Copyright 2008, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Real Estate Leasing, April, 2008

The interplay between leases and mortgages is well settled at common law. Thus, a tenant whose lease has priority over a mortgage is bound by the lease if the mortgagee (lender) enters into possession. At the same time, the mortgagee in possession must honour the lease and cannot oust the tenant. However, a tenant under a lease that is subordinate to a mortgage is not bound by its lease if the mortgagee enters into possession and, accordingly, the tenant may vacate the premises rather than recognize the mortgagee as its landlord. Correspondingly, where the lease is subordinate to the mortgage, the mortgagee is not bound to the lease and may remove the tenant.

Non-disturbance agreements (NDAs) serve to alter the above-described common law. Although there are several reasons why a tenant and mortgagee would want to terminate the lease if the mortgagee goes into possession, tenants and mortgagees usually prefer to play it safe and obtain the protections afforded by an NDA. While entering into an NDA should be a win-win proposition for both tenants and mortgagees, care must be taken to ensure they are carefully negotiated, as a tenant or lender that fails to get it right could find itself in a precarious position. Some of the more significant issues to consider when negotiating NDAs are set out below.

Two Types of NDAs

Generally speaking, there are two types of NDAs. Under the first type, mortgagees simply agree that should they go into possession, they will not disturb the tenant's use and enjoyment of the premises (in other words, they will not evict or oust the tenant). Under the second type, mortgagees go one step further and also covenant to be bound by the terms and conditions of the lease while in possession. The second type is much more advantageous for tenants as it serves to create privity of contract between the tenant and the mortgagee in respect of the lease. Where the tenant is unable to obtain privity of contract, the tenant will only have the protection of enforcing the provisions in the lease that "run with the land." Of course, before agreeing that it will be bound by the lease, a mortgagee must ensure the lease does not contain any provisions that may be problematic for it should it enter into possession.

The Equities/State of Accounts

Many NDAs stipulate that the mortgagee will not be bound by the equities or state of accounts that exist between the landlord and tenant. Specifically, many NDAs state that the mortgagee is not to be bound by any pre-payments of rent, security deposits or other sums that may be payable by the landlord to the tenant (such as year-end adjustments). Also, tenants are often required to waive any rights of set-off, defences or claims that they may assert against the landlord. This is problematic for tenants as they may find they are required to pay a mortgagee amounts they have already paid to their landlord (or amounts they were not required to pay to their landlord). From a mortgagee's point of view, obtaining the foregoing concessions from tenants helps ensure it receives the cash flow it expected to receive and the mortgagee itself is not out-of-pocket.

Lease Amendments, Assignment and Sublets, Terminations and Surrender

One can easily appreciate that a mortgagee would have legitimate concerns in respect of alterations to the landlord-tenant relationship, which it is unaware of and had no input over. Accordingly, many mortgagees seek concessions to the effect the mortgagee will not be bound by any amendments to the lease made without its consent. This will often be expanded to include lease terminations and surrenders, assignments and sublets. However, from a tenant's point of view, consent provisions are problematic simply because they are almost always overlooked with the result that the tenant may lose the benefit of an amendment it had bargained for. In the surrender or termination scenario, it is conceivable that a tenant could find itself liable to a mortgagee long after the tenant has vacated the property with the belief its obligations had come to an end.

Collateral Lease Rights/Financial Obligations

Mortgagees often try to strip tenants of many of their collateral rights. Typical examples include stripping tenants of rights of first offer and refusal and options to purchase. Less typical examples include provisions where the landlord has covenanted to purchase a certain amount of goods or services from its tenant. This may not be fair to a tenant that has relied on these collateral rights as a material inducement to enter into the lease. At the same time, however, it is not unreasonable to permit a mortgagee to extricate itself from a particular lease obligation where it would be impossible for the mortgagee to perform the obligation (for example, where the landlord has agreed to grant an exclusive that extends to more than one property owned by the landlord but that is not subject to the mortgagee's security).

In other cases, mortgagees will try to eliminate potential financial obligations such as landlord's construction obligations and tenant allowances. While one can sympathize with a mortgagee's reluctance to pour more money into an already losing proposition, it is not reasonable to expect a tenant to forego these rights where the cost of the obligations has been incorporated into the minimum rent payable by the tenant.

Mortgage Proceeds

Mortgagees often insist that all insurance proceeds following an event of damage or destruction be used to pay down the debt rather than repair the property. This is problematic from a tenant's point of view as it may find itself in a situation where it is bound to continue to occupy its premises and to perform its obligations notwithstanding that the property is left in an untenantable or quasi-untenantable state. From a mortgagee's point of view, having to utilize insurance proceeds for repairs may not be the best option for the mortgagee as it relates to the recovery of its investment.

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.