Fidelity Mutual Life Insurance Company v. Harris Trust and Savings Bank, Not Personally or Individually but as Trustee Under Trust Agreement Dated 7/7/81 and Known as Trust No. 41295 Kaiser Investments, an Illinois General Partnership

Citations: 71 F.3d 1306; 1995 U.S. App. LEXIS 35071Docket: 95-1884

Court: Court of Appeals for the Seventh Circuit; December 11, 1995; Federal Appellate Court

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Fidelity Mutual Life Insurance Company (Fidelity) initiated a lawsuit against Harris Trust and Savings Bank and Kaiser Investments after a $3.6 million loan secured by a mortgage on commercial property defaulted in February 1993. The loan was supported by a "Borrower's Affidavit" from Kaiser Investments, which included a clause obligating them to indemnify Fidelity for rents collected post-default. Despite collecting nearly $300,000 in rents, Kaiser Investments refused to remit these funds to Fidelity, citing the "rents and profits rule" under Illinois law, which prohibits a mortgagee from enforcing rent provisions until possession is taken or a receiver is appointed. The district court agreed with Kaiser Investments, dismissing Fidelity's claim for indemnification before the receiver's appointment. The court's decision was based on the assertion that the indemnity clause was unenforceable under the established legal precedent. This dismissal was considered a final order, making it appealable. The appellate court expressed that the separation of the indemnity agreement from the loan documents did not exempt it from the rents and profits rule.

In an Illinois land trust, the trustee holds title to the property but does not manage it, leaving control to the beneficiary. The argument posits that if only the trustee were restricted from making an enforceable assignment of rents, it would be illogical since the trustee has no right to receive rents anyway. The appeal succeeds because the indemnity agreement in question is distinct from an assignment of rents and does not transfer the right to collect rents until default occurs. The assignment, executed by the bank and Kaiser Investments, became unenforceable prior to the appointment of a receiver. The indemnity agreement requires Kaiser Investments to remit collected rents to the lender, Fidelity, only after receipt, rather than transferring the right to collect directly to Fidelity. This distinction aligns with the historical context of the rents and profits rule, where property was treated as collateral for loans, complicating the lender's security and potentially leading to forfeitures that could exceed the loan balance.

Courts have determined that a lender who takes land for loan repayment does not gain title but only a security interest, which diminishes as the borrower repays the loan. This security interest does not equate to ownership or a possessory interest, meaning the lender is not entitled to collect rent or income from the property. In "lien theory" states, such as Illinois, this principle asserts that assigning rents to the lender conflicts with their non-ownership status. In contrast, "title theory" states view rents as integral to the mortgagee’s security.

The doctrine regarding rents and profits is described as technical rather than grounded in natural justice, with no clear precedent for restricting a borrower's use of rents received. It is uncertain whether a borrower could legally escrow a portion of rents for the lender in case of default. The rationale behind the rents and profits rule could include simplifying rent payment processes for tenants and ensuring that property maintenance responsibilities align with the right to collect rents, thus preventing property deterioration.

The indemnity agreement in question permits the borrower to collect rents even after default, aligning with the interest of clarity for tenants. However, interpreting "rents or other income" as gross rather than net could undermine the purpose of the rule, particularly for nonrecourse loans, where borrowers aren't liable for deficiencies if property sales yield less than owed. If gross rents had to be surrendered to the lender, it could financially disadvantage the borrower, especially if the costs of generating those rents exceed the shortfall from the property sale, leading to scenarios where the borrower might prefer abandoning the property.

The result of the indemnity agreement between Fidelity and Kaiser Investments is questioned, particularly regarding its alignment with the rents and profits rule, which restricts the assignment of rents upon default. The agreement designates Kaiser Investments as Fidelity's agent for managing the property and collecting net rents, indicating that Kaiser is to deduct expenses before remitting to Fidelity. Importantly, this arrangement does not convert the indemnity agreement into an assignment of rents, which has a specific legal definition. The indemnity agreement does not create a secured interest, thus it does not interfere with the rights of other secured creditors of Kaiser Investments or affect asset marshaling in bankruptcy. Kaiser’s argument for a broader interpretation of the rents and profits rule could incentivize premature foreclosure and receivership, which are costly and against public interest. The indemnity agreement inherently acknowledges Fidelity's loss on the loan, as implied by the term "indemnify," and Fidelity's interest in the rents is purely to mitigate that loss. The nonrecourse nature of the mortgage underscores the commercial validity of the indemnity agreement, emphasizing that the rents are a crucial repayment source if the property’s value declines. The agreement functions as a guaranty without violating the principle that a mortgagee's interest is a security interest rather than ownership. The judgment favoring Kaiser Investments is reversed, and the case is remanded for further proceedings.