FOR THE NORTHERN DISTRICT OF CALIFORNIA
HILLSIDE ASSOCIATES, No. 1-86-01843
v. A.P. No. 1-89-0123
U.S. DEPT. OF HOUSING AND
Memorandum of Decision
The debtor operates a 72-bed nursing home. The U.S. Department of Housing and Urban
Development ("HUD") has succeeded to the rights of the principal secured creditor of the debtor.
It holds a deed of trust to the real property where the nursing home is operated and a security
interest in the debtor's fixtures, personal property, general intangibles and contract rights. The
deed of trust, containing an assignment of rents, issues and profits, was duly recorded; a UCC-1
financing statement was duly filed. The sole issue before the court is whether HUD has a security
interest in funds of the debtor accumulated from postpetition operations.
A. Rights Pursuant to the Deed of Trust
HUD's predecessor in interest made its loan to the debtor for the specific purpose of financing
the debtor's nursing home. It is therefore clear that the parties, among themselves, intended to
grant the deed of trust holder a security interest in the nursing home revenues so that, if there was
ever a default, the secured creditor could step in and operate the nursing home while foreclosure
proceedings were pending. The critical issue here, however, is whether the nursing home revenues
are "rents" or "profits." If they are rents, then HUD has a perfected security interest in them
pursuant to section 9104(j) of the California Commercial Code, which excludes rents from the
perfection requirements of Division Nine. However, if the revenues are not rents, then Division
Nine is applicable; the debtor's rights in the revenues would then be superior to HUD's rights
under the deed of trust pursuant to section 544(a) of the Bankruptcy Code.
There have been several reported cases in the last year or so on the issue of business revenues
as rents. The most recently published, In re Ashkenazy Enterprises, Inc.
94 B.R. 645, applied California law in determining that hotel revenues are not rents. The same
holding was made in In re Kearney Hotel Partners
(Bkrtcy.S.D.N.Y.1988) 92 B.R. 95 (applying
Nebraska law), and In re Greater Atlantic and Pacific Inv. Group, Inc.
B.R. 356 (Missouri law). See also In re Zeeway Corporation
(9th Cir.BAP 1987) 71 B.R. 210
(racetrack proceeds not rents under Arizona law).
A few earlier bankruptcy cases have reached seemingly opposite results. In In re Morning Star
(Bkrtcy.D.Colo.1986) 64 B.R. 818, the court assumed
that motel proceeds were
rents. In In re Flower City Nursing Home, Inc.
(Bkrtcy.W.D.N.Y.1984) 38 B.R. 642, the court
held that medicaid capital cost reimbursement funds were "rents and profits"; it did not discuss
perfection requirements at all. This court believes the reasoning in these cases is flawed and
declines to follow them.
There are no California cases on the issue of business revenues as rents, but there are several
cases where a California court assumed
business revenues were rents. See, e.g., Santacroce Bros.
v. Edgewater-Santa Clara, Inc.
(1966) 242 Cal.App.2d 584. The problem with giving any weight
to these cases is that they dealt with disputes between the debtor and the deed of trust holder. In
such cases it does not matter whether business revenues are rents, or profits, or income; between
debtor and secured party, a security interest is enforceable despite lack of perfection. Section
544(a) of the Bankruptcy Code gives the bankruptcy estate the rights of an intervening third party
creditor. Thus, only cases involving disputes between the deed of trust holder and some other
creditor have any bearing on this case. The leading nonbankruptcy case involving such a dispute,
United States v. P.S. Hotel Corp.
(E.D. Mo. 1975) 404 F.Supp. 1188, aff'd 527 F.2d 500 (8th
Cir.1975), held squarely for the subsequent creditor.
Based on the foregoing cases, and especially the detailed reasoning in Kearney Hotel Partners
the Court rules that while the "rents and profits" clause in the deed of trust is sufficient to establish
HUD's security interest in the nursing home revenues, such revenues are not rents and are
therefore not excepted from Division Nine perfection requirements by Commercial Code section
9104(j) which, like all exceptions to a general statute, should be narrowly construed. 58
Cal.Jur.3d, Statutes, section 116. Since Hillside Associates, as debtor in possession, has rights
superior to those of unperfected lienholders, HUD has no enforceable interest in the nursing home
revenues pursuant to its deed of trust.
B. Rights Pursuant to Security Agreement and UCC-1
HUD concedes that the security agreement and UCC-1 are not models of draftsmanship. It
is not necessary for the court to interpret them, however, because section 552(a) of the
Bankruptcy Code provides that property acquired by the debtor after commencement of the case
is not subject to any lien resulting from a prepetition security agreement. Since the subject of this
lawsuit is only funds accumulated from postpetition operations, any interest created by the security
agreement and UCC-1 is not applicable.
HUD's argument that the postpetition revenues are the proceeds of its collateral is
unpersuasive. While section 552(b) does provide an exception to the general rule in section
552(a), the exception is only meant to apply in situations where raw materials are converted to
inventory or inventory is converted to accounts. Legislative History, H. Rept. No. 95-595, 95th
Cong., 1st Sess. (1977) p. 376, 377. Thus, while the exception might apply to a receivable
generated prepetition but collected postpetition, it is not applicable to a receivable generated
entirely postpetition. Section 552(b) "creates an exception for proceeds generated by prepetition
collateral, and not for property acquired by the debtor or the estate postpetition or proceeds of
the same." 4 Collier on Bankruptcy (15th Ed.), sec. 552.02, p.552-7.
HUD's last argument is that federal nonbankruptcy law somehow excuses HUD from
perfecting its security interest. This argument is based on the provision in section 552(b) that
postpetition proceeds of prepetition collateral are subject to a prepetition security interest "to the
extent provided by such security agreement and applicable nonbankruptcy law, except to any
extent that the court, after notice and a hearing and based on the equities of the case, orders
otherwise." The short answer to this argument is that by its own terms section 552(b) does not
affect the estate's rights under section 544. There is therefore no need to determine if HUD's
interpretation of the term "nonbankruptcy law" is what Congress intended.
Even assuming that the law gives HUD rights in the proceeds of its collateral notwithstanding
the failure to so specify, HUD has not established that the postpetition revenues of the debtor's
business are in fact the proceeds of any property in which HUD held a perfected prepetition
security interest. HUD has the burden of proof as to this issue. 4 Collier on Bankruptcy (15th
Ed.), sec. 552.01, p. 552-6. Accordingly, the HUD's motion for summary judgment must be
Counsel for the debtor shall submit an appropriate form of order, which counsel for HUD shall
approve as to form.
Dated: August 3, 1989 _______________________