Question and Answer for Pages 358-404
Here are some questions that came up, either by e-mail or after class, that go beyond what we covered in class and I'm including them here with my responses.
1. My question about the reading is about the subordination, nondisturbance and attornment agreements. Are these agreements common or are they rare? Are all tenants asked to sign them? Or will the subordination issue be addressed wholly within the lease like in the Dover case?
When an institutional mortgage lender makes a mortgage loan on an office building, shopping center, industrial park, or other project where the property is occupied by long-term tenants (i.e., tenants under leases lasting 3 years or longer), the lender will typically require the borrower to obtain SNDA agreements from all of the tenants, or at least from all of the tenants whose leases have more than a year or two left on the term. If a lease was about to expire and the tenant under that lease didn’t have extension or renewal rights under the lease, the lender might not worry about getting the tenant to sign an SNDA agreement; instead, the lender might instead require the borrower to have its new tenant enter into an SNDA agreement at the time the new tenant signs its lease. For the institutional lender, getting the agreement directly with the tenants is preferable, and the SNDA agreement often addresses some issues that might not be addressed in the tenant's lease (for example, an SNDA agreement might prohibit the tenant from paying rent to its landlord in advance, or state that such a prepayment would not be binding on the lender, even though prepayment of rent might not be strictly prohibited under the lease).
If the mortgaged real estate was an apartment building, the lender wouldn't require SNDA agreements. There wouldn't be a point, really. All of the leases for an apartment building are likely short-term leases of one year or less. Thus, the existing leases may be senior to the mortgage, but they'll be expiring in less than a year anyway (and new tenants that sign new leases will then be later-in-time and thus subordinate to the mortgage anyway). Thus, the lender won’t bother with having the borrower get SNDA agreements from its tenants. The cost of getting the agreements executed wouldn't be worth the limited benefits that having the SNDA agreements would give to the lender.
2. Why does an SNDA agreement typically prohibit the tenant from prepaying its rent?
Actually, most SNDA agreements don't actually prohibit the tenant from paying rent in advance, they just state that if the tenant pays rent in advance without the prior consent of the lender, that payment isn't enforceable against the lender and can't be asserted as a defense if the lender seeks to collect rent from the tenant. In practice, it's the same thing; a tenant that is subject to such a provision won't pay rent to the landlord in advance without getting the lender's prior consent, because they can't be sure they won't have to pay the rent twice if the landlord defaults to the lender.
The concern for the lender is that if the loan gets into default, the borrower might be tempted to cut a deal with the tenants, have the tenants prepay rent in advance for a significant period of time — at a discount, of course — and then the borrower disappears with the money (or distributes the money to its partners, or uses it on some other project). Then, when the lender has to foreclose and take over, the lender doesn't want the tenants saying "I've already paid my rent for the next year."
3. But why would the tenant's prepayment agreement with the landlord be binding on the lender if the lender didn't consent?
The problem is that if the tenant's lease survives the foreclosure sale, then whoever buys the property at the foreclosure sale takes it subject to tenant's rights under the lease. And if tenant has basically modified its lease agreement with the landlord — by the landlord and tenant agreeing that tenant can prepay rent in advance, either in full or at a discount — then the buyer would take the property subject to the tenant's rights. The buyer probably expects to be able to go in and collect rent from that tenant right away, but if the tenant can actually demonstrate that they've legally prepaid rent for the next year, that prepayment would be binding on the buyer. Even if the buyer didn't have knowledge of it, a buyer of land would be deemed to have inquiry notice of the rights of a party in possession of the land, such as a tenant, and are thus deemed to be bound by those rights.
Thus, an SNDA agreement addresses this concern both by (a) subordinating the tenant's lease so that theoretically, at least, the lease could be wiped out by a foreclosure sale (although the nondisturbance clause would not allow the tenant to be evicted as long as the tenant is not in default), and (b) making it impossible for the tenant to prepay rent without the lender's consent and have that prepayment be binding on the lender.
4. In class you were talking about how a borrower might file bankruptcy and try to use rents that accrue during bankruptcy to finance its attempts to reorganize or restructure the mortgage debt. The Millette case suggests that those rents are still subject to the proper lien of the assignee of rents. Practically speaking, what does that mean? Does that mean that the borrower can't use them at all, and has to just turn them over to the lender? Or does the borrower get to use them to maintain the property? What happens?
Good question. We'll talk about this more later in the course when we discuss bankruptcy in further detail. For now, here's the short answer. Because the rents are subject to the assignee's valid lien, the rents are considered to be the lender/assignee's "cash collateral" under Bankruptcy Code § 363. The debtor cannot use cash collateral without approval of the bankruptcy court, and even then can only use cash collateral if it can provide "adequate protection" of the lender/assignee's lien in that cash collateral.
Typically, the court will allow the debtor to use the rents at least to the extent needed to pay the expenses of operating the property (doing maintenance, keeping the property insured, etc.). Those expenditures actually benefit the lender (if the lender took possession of the property, the lender would have to incur those costs), and keeping the property insured and maintained preserves the value of the mortgaged property (and thus the security of the lender's mortgage lien). Thus, a court will typically say that use of the rents to pay the reasonable expenses of operating the property either provides "adequate protection" of the lender's mortgage lien, or that the "equities of the case" justify allowing the debtor to use the rents for that purpose.
