In today's challenging commercial real estate leasing market where foreclosures and restructurings are an increasing reality, it is critical whatever position you play or party you represent, whether it be landlord, tenant, lender or buyer of distressed property, to understand the concepts of subordination, nondisturbance and attornment and how they affect where the parties stand relative to each other, in advancing and protecting their respective interests.
II. The Batting Order
It all starts with “priority” which is the legal concept used to determine the order of preference among competing interests. In California, the basic rule is that the priority of competing interests is determined according to the timing of their creation. In the case of the competing interests of a tenant who leases space in a commercial property, and the landlord's lender who holds a security interest in the same property, priority will dictate whose rights will prevail based on whose rights were first in time.
For example, in the simple case where the tenant's lease was entered into after a loan secured by the property was made to the landlord, the lien of the lender's security interest, typically a deed of trust recorded against the property, will have priority over (i.e., be in first position with respect to) the lease which will be junior and in second position to the loan. In the event of a foreclosure by the lender under the superior lien, the junior lease can be “wiped out” by the lender (i.e. become unenforceable), even if the tenant desires to remain in possession under the terms of the lease and is willing to pay rent after the foreclosure.
III. Rearranging the Line Up
Landlords, tenants and especially lenders are typically not satisfied with relying on this simple rule of priority to determine the order of their competing interests. Instead they look to additional agreements to clarify and regulate their relative rights and positions in the event of a foreclosure. In particular, most lenders require as a condition to lend funds to a landlord, that the lien of their security interest in the leased property be superior to all other encumbrances on the property including leases whenever entered into. If any existing leases are to continue after foreclosure, lenders also commonly require special rights that protect them from incurring liabilities for the prior landlord's defaults. Tenants, on the other hand, are concerned primarily with making sure that no matter what happens to the ownership of the property, their basic occupancy rights under the lease will be protected as long as they are operating in accordance with the lease.
These competing interests of lenders and tenants are usually addressed in three interrelated lease provisions. The first provides for “subordination,” which in the commercial lease context is an agreement by the tenant to consent to a reduction in the priority of its leasehold interest to a position inferior to that of the lender's lien. The second provides for “attornment,” which is the agreement of the tenant to recognize and be contractually bound to the lender as the landlord under the lease in the event lender takes title to the property. The third (which is the least common and most contested) provides for “nondisturbance,” which is the agreement of the lender that, despite the tenant's subordination of its leasehold interest to the lender's interest, the lender will under specified circumstances not disturb the tenant's rights of possession under the lease after foreclosure. For a variety of reasons, lenders are generally unwilling to rely solely on provisions included in the lease to protect their rights and also require that these agreements be evidenced in a separate document that includes the lender as a signatory. This document is typically referred to as a subordination, nondisturbance and attornment agreement or “SNDA.”
IV. Time to Develop a Game Plan
The current application of subordination, nondisturbance and attornment is an outgrowth of lessons learned in prior troubled times. While there is today relatively little disagreement between lenders and tenants as to the basic concepts of subordination, nondisturbance and attornment, most leases go far beyond those basic concepts. SNDAs also have become highly complex documents. In fact, these provisions and forms can be the subject of intense negotiations and have varied in form over time in accordance with changes in market conditions and the relative bargaining power of the parties. Consequently, as is commonly the case in the commercial context where nearly everything is negotiable, it is inadvisable for any of the parties involved in a foreclosure situation to assume that some kind of standard arrangement is in place. On the contrary, in formulating a game plan for how to deal with a pending foreclosure situation, one should expect that it will be necessary to carefully review the precise language of the applicable documents to determine the relative rights and obligations of the parties in any particular situation. While it is unlikely that anything can be done when foreclosure is pending to change one's position in the line up, it is still important to know ahead of time what to expect when the game begins and to have an informed plan that is realistic given the circumstances. For example, if broad nondisturbance protections are in place, the tenant may reasonably expect to be unaffected by foreclosure. On the other hand, where there is no nondisturbance protection or the subordination or attornment provisions are strongly landlord favorable, the tenant may need to prepare for significant challenges.
