recorded in the land records. In these progressive states lenders need not worry about possessing a perfected interest in rents when the borrower files for bankruptcy. However, there are some jurisdictions, the District of Columbia, for example, that still require some affirmative action, such as the exercise of rights under an assignment of rents, in order to obtain a perfected security in rents. In these jurisdictions, a lender should clearly consider obtaining the appointment of receiver. In fact, obtaining a receiver may resolve many issues raised in the Touma case, since the receiver, not the lender will be responsible for operating the real property.

Although, from a lender's perspective one hopes that the Touma case may remain a minority decision, it may well signal the end of the days when a lender could have its rents and apply them too.

Rob Glenn is a Partner in the Northern Virginia office and can be reached at 703- 654-8640, or at rglenn@hklaw.com.