Copyright 2011, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate - Commercial Leasing, October 2011
In establishing its premises at a new location and entering into a new lease, a tenant may invest a considerable amount of money for leasehold improvements. The new business location may also be viewed by the tenant as critical to its operations. However, if the tenant's landlord has previously mortgaged its property and subsequently defaults under its obligations to its lender, the tenant may face the risk of eviction and suffer significant disruption to its operations, as well as financial and business losses, even though the tenant has continually complied with its obligations contained in its lease.
Prior-Ranking Mortgage: A Double-Edged Sword
When a landlord, whose property is already encumbered by a mortgage, enters into a lease with a tenant, the mortgage is in a prior position to the tenant's leasehold interest in the property. All the landlord has is an "equity of redemption" which may be "foreclosed" or extinguished by the lender following loan default by the landlord and lender enforcement of its mortgage. In the absence of an agreement between the lender and the tenant, the tenant can be in no better position than the landlord. This means that the tenant's leasehold interest in the property may be terminated or extinguished as a part of the lender's enforcement proceedings. To many lenders, the word "priority" has certain positive connotations, often denoting a better or preferred position. However, priority in favour of the lender can be a double-edged sword.
If a lease is subsequent in priority to a mortgage and the mortgage is enforced upon default, the tenant is, in turn, free to leave. The case law provides that a tenant, subsequent in priority, may be permitted to escape its lease obligations upon the lender taking possession or otherwise enforcing its security. In a soft leasing market, the lender would want to ensure a steady rental income stream, and the priority of a mortgage over a tenant's lease may, in fact, subvert the lender's desires. In these circumstances, the lender should be asking the tenant to "attorn" to the lender. When a tenant attorns to the lender, the tenant is effectively promising to recognize the lender as its landlord upon default of the landlord's loan obligations. Attornment protects lenders which are enforcing mortgage security from the risk of tenants being released from their leases. A well-drafted attornment clause would require the tenant to attorn to any successor in title, including any purchaser to whom the lender might sell the property following or as part of the exercise of its loan enforcement remedies.
If a landlord executes and delivers a mortgage in favour of a lender having first entered into a lease, the landlord has simply mortgaged its "reversion" in the property previously leased to the tenant. Where no agreement exists between the tenant and the lender, if the lender elects to enforce its security following the landlord's loan default, the lender is bound to honour the tenant's right to possession and certain other provisions contained in the lease, to the extent such provisions "run with the land".
In these circumstances, the tenant, whose lease has priority over the mortgage, enjoys "security of tenure" and is not liable to be evicted from its premises following the lender's loan enforcement, provided that the tenant performs its obligations under the lease. At the same time, the tenant does not have the right to walk away from its lease obligations simply because the lender has stepped into the landlord's shoes, the tenant's tenure at the premises not having been jeopardized by the lender's mortgage enforcement procedures. The result is that both the tenant and the lender must honour the lease following a lender's taking possession or enforcement of its security.
Changes in Priority: Subordination
The rights of the tenant thus greatly depend upon whether its lease has "priority" over the lender's mortgage. The tenant's priority may be lost (a) as a result of the terms of the lease or (b) pursuant to the provisions of a subordination agreement. In many leases, the tenant has agreed to a clause providing for the subordination of the tenant's lease "to any present or future mortgage made by the landlord registered against title to the property". Such an "automatic subordination" provision, without corresponding "non-disturbance" protection, could severely undermine the tenant's rights in a landlord loan default situation.
Regardless of whether an automatic subordination clause is contained in the lease, landlords are often met with a requirement in their loan commitment to obtain subordination agreements from all tenants of the property as a condition to the first advance of the mortgage loan. Many lenders seek such a prior position so they may "pick and choose" which of the leases the lender will agree to honour upon the occurrence of a loan default. Lenders may have a variety of legitimate reasons for desiring such flexibility, including freeing the property from non-arm's-length owner-related leases or "problem" tenants that are driving down the property value, or simply to remove tenants who are paying below market rents in the hope of replacing them with current market deals.
Importance of Non-Disturbance Agreements to Subordinate Tenants
When faced with either subordination requirements in leases or landlord requests for subordination, tenants should seek the protections afforded by non-disturbance agreements. A non-disturbance agreement will create a direct contractual relationship between the tenant and the lender and will provide that the lender will not disturb the tenant's possession and quiet enjoyment of the leased premises on the terms of the lease upon loan enforcement for as long as the tenant continues to pay rent and otherwise complies with the terms and conditions of the lease.
A tenant would be well advised to obtain a non-disturbance agreement from any existing mortgage lender holding a mortgage on the property when the lease is entered into. The tenant should avoid agreeing to "automatic subordination" clauses that could undercut its priority vis-à-vis a subsequent mortgage lender, or modify the provision to indicate that it shall only become effective upon the lender executing and delivering a non-disturbance agreement in its favour.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.