Cash collateral order in bankruptcy constitutes “constructive possession” of property sufficient to allow mortgagee to keep rents

Addressed in U.S. Bank Nat’l Ass’n v. Randhurst Crossing LLC, 2018 IL App (1st) 170348 (Mar. 29, 2018) was whether a mortgagee holding an assignment of rents was entitled to collect rents before a receiver was appointed on the basis that a bankruptcy court had previously ordered that the rents collected from the property’s tenants were “cash collateral” pursuant to § 363(a) of the Bankruptcy Code.

The general law in Illinois is that a mortgagor, as the party in possession and the owner of a statutory right of redemption, is entitled to the rents from the property as long as he retains possession and he does have to account for them to the mortgagee. A clause in a mortgage pledging rents creates an equitable lien upon the rents, which may be enforced by the mortgagee upon default by taking possession of the mortgaged property. At common law, it was strictly held that the mortgagee must take actual possession before it was entitled to rents. However, Illinois follows the modern trend which permits a mortgagee to collect rents once it has taken “constructive” possession of the property. Constructive possession means some affirmative action on the part of the mortgagee.

In the instant case, the court in the mortgagor’s bankruptcy case had ordered that the rents collected from the property’s tenants be considered “cash collateral” pursuant to § 363(a) of the Bankruptcy Code and that defendant was prohibited from using the cash collateral. In the subsequent state court foreclosure proceeding, the mortgagee argued that the cash collateral order was sufficient to establish constructive possession so as to entitle it to the pre-receivership rents. Other cases have found constructive possession where the court appoints a receiver, grants injunctive relief, enters an order allowing defendant to remain in possession but to deposit the rents with the court, or where the mortgagor had contracted away its right to collect the rents without court authorization. The court determined the common theme in these cases was the existence of a court order authorizing the mortgage to collect the rents before it obtained possession.

The First District agreed with the trial court that the cash collateral order was sufficient to show that plaintiff obtained constructive possession over the rents as of the date of the order. The court reasoned that after entry of the order, the mortgagor was unable to use the rents without court approval and, indeed, was found in contempt when it impermissibly used those funds.

The court avoided holding that in the absence of such affirmative action on the mortgagee’s part it would be entitled to rents collected during a bankruptcy. It also noted that the mortgagor’s possession of the rents occurred in the context of the bankruptcy proceeding, meaning that defendant’s status changed from a defendant to a debtor. A debtor-in-possession holds its powers in trust for the benefit of the creditors and has the duty to protect and conserve property in his possession for their benefit. Thus, while the disputed rents remained in the mortgagor’s account until the receiver was appointed, “[it’s] hands were effectively tied with respect to the use of these funds without court permission.”

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