By Michael R. Dover
Kelley Drye & Warren LLP
Distressed properties have long been a target for investors and the continuing weakness in the property market is luring many new players. Foreclosure auctions involving lenders are a typical option investors use to acquire distressed properties. However, many investors are acquiring properties by opting to purchase a foreclosing lender’s note and mortgage at a discount. This article examines common pitfalls relating to collecting rents when an investor purchases a note and mortgage on distressed commercial properties.
Stepping Into A Lender’s Shoes And Collecting Rents
An investor can purchase a note and mortgage and step into a lender’s shoes at any time before the entry of a foreclosure judgment to acquire a distressed property. Under the Illinois Mortgage Foreclosure Law (IMFL), purchasing a distressed property’s underlying note and mortgage allows an investor to exercise all the benefits the original lender would have enjoyed, assuming there are no transfer restrictions in the lender’s original documents. To acquire the property, an investor can negotiate with the defaulting borrower to enter into agreed foreclosure transactions (such as “consent foreclosure” or a “deed in lieu of foreclosure”), and avoid lengthy litigation proceedings by settling claims with the borrower while acquiring the property. Or, an investor may itself initiate or continue as a “lender” in a foreclosure action, minimizing competing bids at the auction to acquire the property.
Whichever option an investor chooses to acquire the property, many look for an immediate source of funds from the commercial property’s rents. This tactic is often more complicated than many investors expect. First, collection of rents requires possession of the property. The Illinois Supreme Court ruled in Comerica Bank-Illinois v. Harris Bank Hinsdale, 284 Ill. App. 3d 1030 (1st Cir. 1996) that a lender (and by implication – an investor holding the debt) must have possession of the foreclosed property to collect rents even if the lender’s documents explicitly state that the lender may collect rents after default. The Court’s ruling rests on a public policy rationale: A lender may not unilaterally collect rents on a property without also assuming the burdens of possessing that property, such as upkeep and maintenance. Therefore, even though some lenders continue to include such provisions in their mortgage agreements, an investor may not rely on these provisions to secure an immediate source of funds after acquiring a lender’s note and mortgage. Second, in Illinois law, a borrower owns the property until after confirmation of the sheriff’s sale. To the extent an investor receives rents and other income derived from the property during the pendency of the foreclosure, it must apply this amount against the amount of the borrower’s debt.
Receivers And Mortgagees In Possession
Still, depriving a borrower of rents during the foreclosure process can otherwise be advantageous to an investor. The IMFL provides two mechanisms for removing possession – and rents – from a borrower prior to a foreclosure judgment. The most common is the appointment of a receiver to manage the property pending a foreclosure. A receiver is tasked with collecting rents on the property and maintaining the property, among other statutorily delineated powers, under an appointment order of the Court. However, despite prevailing misconceptions, a court-appointed receiver in foreclosure actions does not act on behalf of a lender or investor. Rather, an investor may designate the name of a receiver to the Court, who then appoints a receiver to maintain the property as an agent of the Court. The receiver holds rents and other profits in excess of expenses pending release after the sheriff sale confirmation.
Alternatively, the IMFL permits the appointment of an investor as “mortgagee in possession.” This allows an investor holding the mortgage to directly collect rents and be responsible for maintaining the property during the foreclosure action. However, an investor must either segregate these funds or apply the rents to the outstanding balance on the debt as it could be subject to an accounting of the funds collected and expended until the Court’s confirmation of the sheriff’s sale.
Under either scenario, the IMFL favors appointment for commercial properties. In fact, the Court must make an appointment: (i) if the investor requests one, (ii) the mortgage agreement states that it permits an appointment, (iii) the lender demonstrates a default on the note, and (iv) the borrower fails to present a “good cause” why such the appointment should not be made.
Assuming process of service on the borrower in the foreclosure action, an investor’s request for appointment of a receiver or as mortgagee in possession may be lengthy, perhaps taking as long as six to 10 weeks. Accordingly, it is recommended that investors file their request with the foreclosure complaint, or as soon as possible after purchasing the note and mortgage, and expect at least a couple months delay after purchasing a distressed property’s note and mortgage before depriving the borrower of rents.
Michael R. Dover is an attorney in the Chicago office of Kelley Drye & Warren LLP. He represents banks and receivers in commercial litigation relating to secured interest lending and deposit accounts, and assists communications companies in litigation matters involving commercial claims, patents, antitrust and monopolization claims. He can be reached at [email protected].