In re Soho 25 Retail, LLC Benefits Mortgage

Originally published in The Bankruptcy Strategist September 2011

Earlier this year, Judge Sean H. Lane of the Bankruptcy Court for the Southern District of New York held that the post-petition rental income of a debtor-in-possession's commercial real property in New York City was not property of the debtor's estate under section 541 of the Bankruptcy Code, even though the underlying condominium units were owned by the debtor and had become estate property. The bankruptcy court concluded that control of the rental income had transferred to the debtor's mortgagee, who had begun (but not completed) a foreclosure on the commercial property interests of the debtor, before the bankruptcy's filing. In the decision, In re Soho 25 Retail, LLC, No. Adv. 11-1286-SHL, Bkr. 10-15114-SHL, 2011 WL 1333084 (Bankr. S.D.N.Y. Mar. 31, 2011), the exclusion of the rental income stream from the bankruptcy estate thwarted the debtor-in-possession's attempt to reorganize over the mortgagee's objection and markedly improved the creditor's position. Ultimately, the lender won its stay relief motion and completed its foreclosure. The bankruptcy case was dismissed.

Judge Lane's decision merits the attention of mortgage lenders and potential bankruptcy debtors alike, because it could provide significant leverage for secured parties, particularly in single asset real estate cases involving New York property. The holding supports the relatively new theory that New York law permits a mortgagor to transfer its entire interest in rents to a mortgagee upon executing the mortgage, such that the transfer will remain effective in the mortgagor's eventual bankruptcy. The decision also holds that a mortgagee's diligence in enforcing against a debtor upon and after default can cut off the ability of a debtor to use the rental proceeds of the mortgaged property in a subsequent bankruptcy. However, while the bankruptcy court's ruling is certainly good news for mortgage lenders and provides some guidelines for future strategy by both mortgagees and borrowers in distressed situations, the decision also leaves areas of doubt as to how these parties might best guide their behavior to maximize their benefits in a post-Soho 25 world.

Background

In 2006, Soho 25 borrowed $8.5 million from Greenwich Capital Financial Products, Inc. In re Soho 25 Retail, LLC, 2011 WL 1333084, at *1. To secure repayment, the lender obtained a mortgage lien on Soho 25's two commercial condominium units located in a New York City building. Id. at *2. The borrower also executed and delivered an Assignment of Leases and Rents for the lender's benefit. Id. (After the transaction closed, the note, mortgage and assignment of rents were assigned from Greenwich to the current "lender.") In the Assignment, the borrower agreed that it "'absolutely and unconditionally'" assigned to Greenwich and its successors "'all right, title and interest [of the borrower] in and to all present and future Leases and Rents,'" and further stated that the "'Assignment constitut[ed] a present and absolute assignment and [was] intended to be unconditional and not as an assignment for additional security only.'" Id. at *2. Though the recitals of the agreement provided that the "'Assignment [was] being given as additional security for the Loan,'" the lender took the position that it owned the rent stream until the underlying debt was satisfied and that the borrower enjoyed the use of the rental income in the meantime only thanks to a "'revocable license,'" which was limited by the...