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Commercial Foreclosures—The Effect on Existing Leases

A question tenants and lenders frequently ask is whether the lender’s foreclosure will affect the enforcement of a commercial tenant’s previously signed lease agreement.

Unfortunately, there is no easy answer here.  The first inquiry is whether the tenant’s lease agreement was entered into before or after the lender’s recording of a deed of trust.

If the lease agreement was entered into before the lender’s recording of a deed of trust, then the general rule is that the lease agreement remains enforceable, both by the lender and the tenant.

On the other hand, there are exceptions wherein the outcome will be determined by the lease or another agreement and not as a matter of law.  If there is a simple subordination provision in the tenant’s original lease agreement or in a later signed agreement with the lender, then the tenant’s lease may be subordinated to the lender’s loan/deed of trust.  In that event, a lender’s foreclosure will terminate the previously signed lease.

However, the lender may agree to a non-disturbance provision.  If there is a non-disturbance provision, the landlord may not disturb the tenant for the remaining term of the cancelled lease, as if the original lease continued in place, so long as tenant is not in breach of the terms of the original lease.  See Dover Mobile Estates v. Fiber Form Products, Inc. (1990) 220 Cal. App. 3d 1494, 1498 [270 Cal.Rptr. 183].  The non-disturbance provision protects the tenant’s lease rights.

All of the foregoing is fine and well if the lease was entered into before the loan.  But what happens if the tenant’s lease agreement was entered into after the lender’s deed of trust was recorded?

If the lease agreement was entered into after the lender’s recording of a deed of trust, then the general rule is that the lease agreement terminates upon the lender’s foreclosure.  California law follows the extinguishment rule, wherein the lease terminates and the lender’s subsequent acceptance of rent merely acknowledges a month-to-month tenancy.

Again, this outcome can be altered by an agreement; however, usually both the lender and the tenant must be parties to the agreement for a lender to be bound.  On the other hand, if a tenant’s lease agreement contains an attornment provision, then the lender may hold all of the options and may be able to enforce terms of the original lease, even though the landlord was not a party to either the original lease agreement or an agreement with the tenant.  Under an attornment provision, the tenant agrees with the original owner (regardless of when the lease was signed or whether there is a subordination provision) that the tenant will accept and agree to be bound to any successor owner pursuant to a sale or foreclosure.  The exact terms of the attornment provision are critical as to the rights of each of the parties.  For example, the attornment may say it is at the request of the successor which, as discussed below, gives greater rights to the landlord.

An attornment provision creates a third party beneficiary right that survives a lease termination.  Where a tenant agrees to an attornment, effective upon lender’s request, the lender, following foreclosure, can demand that the tenant enter into a new lease under the former tenant’s lease terms.  Furthermore, the failure of the tenant to enter into a new agreement is a breach of contract similar to the original owner’s expectations under the original lease.  (Principal Mutual Life Insurance v. Vars, Pave, McCord & Friedman (1998) 65 Cal.App.4th 1469.)

Accordingly, an attornment provision protects the lender’s rights regardless of the timing of the recording of its lease.  For subordinated leases (by law or contract), if attornment is at the lender’s request (in the absence of a lender approved non-disturbance provision) it grants the lender the option to elect either (i) to bind the tenant to a new lease (under the prior lease terms) or (ii) to treat the tenant’s lease as terminated, and not renew the lease.  This option is not granted to the tenant.

In summary, the enforceability of a lease agreement after foreclosure depends on the timing of the lease recording, the law and the terms of the agreements among the parties.  The foregoing discussion does not apply to residential leases.  Before a lender, tenant or successor owner-in-interest decides to enforce a lease after a foreclosure, careful review of all relevant tenant related agreements is recommended.  This office has been advising clients, owners, lenders and tenants on real estate legal and tax consequences for years, and in every instance we find it critical to review all relevant loan and tenant lease agreements to know the effect of foreclosures on existing lease agreements.

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