Almost every lease of commercial, retail and industrial property contains a so-called “subordination clause,” under which the tenant agrees that the tenant’s rights under the lease will be inferior to the rights of any lender who forecloses on the leased property. It is vitally important that any tenant agreeing to subordinate understand the import of such a provision and the available options. It is the rare tenant who can flatly refuse to subordinate his leasehold interest in the event of foreclosure. But there is much that the well-informed tenant can do to prevent termination of its lease in the event the landlord is foreclosed.
Under the general law of estates, if the lease is recorded or if the tenant is in possession of the leasehold premises before the recording of a mortgage, the lease has priority over the after-granted mortgage or trust deed. A subordination clause in the lease turns this priority on its head. The subordinating tenant agrees that if the landlord’s lender forecloses, the mortgage will take priority over the lease. Subordination clauses are standard in almost every commercial lease, since lenders taking security interests in such property insist upon them as a condition of making a loan.
Upon foreclosure in some states, the mortgage foreclosure simply extinguishes a lease that contain a subordination agreement. In other states, the foreclosing lender has the option of either terminating the lease and or keeping it in place, whichever is to the foreclosing lender’s advantage. In other words, if the lease is below market it can be terminated. If it is above market, the tenant can still be held to lease.
The well-advised tenant will insist on protection in the form of a “non-disturbance and attornment” provision. Such terms provide that the tenant recognizes the foreclosing lender or purchaser at the foreclosure sale as the landlord, but also ensures that the leasehold will continue unless the tenant defaults. By recognizing the foreclosing lender as a new landlord, the tenant agrees to “attorn” to the new landlord, and the new landlord agrees not to “disturb” the tenant’s lease.
It is important that the subordination, non-disturbance and attornment agreement (called an “SNDA”) provide more than simply the landlord’s agreement to recognize the lease and the tenant’s agreement to recognize the new landlord. When the lender has had to foreclose and either retain ownership itself or sell to a third party, a whole raft of issues can arise between the tenants and their new landlord, which should be spelled out in the SNDA.
From the tenant’s standpoint, the lease should include language specifying what happens if the landlord defaults and that default continues after foreclosure. For example, what happens after foreclosure if the landlord has failed to make necessary repairs or maintenance to the premises? The lender should be willing to make necessary repairs, but will probably insist that the tenant waive claims for damages accruing prior to foreclosure. The lender should also be willing to live with the original lease’s provisions for disposition of insurance proceeds, condemnation awards, and deposits.
Before entering into any commercial lease, the tenant should obtain a title report showing any liens or mortgages on the property, or obtain an express representation by the landlord. The tenant should attempt to negotiate a non-disturbance agreement from all such existing mortgage lenders as a condition of the lease. Alternatively, the tenant with substantial bargaining power can insist on a provision giving it the right to cancel its lease if the landlord does not or cannot obtain the lender’s agreement for non-disturbance of the lease.
Subordination agreements are traps for the unwary, but the sophisticated tenant can make sure that the landlord’s problems do not become the tenant’s problem too.
*This post was written by Attorney Rick L. Knuth