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

The main issue addressed in U.S. Bank Nat’l Ass’n v. Randhurst Crossing LLC, 2018 IL App (1st) 170348 (Mar. 29, 2018) is whether a mortgagee holding an assignment of rents was entitled to collect rents before it a was receiver appointed where a bankruptcy court had previously ordered that the rents collected from the property’s tenants be considered “cash collateral” pursuant to § 363(a) of the Bankruptcy Code which the mortgagor was prohibited from using.

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”, as opposed to actual, possession of the property. Constructive possession means some affirmative action on the part of the mortgagee.

In U.S. Bank Nat’l Ass’n v. Randhurst Crossing LLC, the mortgagee argued that a cash collateral order entered by the bankruptcy court was sufficient to establish constructive possession so as to entitle it to the pre-receivership rents. The court looked at other cases to determine what action constitutes “constructive possession”. Courts have found there was 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 the mortgagor had contracted away its right to collect the rents without court authorization. What the cases have in common is there was a court order authorizing the mortgage to collect the rents before it obtained possession.

Here, the court in the mortgagor’s bankruptcy case 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 be prohibited from using such cash collateral. The First District agreed with the trial court that this order was sufficient to show that plaintiff obtained constructive possession over the rents as of that date.

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 and was ordered to return them. The court studiously 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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