Foreclosing To Extinguish or Not Extinguish A Lease

To foreclosure, or not to foreclose, that is the first question. To extinguish or not to extinguish a lease, that is the second but more complicated question.

When considering a loan, lenders typically value the underlying collateral by looking at standard metrics, such as comparable values and rent rolls. These lenders simply hope to have protection if a foreclosure is warranted before taking over and selling the property. However, a more strategic lender should evaluate the potential value of the collateral after a foreclosure, which includes a review of all lease agreements to see what agreements have been extinguished, what agreements may not be extinguished and how to use the maximum leverage against any tenants in either case.

In California, leases are treated like liens and leases that are subordinate to the lender’s deed of trust are also extinguished upon foreclosure. Leases created after the recording of the deed of trust are always subordinate and always extinguished. Leases prior to the recording can, via various SNDA provisions, result in their extinguishment, non-extinguishment or potential extinguishment after foreclosure.

Lenders should ensure that they thoroughly review these provisions. Simply accepting rent from the tenant is not sufficient to reinstate the original lease and a tenant can then vacate the month-to-month agreement. This could be extraordinarily contentious if the lender has sold the property claiming that the lease continued. On the other hand, a lender who knows what is extinguished can threaten these tenants with immediate eviction and if timed properly, these tenants will willingly agree to extremely favorable terms to unlock a hidden value.

Lenders can, with some review and strategic planning, drastically improve a rent roll by resetting old long-term leases to market rates and raising the collateral’s value for sale. Lenders on the other hand who do not review these agreements could find themselves subject to litigation or unable to enforce a lease agreement because they gave all their leverage to the tenants before realizing what their borrowers agreed to.

First Consideration: Determine Which Leases Are Automatically Extinguished

As explained in the case of Dover Mobile Estates v. Fiber Form Prods. (1990), 220 Cal.App.3d 1494, a lease that is created after the deed of trust was recorded is subordinate to the deed of trust.

Exceptions apply if the lease was executed and recorded prior to the recording of the deed of trust or if the lender had notice of an unrecorded lease at the time of recording. While borrowers may be required to provide updated rent roll information or lease agreements, lenders should keep detailed records of which, if any, leases they obtained prior to the recording of the deed of trust and note when they first received notice of any leases after recording the deed of trust.

Under California law, subordinate leases, like a junior lien (such as those created after the deed of trust is recorded or that the lender was not notified about, are automatically extinguished after a foreclosure. The tenant’s remedy is a civil lawsuit against its former landlord/the borrower.

In one case, a lease agreement for a hotel tenant was executed after the lender’s deed of trust was recorded. After foreclosure of the property, the lender’s counsel informed the tenant that, with the lease extinguished, rent would be increased and rent would only be accepted on a month-to-month basis to improve the chances of a sale of the property itself. The tenant’s significant investment in the property encouraged it to raise funds and make a quick offer to purchase the property for above the market rate offers the lender was receiving.

Second Consideration: Determine if There are SNDA provisions

As explained in the case of Miscione v. Barton Dev. Co. (1997), 52 Cal.App.4th 1320, leases can contain subordination, nondisturbance and attornment provisions, known as SNDA provisions. A sophisticated lender can require a borrower to execute separate three-party SNDA agreements between the lender, borrower and the tenant that ensure that the landlord has maximum control and power over the tenants if there is a foreclosure.

• A Subordination (S) provision or agreement operates the same as mortgages, changing lien rights or other security interests.

In the Dover case, the tenant agreed to ‘automatic subordination,’ namely that the lease was subordinate to any deeds of trust unless the lender chose to have the lease be superior. The lender did not make that choice, and after foreclosing, continued to accept rent from the tenant. The appellate court ultimately determined that the lease was an extinguished subordinated lease automatically terminated upon foreclosure. In the lawsuit following the tenant abandoning the property, the tenant was not liable after the tenant gave 30 days’ notice, terminating the a month-to-month agreement and had no further obligation to pay rent.

In an example of proper strategic planning, a commercial lease agreement for a café was signed years before the deed of trust was recorded and was operating at below-market rent due to a below inflationary rate of increase when foreclosed upon. The lease contained a provision stating that the tenant’s interests would forever be subordinate to any other interests of its landlord, the borrower.

