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�� VISIT US ONLINE @ DSNEWS.COM COVER STORY MARKET PULSE SARE Rules Adequate Protection Dealing with SARE Debtor Strategies If the SARE debtor elects the monthly interest payment option of 362(d)(3)(B)���which often isn���t feasible because the gross rents aren���t large enough to cover both operational costs and the required interest stroke���the central question is whether, in addition to the interest payments, the debtor must also pay something as adequate protection of the lender���s interest in the assigned rents. This question arises because of a peculiar exception in 362(d)(3)(B)(i), which says the monthly interest payments ���may, in the debtor���s sole discretion, notwithstanding section 363(c)(2), be made from rents[.]��� The referenced Bankruptcy Code section 363(c)(2) speaks to the baseline requirement of adequate protection for the debtor���s use of a secured lender���s ���cash collateral,��� which can include proceeds of assigned rents. 63 POINT��� COUNTERPOINT Any discussion of lender strategy in SARE cases needs to be prefaced with a little background on the Bankruptcy Code���s SARE rules and the basics of adequate protection. The SARE rules in Bankruptcy Code section 362(d)(3) were enacted to make it easier for CRE mortgage lenders to lift the automatic stay and avoid situations where zero-equity SARE properties get stuck in Chapter 11 for extended periods. But in reality, the rules actually give debtors something of an edge in defending lender relief from stay motions, at least for the first 90 days of bankruptcy. Bankruptcy Code section 362(d)(3) permits SARE debtors to withstand a lender motion for relief from stay for the first 90 days of bankruptcy if, in the interim, the debtor either (i) files a realistic plan of reorganization or (ii) starts making monthly payments of non-default interest on the mortgage debt. As long as the SARE debtor can execute one of these two options, it theoretically can take advantage of this 90-day breathing spell, even if the property is indisputably under water. Separate and apart from the SARE rules of 362(d) (3) is the broader and more well-developed requirement MARKET PULSE But lenders and special servicers in SARE cases where the property lacks any equity are often better off prosecuting their Bankruptcy Code rights to ���adequate protection��� in assigned rents, in lieu of (or at least ahead of) an absolute assignment argument. Why? If the property is under water, and the SARE debtor doesn���t have any other unencumbered assets, it will be pretty difficult for the debtor to keep the assigned rents, pay the lender/special servicer nothing for the privilege, and still meet the Bankruptcy Code���s stand-alone adequate protection requirements for assigned rents under recent legal precedent. BEST PRACTICES But U.S. bankruptcy courts don���t uniformly recognize even the most ironclad ���absolute��� assignments of rents, and both CRE portfolio lenders and CMBS special servicers often find themselves at a strategic crossroads when prosecuting relief from the automatic stay or opposing a cash collateral motion in a borrower Chapter 11. In June 2012, the Bankruptcy Court for the Eastern District of New York (Judge Stong) emphasized this point in holding that what appeared to be an absolute assignment of rents was nothing more than a grant of a security interest in the rents under applicable New York law. Perplexingly, Judge Stong���s conclusions in her In re South Side House, LLC, opinion directly contradicted those of the Southern District of New York in the 2011 In re Soho 25 Retail, LLC, case, in which an absolute assignment was upheld as being an outright conveyance of the rents. If this split between the Eastern and Southern Districts of New York illuminates anything, it���s that the enforceability of absolute assignments in Chapter 11 can be highly unpredictable, with significant variance from jurisdiction to jurisdiction and judge to judge. That���s at least part of the reason why, in many single asset real estate (SARE) cases���where the borrower���s sole source of liquidity is assigned rents���an absolute assignment theory may not be the lender���s best avenue to protecting the rental income stream and quickly exiting the property from Chapter 11. If my experience is representative, the absolute assignment theory is often the first strategy portfolio lenders and special servicers will suggest for protecting future rents from becoming a SARE debtor���s war chest for legal fees or other questionable, non-operating Chapter 11 expenses. And in some absolute-assignment-friendly jurisdictions, that indeed may be the best angle to pursue. of ���adequate protection.��� Various subparts of Bankruptcy Code sections 361, 362, and 363 collectively require a debtor using or spending a secured lender���s collateral to ���adequately protect��� the lender from any decrease in value of the collateral that occurs, over time, as a result of the debtor���s use or disposition of the collateral. If the collateral isn���t expected to decline in value while the debtor uses it, no adequate protection is required. But if the lender can prove a decline is likely, the debtor will have to compensate (adequately protect) the lender for the amount of the expected decline���with cash payments, a ���replacement lien��� on new collateral, or something else of value. Calculating the amount of required adequate protection���the amount of decline in collateral value over time���can be tricky, especially when it comes to things like rents receivable. Suffice it to say there is a decent body of case law out there debating whether a debtor���s use of assigned rents results in the security interest in the rents losing value on a dollar-for-dollar basis (i.e., whether the amount of adequate protection required equals 100 percent of the amount of rents the debtor keeps/uses). The good news for lenders and special servicers is that, within this body of debated law, there is substantial support for this 100 percent diminution proposition, led by a series of recent decisions from courts in the Sixth Circuit. This notion of dollarfor-dollar diminution is the critical underpinning for the adequate protection lift-stay strategy discussed below. INDUSTRY INSIGHT M ost commercial real estate lenders are pretty diligent when it comes to documenting an assignment of rents���making sure the assignment is drafted to afford the lender the greatest level of protection available under state law. In many instances, this means the assignment is designed as an ���absolute��� assignment in which all of the borrower���s interests in the rents are conveyed to the lender the moment the assignment is executed (versus only being pledged as additional collateral to secure the underlying mortgage debt). If the borrower files a Chapter 11 bankruptcy at some point down the road, an absolute assignment should suffice to keep future rents out of the borrower���s bankruptcy estate altogether. Or so the theory goes.

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