Effective January 1, 1997, a new California assignment of rents law went into effect, as new Civil Code Section 2938, superseding former Civil Code Sections 2938 and 2938.1. (The legislation was introduced as Senate Bill 947.). The purpose of the law is to provide lenders with a clear path for enforcement of their rights to rents upon a borrower’s default and to provide certainty for the attorneys preparing assignment documents. As the new legislation allows for a lender’s self help in collecting rents which represent their security, many receivers have expressed concern as to the future need of lenders for a receiver and, if there is such a need, the extent of a receiver’s power to collect rents under a lender’s deed of trust or separate assignment of rents.

Prior to the enactment of the new law there had been much controversy over the characterization of rents as security: whether they were “absolute” and therefore “owned” by the lender, or “conditional” and not amenable to collection without the lender’s having taken certain steps to perfect its rights prior to enforcement. The concept of “perfection” has been the subject of extensive discussion and conflicting judicial opinion, especially in the bankruptcy context. The subject has been further confused by lenders’ and commentators’ fear that by accepting rents, including rents collected by a receiver, a lender might be found after the fact to have violated the one action rule of C.C.P. §726.

The new statute settles these issues. All assignments of rents, no matter how they are denominated, are now characterized as assignments as additional security. This does away with the fiction of a lender’s ownership of those rents, with a license back to the borrower to collect them so long as the loan is not in default. By discontinuing the “absolute” assignment, there is only one method of “perfection” of a lender’s rights to the rents, which is now statutorily recognized to be by recordation (of the deed of trust or separate assignment of rents). In addition, the statute provides four permissible methods of enforcement: (1) by appointment of a receiver; (2) by the lender obtaining possession of the rents; (3) by delivery of a demand to the tenants for payover of the rents; and (4) by delivery of a demand to the borrower for payover of the rents. The statute actually sets forth a form of notice to tenants which is specifically required to be used . The demand is effective upon actual receipt by the tenant. In the case of multiple demands, the tenant does not have the burden to determine which of competing lenders has priority; lenders must adjust their rights among themselves under subdivisions (f) and (h). A non-residential tenant who fails to pay rent to the lender in accordance with the lender’s demand is subject to double exposure for payment of rents. (This is not the case with residential tenants.)

Following one of the stated enforcement methods, the lender is entitled to all accrued and uncollected rents and all rents accruing after enforcement. Presumably, this means that a receiver’s appointing order should allow the receiver to collect unpaid rents which were due prior to his or her appointment. (Before enactment of the statute, some commentators believed that to collect such rents exposed a lender to a claim of violation of the one action rule and the possibility of loss of its security or, in an extreme case, to loss of the entire debt.) The new statute makes it clear that neither the collection of rents or their application to the debt will subject a lender to loss of its lien, render the obligation unenforceable, or otherwise limit the lender’s rights with respect to its collateral. This means that application of rents to a debt does not result in a lender’s loss of its right to a deficiency judgment after a judicial foreclosure sale.

In addition, pursuant to C.C. §2938(f), leases, rents, issues, and profits of real property include the cash proceeds of same. The enforcing lender has priority over third party recipients of proceeds to the extent that those proceeds are identifiable by segregation or, if they are commingled, by tracing . Upon a senior creditor’s demand to a previously collecting junior creditor, should the junior subsequently collect rents, the senior creditor has the right to immediate turnover of those funds. The enforcing lender, however, has no right to proceeds transferred in the operation of the borrower’s business, subject to fraudulent conveyance and other applicable law.

Subdivision (g) of the new statute is the most likely reason that lenders will continue to seek receivers. Where a lender is successful in collecting the rents, the borrower or any of its other assignees can demand that the collecting lender use those rents for the “reasonable costs of protecting and preserving the property”, including payment of taxes and insurance and compliance with building and housing codes. The collecting lender then becomes obligated to do so, and that obligation continues until the lender either ceases to collect the rents or has a receiver appointed to do so. Without the appointment of a receiver, the obligation to operate and manage the property remains that of the borrower. While the collection of rents will no longer cause a lender to be deemed a mortgagee in possession, this commentator believes that most lenders will opt out of the “direct collection” authority due to subdivision (g), which may well result in a lender ultimately being held to a higher standard of care.

The new legislation is not applicable to any contracts entered into before January 1, 1997. The parties to loan modifications can elect to have the new statute apply, however.

Section 4 of Senate Bill 947 added a new subsection to C.C.P. §564(b), which is the statute under which most receiverships are instituted. Subsection (b)(11) now gives statutory authority for the appointment of a receiver under an assignment of leases, rents, issues, or profits pursuant to new Civil Code Section 2938(g).