When a lender forecloses a mortgage on commercial property that its borrower has leased to one or more tenants, the process may result in unexpected consequences.
Foreclosure ordinarily extinguishes all interests in the property that are junior to the mortgage, including leases entered into after the mortgage was given. After a foreclosure, a tenant that wants to stay on the property may not be allowed to, while a tenant looking to walk away from its lease has the right to do just that. That is exactly what happened in the recent Court of Appeals case, Sturgis Building, LLC v. Kirsch Industrial Park, Case No. 327454, Aug. 9, 2016. The court’s opinion is a reminder to lenders, owners and tenants of the importance of executing a subordination, non-disturbance and attornment agreement (“SNDA”) for leased commercial property.
The mortgage lender in Sturgis commenced a judicial foreclosure on leased commercial property after the borrower defaulted, and obtained a judgment for the sale of the property. The lender purchased the property at the county clerk sale “free and clear” of junior interests. Subsequently, one of the property’s tenants informed the lender that it considered its lease terminated, and gave notice that it was vacating its space. The lender disagreed, and argued that it had stepped into the shoes of the prior borrower/landlord and could enforce the lease because, among other things:
1. its mortgage contained an assignment of rents provision that MCL 554.231 made binding on the tenant; and
2. the lease at issue contained a “subordination of lease” clause.
The Court of Appeals disagreed with the lender, and upheld the tenant’s right to vacate the property.
As to the lender’s first argument, the Court of Appeals acknowledged that MCL 554.231 permits mortgages to contain “assignment of rents” provisions, which allow a lender to collect rents due to a borrower in the event of a default. But, the Court of Appeals rejected the lender’s argument that the assignment of rents provision in the mortgage effectively assigned to the lender the entire lease upon default. The court ruled that an assignment of rents does not require either a landlord or a tenant to continue a lease that would otherwise terminate post-foreclosure.
The lender’s second argument met a similar end. The “subordination of lease” clause in the lease at issue required that the tenant permit the landlord to subordinate its lease to the lien of any existing or future mortgagees, and that the tenant acknowledge in writing any existing assignment of rents provision contained in the landlord’s mortgage. Once again holding that an assignment of rents does not equal an assignment of an entire lease, the Court of Appeals found that this “subordination of lease” clause failed to support the lender’s argument that it could enforce the tenant’s lease post-foreclosure.
So, can a foreclosing lender avoid finding itself in this situation? Yes – by requiring any tenants on the mortgaged property to enter into a subordination, non-disturbance and attornment agreement (“SNDA”). An SNDA will require the tenant to perform the lease (to attorn) after a foreclosure, and will require in return that the lender not disturb the tenant’s possession after a foreclosure, so long as the tenant complies with its lease. The lender in Sturgis did not obtain an SNDA, and tried to back-fill its way into such an agreement through an assignment of rents clause. The Court of Appeals made crystal clear that such an attempt will not work.
Ordinarily, a lender holding a mortgage on leased commercial property will want tenants to remain in possession and paying rent following foreclosure. In the overwhelming majority of cases, the lender winds up owning the property after it forecloses, and will have an easier time selling the collateral to recover its losses if there are enforceable leases in place. SNDAs provide this protection, and lenders should insist that their borrowers obtain SNDAs from their tenants. Variations are possible. A lender may want the option of terminating a lease after a foreclosure proceeding. In such a circumstance, it is possible to draft language that makes the non-disturbance optional based on future changes in the rental market or other relevant conditions.
SNDAs benefit tenants as well, by ensuring that foreclosure of their landlord’s mortgage will not terminate their right to occupy the leased premises. A tenant’s pre-lease due diligence should include a title search to determine if the property has been mortgaged, and an SNDA will ordinarily be advisable if that is the case.
Sturgis shows the importance to both lenders and tenants of being aware of and contractually addressing the interplay between mortgages and leases on commercial property and the consequences of foreclosure.
For questions or to learn more about this topic, contact attorney Jonathan T. Walton, Jr. at 313.965.9038 or jwalton@fraserlawfirm.com, or attorney Paul C. Mallon, Jr. at 313.965.9043 or pmallon@fraserlawfirm.com.
Jonathan’s legal practice focuses on cases arising from commercial transactions, the Uniform Commercial Code, the federal and state securities laws, banking laws and bankruptcy litigation. In the areas of banking, commercial, construction and real estate litigation, he represents lenders, contractors and owners on construction-related claims, and lenders and borrowers in commercial and residential foreclosure matters, large loan defaults and collections, lien priority disputes, and title insurance company liability.
Paul focuses his practice on commercial litigation of all varieties, including breach of contract claims, promissory note and collection claims, enforcement of security instruments and guaranties, fraud, shareholder disputes and derivative claims, commercial mortgage foreclosure and other real estate disputes, fiduciary duty claims, and enforcement of restrictive covenants.