Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Real Estate Mortgage Enforcement, October 2008
When lending on the security of tenanted commercial property, a lender will generally seek to have its mortgage security rank in a prior position to the leasehold interests of tenants, on the basis that this priority will put the lender in the driver's seat in an enforcement scenario. Whether this priority actually leads to the desired result for the lender on enforcement depends on an understanding of the concepts of subordination, non-disturbance and attornment governing the relationship between the lender and tenants, as well as the state of the leasing market at the time the lender enforces its security.
If a landlord mortgages its property and subsequently grants a lease of that property, the lender's rights are paramount. In other words, for leases entered into after the registration of a mortgage, the lender's mortgage will have priority over the lease. After default under the mortgage, if the mortgagee wishes to assert its paramount right to possession, the mortgagee may elect to evict the tenant in the absence of any agreement to the contrary between the lender and the tenant.
With respect to leases entered into prior to the registration of the mortgage, the lender can be in no better position than the landlord in enforcing the tenant's obligations following a default by the landlord under the mortgage. Provided the tenant performs its obligations under its prior-ranking lease, the lender cannot terminate the lease or seek to take possession of the premises. After default, the lender may elect to serve a notice on the tenant requiring the tenant to pay all future rent to the lender. Although the lender can enforce the tenant's obligation to pay rent and perform its other obligations under the lease, the tenant is also entitled to performance by the lender of the landlord's covenants under the lease upon paying rent to the lender, absent any contractual provisions to the contrary protecting the lender.
Subordination of Leasehold Interests
If a lender's mortgage does not have priority over a lease, a lender might insist that the borrower require the tenant under the prior lease to "subordinate" its leasehold interest in the property to the mortgage. In anticipation of this lender requirement, leases frequently provide that tenants subordinate their leasehold interests (often automatically) to any current or future mortgages affecting the property.
Since a lender's priority over a tenant's leasehold interest will entitle the lender to terminate a lease and evict a tenant in an enforcement situation (in the absence of any agreement to the contrary between the lender and the tenant), a lender might consider it desirable for this order of priority to exist in a leasing market where rents are on the increase. This would give the lender flexibility to rent the property to another tenant at a higher rent.
As a practical matter, however, a lender will most likely want to preserve arm's-length commercial tenancies to keep the income stream from the property flowing. As we will see below, it may be preferable from a lender's perspective to have a lease state that the tenant will subordinate its interest to any future mortgages only when requested to do so by the landlord or the lender.
A commercial tenant who invests considerable money in its premises for leasehold improvements, or views its premises as a critical business location, will desire security of tenure if the landlord defaults under its obligations in a mortgage with priority over the tenant's lease. As we have seen above, even if the tenant has continually complied with all of its obligations in the lease, the tenant may be forced to vacate its premises by a prior mortgage lender conducting mortgage enforcement proceedings, as the lender's enforcement action might extinguish the tenant's interest in the property. This would result in a loss of business and cause considerable disruption to the tenant's operations.
Accordingly, when faced with subordination requirements in a lease or a request for subordination, or when the tenant discovers that its lease will be subject to a prior mortgage, a sophisticated tenant may insist that the prior mortgage lender enter into a "non-disturbance agreement" with the tenant. This agreement will provide that in the event of sale or foreclosure, the lender will not disturb the rights of the tenant to possession under the lease, so long as the tenant continues to comply with its obligations in the lease.
The Goodyear Decision
Although it would seem that a lender with priority of its mortgage over leases would put the lender in a superior position, there are risks to a lender having priority over tenants' leases where the lender has not relinquished its paramount right of possession. The 1998 Ontario Court of Appeal decision of Goodyear v. Burnhamthorpe confirmed that a tenant, subsequent in priority to a mortgage, may be permitted to terminate its long-term, above-market lease obligations upon the lender entering into possession and claiming rent or completion of a sale or foreclosure. The court's view was that it would be unfair to bind the tenant to its long-term lease obligations while the lender retained the right to evict the tenant at any time, even though the tenant was not in default under the lease. Accordingly, the court held that the tenancy relationship between the landlord and the tenant was terminated and a new year-to-year tenancy relationship was created between the mortgage lender and the tenant, which either party could terminate upon six months' prior notice.
The lesson here from a lender's point of view is that if a lender takes possession of leased premises after a borrower's default, this may cause the termination of leases upon which the lender is relying for payment of its mortgage.
As the value of a commercial property lies in its rental income flow, lenders will generally wish to keep leases in place in the event of mortgage enforcement proceedings. Consequently, if a lender wishes to ensure it can pass along long-term tenancies to a prospective purchaser, it should enter into non-disturbance agreements with tenants containing an "attornment" clause, in which the tenant agrees to recognize the lender as its landlord after (a) receiving a notice of attornment from the lender, (b) the lender takes possession of the property or leased premises, or (c) the landlord's interest in the property is transferred to any successor in title as a result of mortgage enforcement proceedings, including foreclosure or power of sale. Leases often also contain attornment provisions, which can be enforced by the lender. It is good practice for a lender in approving the standard form of lease used by the borrower, to confirm that the form of lease contains a covenant by the tenant to attorn to the lender at the request of either the landlord or the lender.
As illustrated above, a lender must not only have an understanding of the rank in priority of its mortgage security in relation to the leasehold interests of tenants, but also a grasp on the impact that these relative priorities could have on the expected income stream from the property in an enforcement situation. It is likely that some combination of subordination, non-disturbance and attornment will put a lender in a position to continue to enforce leases and derive the expected rental income from the property in an enforcement scenario.
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.