Priorities Upon Mortgage Default: Achieving Predictable Results in a Not-So-Predictable Market

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Iris Tam

Many mortgage lenders lending on the security of commercial properties will seek to have their mortgage in a prior position to other interests, such as tenants’ interests, in the property.

This would seem like the obvious choice, as the word “priority” has certain positive connotations, often denoting a better or preferred position. In the reality of commercial real estate, however, the correctness of this assumption will depend on the leasing market at the time the lender enforces its security. Consequently, gaining a clear understanding of the concepts of priority, subordination, non-disturbance and attornment is crucial to accommodate, with the most certainty possible, the lender’s interests upon mortgage default, while simultaneously responding to the legitimate expectations of tenants.

Priority: General Principles
If a landlord mortgages its property and subsequently grants a lease of that property, the lender’s rights are paramount: the tenant’s right to possession is subject to the lender’s rights to take possession upon the landlord’s default and to have recourse to the property for recovery of the indebtedness secured by the mortgage. Conversely, where a lease is prior to a mortgage, the lender can be in no better position than the landlord in enforcing the tenant’s obligations following the landlord’s default. Provided the tenant performs its obligations under a prior-ranking lease, the lender cannot terminate such lease or seek to take possession of the premises.

Subordination
Priority of a mortgage over a lease would, therefore, be beneficial in a strong market, where the lender would want the flexibility to terminate the lease and rent the property to a third party for higher rent. Accordingly, where a prior-ranking lease exists, the lender will often insist that the landlord require the tenant to enter into an agreement subordinating its leasehold interest to the mortgage. In anticipation of this requirement, many leases include a “subordination clause.” Important to note, however, are two factors that may reverse the beneficial effects of either a prior-ranking mortgage or a subordination clause. These factors demonstrate that lenders require more than the protection of priority.

Non-Disturbance
Sophisticated commercial tenants will not easily succumb to a subordination of their leasehold interests, as with this subordination comes the risk of eviction and, in turn, financial and business loss. Accordingly, when faced with subordination requirements or the realization that their lease is subject to a prior-ranking mortgage, tenants will likely request that the lender enter into a “non-disturbance agreement” with them. This agreement will create a direct contractual relationship between the lender and tenant and provide that, upon a sale or foreclosure, the lender will not disturb the tenant’s possession for so long as the tenant continues to pay rent and otherwise complies with the terms and conditions of the lease. For all practical purposes, therefore, a non-disturbance agreement restores the lender to the same position as one enforcing security on a property with a prior-ranking and unsubordinated lease.

The Consequences of Goodyear
If a mortgage has priority over a lease, and the mortgage is enforced upon default, the tenant is in turn free to leave. Such was the case in Goodyear v. Burnhamthorpe, where the Ontario Court of Appeal confirmed that a tenant, subsequent in priority, may be permitted to escape its long-term, above-market lease obligations upon the completion of a sale or foreclosure by a lender. Consequently, in a soft leasing market, where the lender would want to ensure a steady rental income stream, a subordination clause or prior-ranking mortgage may in fact subvert those interests. One way to avoid this problem is by drafting the subordination clause in a way that makes subordination optional at the instance of the landlord or lender. A more prudent step would be the insertion of an “attornment clause” in a non-disturbance agreement.

Attornment
When tenants attorn to the lender, they are effectively promising to recognize the lender as their landlord upon default of the original landlord’s mortgage 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 include an obligation by the tenant to attorn to any successor in title which the lender might put in place through the exercise of the lender’s remedies upon default.

Subsequent Leases
With subsequent leases, a lender can avoid the results in Goodyear by insisting upon a “reverse subordination clause” within the lease, which would deem any future lease and rights of future tenants to be prior to the mortgage. Again, it would be prudent to make this clause optional for the lender so as to protect the lender from having to submit to an insupportable lease struck between a landlord and tenant.

The lender could also insert an attornment clause in the lease itself, exercisable upon the occurrence of certain events (i.e., the lender taking possession of the property) and at the lender’s option. Under these circumstances, the lender would have the flexibility to deal with varying market conditions: by choosing to maintain its prior-ranking mortgage priority, the lender could terminate less profitable leases in a strong leasing market; conversely, by enforcing the attornment or reverse subordination provisions, the lender could require tenants to remain in possession and continue paying rent in a weak leasing market. These provisions could, nonetheless, be subject to a non-disturbance agreement.

Conclusion
The end result of the interplay between these three concepts is that in most circumstances, tenants will gain non-disturbance rights in return for their attornment, and when necessary, subordination to lenders. Utilizing this formula in the one of the various manners contemplated above will provide lenders and tenants the most predictable results in the face of not-so-predictable market forces.