Impact of Foreclosure on Leases
Impact of Foreclosure on Leases
by Bryan Mashian, Esq.
Foreclosure of a real estate loan generally extinguishes a lease that is junior to the loan. So, the termination of a lease and the resulting forced relocation could ruin a tenant’s business. Conversely, a lender may lose a rental stream by inadvertently terminating the lease of a creditworthy tenant paying rent at market rates or better. To prevent such unintended consequences, the parties should use Subordination, Nondisturbance and Attornment (SNDA) agreements which are intended to maintain the status quo in case of a foreclosure, i.e., the tenant continues in possession under the same lease and the lender continues to receive rent under that lease.
SNDAs – Mutually Beneficial
Under a typical SNDA, the lease is subordinated in priority to the trust deed of the loan. This provision is often required because banking regulations mandate that the loan be ahead of any other interests in the property. In return, the SNDA will protect the tenant and provide that, in case of foreclosure, the tenant’s possession will not be disturbed, and the tenant can continue to occupy its premises. Also, for the benefit of both parties, the SNDA will provide that the lease will continue in full force and effect. So, the SNDA will require the tenant to “attorn” to the successful bidder at the foreclosure sale, and the buyer (as the new landlord) to abide by the lease.
Alternatives to SNDAs
While an SNDA can create a “win-win” situation for both the lender and the tenant, some lenders only offer a “Subordination and Attornment” agreement. This agreement is somewhat lopsided as it does not contain a nondisturbance clause to protect the tenant. Such an agreement, for example, would allow the new landlord the option of either keeping or terminating a tenant’s lease after a foreclosure. Such unilateral arrangements are not acceptable to most tenants. Also, these agreements may be challenged if the tenant later claims that the tenant did not really understand the impact on its business, or because the tenant did not receive any “consideration” for executing an unequal agreement. Such an uneven arrangement may also cause some practical disadvantages. For instance, the tenant may be discouraged from spending money for leasehold improvements that ultimately boost property values since the tenant is concerned that it may be evicted after a foreclosure.
No SNDA? All Is Not Lost
If there is no SNDA agreement in place prior to foreclosure, a lender may be able to persuade the tenants to sign on the dotted line before or after foreclosure is complete. But to achieve this result, the lender may have to make major concessions to the tenants. The tenants, however, should not feel that they necessarily have the upper hand in this scenario. If permitted by the lease and depending on the facts, the lender may be able to unilaterally elect to subordinate its loan to the lease before the foreclosure sale. There is a risk, however, in this strategy since the lender may not be aware of the exact status of the lease. For example, there may be an unfavorable lease amendment of which the lender is not aware, and by subordinating, the lender could be bound by this amendment.
The lender can alternatively elect to use judicial foreclosure (instead of foreclosure by a trustee, as is often done). Here, the lender could deliberately omit the junior lessees from the parties named in the foreclosure action and thereby leave them in place. But, there is no decisive California authority on the effectiveness of such a procedure. Also, judicial foreclosure is usually slow and more expensive.
If the junior leases are unrecorded, any judgment in a judicial foreclosure action would be conclusive against the holder of such an unrecorded interest. So, tenants should ensure that their leases are recorded to avoid such an outcome.
The most prudent course of action for all concerned is not to rely on the uncertainties of judicial foreclosure or the legal process in general. Obtaining SNDAs from any existing tenants before the loan is made will help provide certainty and clarity to both parties. Lenders should also require the borrower/landlord to obtain SNDAs from new tenants as new leases are signed.