V. Playing the Game: Hits, Outs, Runs and Errors
The following are some of the most important guidelines to consider in evaluating how the game will be played out in specific situations:
1. Subordination. Leases and SNDAs typically include both an “automatic” subordination provision and a requirement for the tenant to enter into an SNDA directly with the landlord's lender. As discussed above, SNDA forms can vary greatly depending on whether they are landlord or tenant favorable. The first thing any party should do in evaluating their position with respect to a lease that may be subject to foreclosure is to establish whether any SNDAs are required and, if so, whether the required SNDAs have been executed and recorded. Not only lenders, but also buyers of distressed properties, should be concerned if SNDAs have not been properly handled. This can also be critically important to the tenant if the missing SNDA form includes nondisturbance protections.
In the absence of an effective nondisturbance agreement, subordinated tenants should be prepared, in the event of a foreclosure, to deal with a situation where the lender or its successor have the right to terminate the lease. Given current market conditions where paying tenants are at a premium, this may be less of a threat than in the past. However, where a tenant has invested a significant amount of funds in leasehold improvements or has nontransferable goodwill embodied in the site, even in this market the tenant may be subject to pressure to renegotiate lease terms including rent.
Of course, in this market, termination of a lease may actually be a positive for certain tenants. To prevent the automatic termination of valuable leases upon foreclosure, lenders typically reserve the right at their discretion to reverse the subordination order. However, particularly with older leases, this is not always the case, and the automatic subordination provision may provide the tenant with an unexpected exit opportunity that in this market could entirely shift the negotiation dynamics in the tenant's favor. Any buyer who is relying on the tenant's rental stream to support the value of the property should be careful to evaluate this potential for termination of important leases.
2. Nondisturbance. Even where there is nondisturbance protection for the tenant in the lease and SNDA, the scope of this protection can vary widely as a result of inclusion of various lender protective carve-outs which must be carefully evaluated in each situation. In addition, almost all SNDAs contain a provision that provides that the nondisturbance protections will not extend to any amendment or modification of the lease made without the lender's consent. Therefore, a tenant seeking to modify the lease in order to ameliorate the current difficult economic conditions should be aware that failure to obtain the lender's consent to any change in terms (i.e., a reduction of rent or the payment of an early termination fee) may result in that agreement being ineffective against the lender – thereby causing significant economic damage to the tenant in the event of foreclosure. The prudent tenant should be careful to obtain and document the lender's consent to any amendment.
3. Attornment. Lender-favorable arrangements may also exist with respect to attornment provisions which allow the lender or its successor to “clean up” the lease for financing purposes in the event of a foreclosure. Attornment provisions may also significantly limit the lender's liability for any of the landlord's defaults prior to the foreclosure. Once again, it is better to be prepared than surprised. If the landlord is obligated to perform significant obligations or make sizable payments to the tenant under the lease (e.g., the payment of a tenant improvement allowance), limitations on these obligations transferring to the new landlord could prove very damaging to the tenant. On the other hand, without such protective language, the lender or its successor may be responsible for costly obligations which may reduce the value of the property to any prospective buyer. As with the other issues addressed above, the specifics of the applicable documents involved and not just general legal principles will determine the parties' relative rights.
In the current downturn in the commercial real estate market, as Yogi Berra once said, “it's like dèjá vu all over again,” and we are forced to revisit lease provisions such as subordination, nondisturbance and attornment that for the most part lay dormant during boom times. Given the potential impact of these provisions on the continuation of leases and the value of distressed properties, all parties involved with properties facing possible foreclosure are advised to dust off the old rule book and carefully examine where they stand. As Yogi also said, “If you don't know where you are going, you might end up someplace else.”
Robert McCormick specializes in commercial leasing, common interest developments and real estate acquisitions and financing. He can be contacted at firstname.lastname@example.org.
Please note that the information contained in this newsletter is not intended to provide specific legal advice. You should consult with an attorney and not rely on any information contained herein regarding your specific situation.