In re Soho 25 Retail, LLC Benefits Mortgage

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Earlier this year, Judge Sean H. Lane of the Bankruptcy Court for the Southern District of New York held that the post-petition rental income of a debtor-in-possession’s commercial real property in New York City was not property of the debtor’s estate under section 541 of the Bankruptcy Code, even though the underlying condominium units were owned by the debtor and had become estate property. The bankruptcy court concluded that control of the rental income had transferred to the debtor’s mortgagee, who had begun (but not completed) a foreclosure on the commercial property interests of the debtor, before the bankruptcy’s filing. In the decision, In re Soho 25 Retail, LLC, No. Adv. 11-1286-SHL, Bkr. 10-15114-SHL, 2011 WL 1333084 (Bankr. S.D.N.Y. Mar. 31, 2011), the exclusion of the rental income stream from the bankruptcy estate thwarted the debtor-in-possession’s attempt to reorganize over the mortgagee’s objection and markedly improved the creditor’s position. Ultimately, the lender won its stay relief motion and completed its foreclosure. The bankruptcy case was dismissed.

Judge Lane’s decision merits the attention of mortgage lenders and potential bankruptcy debtors alike, because it could provide significant leverage for secured parties, particularly in single asset real estate cases involving New York property. The holding supports the relatively new theory that New York law permits a mortgagor to transfer its entire interest in rents to a mortgagee upon executing the mortgage, such that the transfer will remain effective in the mortgagor’s eventual bankruptcy. The decision also holds that a mortgagee’s diligence in enforcing against a debtor upon and after default can cut off the ability of a debtor to use the rental proceeds of the mortgaged property in a subsequent bankruptcy. However, while the bankruptcy court’s ruling is certainly good news for mortgage lenders and provides some guidelines for future strategy by both mortgagees and borrowers in distressed situations, the decision also leaves areas of doubt as to how these parties might best guide their behavior to maximize their benefits in a post-Soho 25 world.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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