But this would not permit the debtor to use the rents to pay its lawyers' fees, or to pay for the cost of its expert witnesses (like the appraiser that the debtor might have to hire to value the property for purposes of trying to get its plan of reorganization prepared and confirmed), or other "expenses" that are unrelated to property operation. The debtor couldn't use the "cash collateral" to pay those expenses unless it could provide adequate protection in the form of a replacement lien on another asset. Thus, the "net rents" (what the debtor has left over after paying the necessary and reasonable expenses of operating the property) will have to sit in an account and accumulate during the bankruptcy, so that they can be applied against the mortgage debt.
[The response above assumes that, as in the typical bankruptcy case, the property is not worth enough to repay the debt in full. If the property was actually worth MORE than the unpaid debt, the court might allow the debtor to use the rents on the theory that the excess value in the land (the "equity cushion") provided the lender with sufficient adequate protection of its lien, because as long as the property was worth more than the unpaid debt, the lender will be ultimately be repaid in full anyway.]
5. If there is no reason to believe that the mortgagor is withholding the cash flow from a commercial property, why would a mortgagee bother to ask the court to appoint a receiver?
In that instance, the mortgagee probably wouldn't bother, honestly. But in the typical case, the lender thinks there IS reason to believe the mortgagor may be skimming rents, and getting a receiver into possession to evaluate the fundamentals of the property (how much rent is being generated? what are the actual maintenance expenses? etc.) may be necessary to make sure that the property is adequately maintained throughout the foreclosure process. Part of the problem is that in many cases, the borrower wants the lender to accept something less than full installment payments, but the borrower may not produce the sort of audited financial statements that would give the lender comfort about the project's true financial picture, or the borrower may be unwilling to turn over its books and records to the lender to allow the lender to make that judgment. If the lender isn't getting full cooperation from the borrower, it tends to generate suspicion that the borrower may be doing something it shouldn't (skimming rents).
6. If a borrower objects to the appointment of a receiver, what recourse does the Borrower have?
First, of course, the borrower can try to persuade the court that the loan is not in default; if there's no default, then appointment of a receiver would not be appropriate (as appointment of a receiver is a remedy for default). But if the borrower is in default, then the borrower's only recourse is to try to persuade the court that it should NOT exercise its discretion to appoint a receiver because appointment of the receiver is not necessary. This does get somewhat into the discussion of February 4's class with regard to waste, but if the borrower can persuade the court that the value of the land is higher than the balance of the debt (i.e., that the lender is oversecured), the borrower may be able to persuade the court that the lender's security is not really seriously threatened and thus appointment of a receiver is not appropriate (because the lender's other remedies — to pursue its right to foreclose — should be sufficient. If the borrower can persuade the court that the situation isn't as bad as the lender alleges — if the borrower can show that the property is being adequately maintained, and isn't dropping in value — some courts will refuse to appoint a receiver.
7. I have a question about Millette. O'Neal, the judgment creditor in the case, brought a garnishment action against the County to collect the rents and apply them against the debt, but it isn't clear that it gave notice of that garnishment to the Bank which held a recorded mortgage and an assignment of rents. In the context of a garnishment, shouldn't O'Neal have to give notice to the Bank and join them in the garnishment action so that the court could address which of the parties was actually entitled to priority in the rents? How could O'Neal garnish the rents and collect any of them and apply them toward its judgment when the Bank has already recorded an assignment that should have alerted O'Neal as to the Bank's prior lien on rents?
This is a good question, and your procedural point is a good one. First, note that in Millette, the exact chronology of events isn't clear, but it does appear that O'Neal did not join the Bank to the garnishment at the time it served the writ of garnishment. Instead, it appears that Bank only learned of the garnishment later, probably because the County (knowing that there was a recorded assignment of rents) called the Bank and told them, at which point Bank intervened in the garnishment action [pages 374 and 376]. Probably, the County learned of the Bank's mortgage at the time it entered the lease, and it may even have been asked by the Bank to enter an SNDA agreement or the like — and thus it wouldn't have been surprising for the County to call the Bank and say "Hey, we just got served with a garnishment order by O'Neal; if you're claiming any interest in the rents we owe, you should probably intervene." In any event, even if O'Neal should've served the writ on the Bank as well as on the County, the fact that it didn't is essentially mooted by the fact that the Bank promptly intervened and asserted its interest in any rents that had yet to accrue.
It is likely that O'Neal didn't join the Bank because either (a) it didn't know about the Bank (because it hadn't searched the land records) or (b) it wanted to take the legal position that it did — that Bank's lien on the rents was inchoate and thus it didn't HAVE to join the Bank because Bank hadn't yet taken steps to enforce its lien on rents. But it turned out that the court rejected O'Neal's argument anyway, suggesting that in fact, the Bank had already taken and perfected its lien on future rents by recording its assignment in the land records. For that reason, having established its right and its priority, the Bank's interest in rents was superior to that of O'Neal.
On the actual facts in the case, it isn't clear that O'Neal had actually collected any of the rents from the County and had applied them against the debt, and if anything I said in class seemed inconsistent with that, then I'm sorry for that confusion. In fact, it seems more likely that the Bank got involved in the case right away, before any rents actually got paid to O'Neal.
You could have a situation, of course, where O'Neal might have served the garnishment order on the Bank too, and the Bank might have failed to respond, in which case the court might have allowed O'Neal to garnish the funds and apply them to the debt (analogous to a default judgment). But there, the Bank asserted its rights right away by intervening, and at that point, under the court's reasoning, O'Neal can't get priority as to any of the future rents at that point.