Interaction of Mortgages and Leases

Why would a mortgagee want possession of “income property” prior to foreclosure? To stop waste or to make repairs. To rent out the premises (if vacant) To intercept the rents and apply them to the debt and repairs.

How does a mortgagee get possession? ●Title theory state: on demand at any time (theoretically) ●Intermediate theory state: on demand if there is a default ●Lien theory state: only upon voluntary relinquishment by the mortgagor. mortgagor abandons. mortgage authorizes it upon default. (Nearly all lien theory states accept this.)

Is it wise for a mortgagee to take direct possession? ●Very strict (fiduciary) duty of accounting. ●Duty to care for the property. ●Duty to 3d parties in tort. ●Duty to comply w/running covenants. ●Duty to pay association assessments ●Statutory duties (asbestos, implied warranty). ●Doing so may terminate junior leases (in “title theory” states).

What acts might result in “possession” by a ME? ●Collecting rents (No) ●Entering into a new lease with a tenant (Probably yes) ●Evicting a tenant for nonpayment (Probably yes) ●Making repairs at a tenant’s request (Probably yes) ●Cultivating or harvesting crops (Yes)

Most lenders are reluctant to become “mortgagees in possession.” As an alternative, they usually prefer to have a receiver appointed by a court.

What happens to existing leases when a mortgage is foreclosed? The answer depends on the relative priority of the mortgage and the lease.

If lease has priority: ●Foreclosure purchaser has no right to terminate lease. ●Tenant has no right to terminate lease. ●Tenant must attorn to foreclosure purchaser (just as if MR had sold the property). MRTenant MRME Purch. Forecl. Lease Mortgage

If mortgage has priority: ●If T is made a party to foreclosure, T’s lease is destroyed. ●If T is made a party, even if the foreclosure purchaser wants to keep T on the lease, T can “walk” (terminate)! ●Texas agrees: Med Center Bank v. Fleetwood, 854 S.W.2d 278 (Tex.App.-Austin,1993) MRME MRTenant Forecl. Lease Mortgage Purch.

If the tenant doesn’t want the lease terminated… Would the tenant have a claim against the landlord-mortgagor for damages, for its failure to make the mortgage payments? What theory would the tenant use? Texas denied such a tenant’s claim, where the lease expressly stated that it was “subject to” existing mortgages. See HTM Restaurants, Inc. v. Goldman, Sachs & Co., 797 S.W.2d 326 (Tex.App.1990) Was this correctly decided?

If mortgage has priority: ●Suppose ME wants to keep the lease in effect (because it’s advantageous to the landlord, and hence will bring a better foreclosure sale price). ●So ME intentionally “omits” making the Tenant a party to the foreclosure? Will this work to preserve the lease? MRME MRTenant Forecl. Purch. Lease Mortgage

If mortgage has priority: In half the states, T is deemed a party and automatically wiped out or can intervene and insist on becoming a foreclosure party. (The so-called “Automatic” states) In the other half of states, T can’t intervene; so ME can “pick and choose.” MRME MRTenant Forecl. Purch. Lease Mortgage

In a judicial foreclosure, Texas is a “pick and choose” state: “[W]here suit is brought to foreclose a prior lien on land, which prior lien was in existence, and of which constructive notice was given by the record of such lien to the tenant who afterwards acquired the lease, and the tenant is not made a party to the foreclosure proceedings, such tenant is not bound by the decree rendered or by the subsequent proceedings in such suit.” Kennerly v. B.F. Avery & Sons Plow Co., 300 S.W. 159 (Tex.Civ.App. 1927), reversed on other grounds, 12 S.W.2d 140 (Tex.Com.App.1929)

Query: What’s the effect of a foreclosure by power of sale? ●Many power of sale statutes don’t even require notice to junior tenants (e.g., TX, MO). ●(See the Texas statute on the next slide.) ●Are they therefore cut off automatically by a power of sale foreclosure? (Probably so). ●If notice to them is required, can the ME preserve them by not giving them notice? ●Or does that make the foreclosure void?

Texas notice of nonjudicial foreclosure sales by trustees (V.T.C.A (b)): Notice of the sale, which must include a statement of the earliest time at which the sale will begin, must be given at least 21 days before the date of the sale by: (1) posting at the courthouse door of each county in which the property is located a written notice designating the county in which the property will be sold; (2) filing in the office of the county clerk of each county in which the property is located a copy of the notice posted under Subdivision (1); and (3) serving written notice of the sale by certified mail on each debtor who, according to the records of the mortgage servicer of the debt, is obligated to pay the debt.

Old TownFiber Form Old TownSaratoga Dover Lease D/T Fcl

What would the priority between the lease and mortgage have been, absent any lease clause? What was the effect of the lease clause dealing with priority? Priorities:

“Tenant agrees that this Lease shall be subordinate to any deeds of trust that may hereafter be placed upon the premises.” “Any beneficiary, at its option, may elect to have this Lease superior to its deed of trust.”

Old TownFiber Form Old TownSaratoga Lease D/T Fcl Dover Who could have elected to make the lease superior? How? When? Should it have done so?

Old TownFiber Form Old TownSaratoga Lease D/T Fcl Dover Could Saratoga have preserved the lease by “omitting” FiberForm from the foreclosure? Could they in a Texas D/T nonjudicial foreclosure? (Apparently not; there’s no mechanism for doing so.)

Old TownFiber Form Old TownSaratoga Lease D/T Fcl Dover Was it wise of Fiber Form to pay rent to Dover after the foreclosure? “However, the purchaser at the sale and the tenant may continue the lease; if the tenant offers and the purchaser accepts rent payments after the foreclosure, they have impliedly done so.” See Twelve Oaks Tower I, Ltd. v. Premier Allergy, Inc., 938 S.W.2d 102(Tex.App.-Houston 1996).

