Money and Dirt: A blog on legal issues impacting California real estate investment, development, and secured lending

When a Lender Forecloses on a Leasehold Interest….

Loans are often secured by the fee title to real property owned by the borrower.  But loans can also be secured by the borrower’s leasehold interest in property.

When a lender forecloses on a leasehold interest, things can get messy in unexpected ways.  Does the foreclosing lender assume all obligations of the lease?  Many commercial leases run for a decade or longer, so this obligation can be substantial.

A case recently published by California’s Second Appellate District — BRE DDR BR Whittwood CA LLC v. Farmers & Merchants Bank of Long Beach — helps clarify the lay of the land.

Facts: lender forecloses on borrower’s leasehold interest, but doesn’t want to pay rent for remainder of 15-year lease term

The lease

In 2006, the owner of a shopping center entered into a 15-year lease with a tenant for restaurant space.

One provision in the lease permitted the tenant to encumber its leasehold interest with a mortgage, and stated that if the mortgage lender succeeded to the tenant’s interest under the lease, the lender “shall assume all of Tenant’s obligations under this Lease.”

The loan, default, and foreclosure

Around a month after the lease was signed, Farmers & Merchants Bank of Long Beach loaned funds to the tenant, presumably for restaurant-related tenant improvements, and recorded a construction deed of trust securing the loan.  The security for the loan was identified as the tenant’s leasehold estate in the property.

Two years later, the tenant defaulted on the loan.  Farmers & Merchants foreclosed and obtained the leasehold estate with a credit bid.  Several months later, Farmers & Merchants recorded a grant deed transferring the leasehold estate to an LLC affiliated with the bank.  That LLC made rent payments through July 2014, and then stopped, and surrendered possession of the premises with the intent to terminate the leasehold estate.

Trial court ruling: bank is on the hook for rent for the remainder of the lease term

The shopping center owner sued the bank for damages under the lease.

The trial court granted the shopping center’s motion for summary judgment, ruling that the bank was liable for the rent payments for the duration of the 15-year lease.  The court was persuaded by the facts that the construction deed of trust and the foreclosure sale documents specifically identified the lease, and the lease provided that any foreclosing lender was obligated by the lease terms.

The bank appealed.

Court of appeal’s opinion: bank did not expressly assume the lease, so off the hook

The court of appeal reversed, ruling in favor of the bank.

The court explained that a lender who takes possession of leased premises following a foreclosure is considered an “assignee.”  An assignee’s liability under a lease depends on the nature of the assignment.

If the assignee simply takes possession and nothing more, then it is bound by “all lease covenants which run with the land” such as paying rent, keeping insurance current, making repairs, and paying taxes (if the lease so provides), but “these obligations terminate when the assignee terminates his possession.”

If, on the other hand, the assignee expressly agrees to assume the obligations of the lease, then the landlord and assignee are contractually bound, and the assignee is “required to perform all covenants of the lease for the remainder of its term[.]”  An express assumption of a lease “requires specific affirmation by the assignee to bind itself to the lease obligations.”

Under the facts presented, the court held there was no express assumption of the lease by the bank.  Instead, “the language of the documents served to acknowledge the lease rather than assume its obligations.”  The court concluded there was nothing more than a “naked assignment” of the lease, and the bank never assumed the lease obligations, including the payment of rent beyond the period during which the bank was actually in possession.

Lesson

Lenders foreclosing on borrowers’ leasehold interests and obtaining possession of the leased premises will not be liable for the entire lease term unless they expressly assume the lease.

The court’s opinion explained what the shopping center could have done to better protect itself:  “Landlord could have protected itself by requiring the mortgage lender to sign the lease or a document assuming the lease obligations.  It did not do so.  Landlord, as a signatory to the initial lease, was in the best position to protect itself by including provisions in the lease requiring consent and assumption.”

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