Even though the lender had been aware of this prior lease before recording the deed of trust, after completing the foreclosure, the lender’s counsel immediately informed the tenant that the lender was now owner of the property, would not accept rent at the prior rate, and would be issuing a three-day notice to quit. Before the tenant’s eviction began, the tenant immediately agreed to market rate on a month-to-month subject solely to the new owner/lender’s termination with a significant penalty for the tenant to terminate within the next year. This created an increased sales price for the lender’s exit.

As the Dover court noted, a tenant under a subordinate lease could bargain with the borrower/former landlord for notice and any right to cure a default by the borrower to the lender. Lenders may want to consider including such rights for a tenant that is more financially stable than the landlord.

• A Nondisturbance (ND) provision or agreements states that the tenant is allowed to remain on the leased premises if the tenant complies with the lease and the lease is not in default.

As the Dover court explained, the tenant under a subordinate lease could gain protection by negotiating for this clause. In this situation, a sophisticated lender’s counsel should review the tenant’s lease agreement in detail and determine if there are any, even if highly technical, covenant violations that could set up a potential threat of termination of the lease so as to encourage more favorable lease terms for the lender.

• Attornment (A) is where the tenant agrees that, upon a foreclosure, the lease would not be extinguished but the tenant would be subject to a new landlord. As the Miscione court explained, a borrower/landlord could use this provision to demonstrate to a lender that the tenant would be bound to a new landlord after a foreclosure, which “could be a persuasive argument to a lender who was considering the financial condition of the landlord or the landlord’s position vis-à-vis other parties involved with the real property.”

The court in Principal Mut. Life Ins. Co. v. Vars (1998) 65 Cal.App.4th 1469, quoted a journal article saying that attornment clauses help “in clarifying their rights and responsibilities in the event of foreclosure,” which “boosts and fosters certainty,” “not only to tenant entrepreneurs, but to portfolio-balancing mortgagees as well.”

In Miscione, the lease agreement contained a mix of these provisions but the attornment language required (1) the tenant to attorn to the purchaser after the foreclosure sale, (2) the purchaser to ‘acquire’ the property and (3) the purchaser to ‘accept’ the premises subject to the lease.

The litigation ensued because the lender/purchaser sold the property and the tenants abandoned the property defaulting on the rent while claiming that their lease had been extinguished. The tenants were successful at the trial court but a divided appellate court ruled that the lender/purchaser had ‘accepted’ the premises subject to the lease when it gave notice that it was the new owner, demanded that all rent payments be made to it and then later acknowledged that it wanted the tenant to abide by the lease.

In contrast, the Vars lease agreement stated that the tenant would “enter in a new lease” with the purchaser. This meant that the prior lease was extinguished and the tenant’s failure to do so was a breach of the agreement.

A Checklist in Preparation for a Foreclosure

Before any California lender considers a deed in lieu of foreclosure, a withdrawal of the foreclosure, or any negotiations with a borrower, the lender should review the file and reflect upon each of the following:

• What leases, if any, were recorded prior to the recording of the deed of trust.
• What leases, if any, were provided to the lender from the borrower as part of the loan file.
• Which leases, if any, are best extinguished at foreclosure.
• Which leases, if any, are best continued after a foreclosure.
• Whether any agreement requires the borrower to subordinate prior leases to the lender.
• Whether to require the borrower to sign any sort of SNDA agreement with a tenant.
• Whether to require the borrower to amend their agreements with any tenants to permit the tenants to cure any monetary default by the borrower.
• Whether and when to pressure the tenants and attempt to maximize returns after a foreclosure.

Closing Thoughts

The takeaway is simple: review the agreements that the borrower has entered into to understand the consequences of foreclosing. Understand what happens after a foreclosure and formulate a plan to maximize leverage or minimize potential liability.

Foreclosures have numerous consequences, not all of which are easily determined or easily resolved before the process is complete. Some parts involve negotiations after the fact and maximal pressure can be achieved in days or weeks that could result in years of benefits. Similarly, a settlement without other considerations may be leaving potential pitfalls should there be a need to later foreclose.

For lenders interested in a holistic approach to maximizing value, from evaluating the true potential of the collateral to attempting to pressure tenants after a foreclosure has been completed, Geraci LLP’s attorneys can provide strategic vision and planning. We would much rather help structure the plan to maximize pressure and maximize value from the start rather than advising that a loan was extinguished by a lack of planning.