RECEIVERSHIPS AND CONTROLONOMICS

By Gordon L. Gerson, Esq.

September 2007

"Controlonomics" is core to lender-think in both loan origination and loan servicing.

Applying controlonomics to the defaulted commercial real estate loan means not just control, but aggressive and tight control. This also means having a court-appointed receiver to control the operation, management and maintenance of the mortgaged property, control the income from the mortgaged property, and by virtue of the foregoing, better control of the foreclosure process.

This article will summarize the benefits of the receiver to a lender, the role of a receiver, how a receiver is appointed, how a receivership operates, and key issues of concern with respect to receiverships.

Controlonomics are embedded within well-drafted loan documents in commercial lending transactions. A well-drafted deed of trust or mortgage (in this article, both referred to as a "Mortgage"), include an "Assignment of Leases and Rents" provision, and in some lender's loan closing packages, a separate stand-alone document entitled "Assignment of Leases and Rents". Some lenders engaging in a heavy application of controlonomics, have the "Assignment of Leases and Rents" provision in both the Mortgage and the stand alone assignment of leases and rents document.

Key words and phrases found in typical assignment of leases and rents provisions, are the following (collectively, the "Assignment of Leases and Rents Covenant"):

• Unequivocal language that the borrower (referred to in deeds of trust as the trustor and in mortgages as the mortgagor) "irrevocably, absolutely, presently and unconditionally assigns to lender (sometimes referred to in deeds of trust as beneficiary and in mortgages as the mortgagee) all rents, royalties, issues, profits, revenue, income and proceeds of the mortgaged property (collectively, the "Rents")", and assigns all its right, title and interest in and to all the leases and agreements of any kind relating to occupancy of the mortgaged property (collectively, the "Leases") to the lender.

• So long as there has not been an Event of Default (as defined in the Mortgage, loan agreement, or other loan documents) the borrower has a license (the "License") to collect and retain the Rents.

• If an Event of Default has occurred and is continuing, the lender shall have the right to terminate the License without notice to or demand upon the borrower and without regard to the adequacy of the lender's security under the Mortgage¹.

• If there has been an Event of Default, the lender has the right to have a receiver appointed to collect the Rents (although this provision may sometimes appear in the section of the Mortgage entitled "remedies," which outlines all actions a lender may take if there has been an Event of Default).

The right to have a receiver appointed by the court may be viewed as a contractual right or statutory right, or both, depending on the state where the mortgaged property is located, or whose law governs the enforcement of the loan documents containing the Assignment of Leases and Rents Covenant. In California, there is a long line of cases that have addressed the enforceability of contractual provisions in a Mortgage granting a secured lender the right to collect the Rents pursuant to the terms of the Assignment of Leases and Rents Covenant following an Event of Default, and the right to have a receiver appointed. The power of the court to specifically enforce the Assignment of Leases and Rents Covenant through the appointment of a receiver has been consistently recognized; moreover, it has been commonly recognized that in the case of an express assignment of Rents in a Mortgage, the lender is not required to allege or prove that the property itself is insufficient to discharge the secured debt. All that must be shown to the court is that there has been an Event of Default.

Judicial procedure for appointment of a receiver may differ from state to state. In California, a lawsuit is filed which must include a cause of action for the specific performance of the Assignment of Leases and Rents Covenant, which provides an independent contractual basis for the appointment of a receiver. The court appoints a "third party," who is generally an individual or company who has been recommended by the lender, but who by law, is an independent agent appointed by the court, acting on behalf of the court (and not the lender) and is held accountable to the court. Companies or individuals appointed as receivers are usually those who have demonstrated experience acting as receivers or in managing assets similar to the mortgaged property.

Controlonomics in the realm of receivership law requires a well-drafted court order spelling out the scope of responsibility and authority of the receiver. For instance, (i) the order may authorize the receiver to simply collect monthly rents or it may be drafted broad enough to provide the receiver with the power and authority to market and sell the mortgaged property, but seldom will it give the receiver control over assets of the borrower other than the Rents and the mortgaged property. The well-drafted receivership order will also give the receiver authority to engage professionals, if required, including, but not limited to, property managers, legal counsel and accountants; (ii) set forth the receiver's reporting obligations, amount of compensation and conditions or requirements for disbursement of compensation and the amount of a bond; (iii) provide or require that the receiver file monthly reports with the court (and copies to both borrower and lender), outlining services performed, Rents collected, and disbursements made.

The receivership ends when either the borrower reinstates its loan or the mortgaged property has been foreclosed upon. At such time, the receiver renders a final report to the court and is discharged.

Whether a high tower office building, roadside motel, or 12-unit apartment building secures the loan that is in default, controlonomics dictates that the lender will exercise its rights pursuant to the Assignment of Leases and Rents Covenant to control the Rents from the mortgaged property so that the borrower does not collect the Rents and instead of applying the Rents to the outstanding indebtedness, pockets or diverts the Rents for other business purposes or personal use.

Controlonomics also dictates that the lender will want to control the mortgaged property and thereby avoid deterioration of the mortgaged property whether by deferred maintenance or in-attention to tenant needs and landlord defaults of leases, since a borrower who expects to be foreclosed upon is not likely to exercise prudent property management.

In summary, the lender wants to control the "status quo" through the date of the foreclosure sale when the mortgaged property is sold to a third party, or if no bidder at sale, at such time that the lender becomes the owner of the mortgaged property.

A well-planned foreclosure strategy must necessarily include whether controlonomics requires the appointment of receiver, and while there may be some justifiable reasons why a lender may opt not to have a receiver appointed, consultation with counsel should be part of the decision-making process.

DISCLAIMER: This article is intended to provide a general overview of lending issues. It is not intended nor should it be relied upon as legal advice. Each loan is fact specific and as such different principles of law may apply, and counsel should be consulted. For additional information contact Gordon L. Gerson at GERSON LAW FIRM APC, ggerson@gersonlaw.com or call (858) 452-5400.

¹ "Adequacy of security" is broadly interpreted to mean whether the value of the mortgaged property after sale, is sufficient to satisfy the outstanding indebtedness owed to the lender.