Any of three different (but similar) types of clauses might have let Saratoga keep FiberForm’s lease… “Optional unsubordination” (the actual case)  (Could ME unsubordinate without a clause? See Mortgages Restatement § 7.7) “Attornment” clause. “New Lease” clause. Must the clause be in the lease? What about putting it in the mortgage?

Most printed form commercial leases contain one of these clauses. Why? They give the lender (existing or future) all the “marbles.” Hence, they make the landlord’s interest highly “financible.” But a powerful tenant would never sign one of these forms!

Assume that the mortgage has priority over the lease; how does the mortgage keep the tenant? “Pick and choose” states “Automatic termination: states Judicial foreclosure: Omit junior tenants from service. Nonjudicial fore- closure: Don’t give junior tenants notice Judicial foreclosure: Junior tenants can intervene. Nonjudicial fore- closure: junior ten- ants are terminated.

Assuming they have a choice, how do foreclosing mortgagees (and foreclosure purchasers) evaluate whether a lease should be preserved? 1. Characteristics of the tenant and the lease. 2. Debt service coverage ratio. 3. Estoppel statements from the tenants.

Characteristics of the tenant and the lease: T’s financial condition & rent payment record Rent and rent escalation clauses Landlord’s financial duties Casualty loss/rebuilding Renewals & extensions Exclusive clauses Assignment/subletting rights Duty to operate (“lights on”)

The lender may also consider the “debt service coverage ratio”: ●Net rents (after paying operating expenses, but before payment of debt service) (also called “net operating income” or NOI) must be at least (say) 120% of debt service. Net rent Debt service

An example from which to compute the debt service coverage ratio: Gross Rent $ 100,000 Maintenance 6,000 Mngmt, insur., etc. 27,000 Property taxes 15,000 Net rent before debt service (NOI)..$ 52,000 Debt service $ 40,000 Net cash flow $ 12,000

Debt service coverage ratio: Net rents before debt service Debt service $52,000 $40,000 = 130%

When lending on a building with existing tenants, why does a lender require “estoppel statements” from the tenants? The lender may refuse to loan without estoppels from a percentage (say,75%) of all tenants, and from all the “major” tenants. Tenant estoppels

What do estoppel statements say? ●Lease is valid & binding. ●No modifications have been made. ●Rent is as stated. ●No prepaid rent or rent concessions have been made. ●Amount of security deposit. ●Term & renewal options. ●T has no claims against Landlord for breach, except [?]

A lender may also want estoppels from the major tenants before deciding whether to terminate them in foreclosure. (But they can be hard to obtain.)

The SNA: A three-cornered agreement: Tenant Lender Landlord

If the parties have an express agreement, what would the mortgagee like (especially in “automatic” states)? ●Subordination of the lease. ●Attornment agreement by T (or “new lease” clause) (or optional “unsubordination”). This is just what most “small tenant” form leases say.

If the parties have an express agreement, what would the tenant like (especially in a “pick and choose” states)? ●A nondisturbance agreement, promising T won’t be kicked out upon foreclosure (provided, of course, that T is in compliance with the lease). ●Powerful tenants always insist on this.

In the “real world”: ●Strong Landlord: Subordination and Attornment ●Strong Tenant: Nondisturbance ●Balanced bargaining: Subordination, Attornment, and Nondisturbance (SNA)

What does the SNA achieve? ●1. Technical priority for the lender. ●2. Fairness between lender and tenant (neither can break the lease on account of foreclosure).

Why would L want a subordination from T, if L is going to give T a non- disturbance clause anyway? ●The lender’s regulators may limit the lender to 1st liens. ●The lease and mortgage may have conflicting clauses on fire insurance proceeds, condemnation, etc. The document with priority will prevail, and the lender wants that to be the mortgage!

Now let’s look in detail at the wording of the SNA agreement…

Clause 1. Nondisturbance: Provided that T is not in default, T’s rights and privileges under the Lease shall not be terminated or interfered with by Lender in the exercise of Lender’s rights under the Mortgage.

Clause 2. Attornment: If mortgage is foreclosed, or deed in lieu is given, T shall attorn to Lender or purchaser. T’s rights under the lease shall not be impaired, or T’s obligations increased.

Clause 5. Subordination: T agrees that the Lease shall be subordinate to the lien of the Mortgage, and all other documents securing the debt, and all extensions, modifications, and renewals.

Clause 3. Lender’s rights and obligations: In event of default by L, Lender (or foreclosure Purchaser) shall have same rights as Landlord, and shall be bound to T by all covenants in the lease.... except:

Clause 3. Exceptions to Lender’s obligations (T will resist; these may be negotiable): Prior L’s defaults Prior L’s acts or omissions Offsets against prior L Rent prepaid to prior L for more than 1 month Amendments to lease made without Lender’s consent Construction of improvements promised by prior L

A few more exceptions to Lender’s obligations which lender may demand: ●Not bound by any “radius” or “exclusive” clauses in the leases ●Not bound by warranties given by Landlord (e.g., regarding zoning) ●Not bound by options held by T to lease additional space ●Not bound to use fire insurance proceeds to rebuild

And yet a few more possible exceptions to Lender’s obligations: ●Lender not bound to refund security or reserve deposits Alternatively, Lender can require deposits be escrowed with Lender, and pledged so Lender can take them over upon borrower’s default ●T agrees to give Lender notice of any Landlord default, and opportunity to cure it.

The end All of these exceptions to the lender’s obligations are negotiable, and a powerful tenant may be very resistant to them.