This article discusses attornment, subordination and nondisturbance clauses in nonresidential lease agreements, and their use by landlords and lenders to alter the priorities of leases and trust deeds.
Altering priorities for lenders
A lender holds a recorded trust deed lien on the fee ownership interest in nonresidential income-producing real estate. The trust deed contains a due-on provision that states the owner may not sell, lease or encumber the secured property without the prior written consent of the lender, also called a transfer clause or alienation clause.
The lender has advised the owner it will consent to new leases under the due-on clause on the condition the lease agreement contain an attornment clause and a lender subordination clause.
A tenant enters into a lease agreement with the landlord that contains an attornment clause. The lease agreement is approved by the lender.
The attornment clause states the tenant will recognize a buyer of the property at a foreclosure sale as the new landlord under the lease if the buyer exercises his right under the attornment clause to enforce the lease agreement.
Later, the owner defaults on the first trust deed. The lender notices a foreclosure sale and acquires the property with a credit bid.
After the lender acquires the property, the lender mails a written notice to the tenant stating:
- the lender is the new landlord under the lease agreement; and
- the tenant is to pay rent to the lender.
The tenant does not pay rent and vacates the premises.
The lender claims the tenant is required to accept the lender as the new landlord under the attornment clause in the tenant’s lease agreement with the prior owner since the lender purchased the property at the foreclosure sale and declared himself to be the landlord under the lease.
The tenant claims the attornment clause is unenforceable since the lease agreement that contained the clause was junior to the lender’s trust deed and was eliminated by the lender’s foreclosure sale.
Is the tenant required to accept the lender as the new landlord and perform under the lease?
Yes! While the leasehold interest, the lease held by the tenant, was eliminated from title by the foreclosure sale, the lease agreement remains enforceable. Thus, on notice from the lender, the tenant is required to recognize — attorn to — the lender as the substitute landlord under the lease.
The lease is restored and reattached to title after the foreclosure sale when the lender (or other purchaser at the foreclosure sale) exercises the right given under the attornment clause to enforce the lease agreement as the new substitute landlord. [Miscione v. Barton Development Company (1997) 52 CA4th 1320]
The attornment clause contracts around the permanent elimination of a junior leasehold interest on completion of a foreclosure sale by a senior trust deed lender. The clause allows the purchaser at the lender’s foreclosure sale to restore the extinguished lease as though it were unaffected by the foreclosure sale.
Priority on foreclosure
A tenant’s lease, whether or not recorded, has priority on title over an interest in the property held by another person, such as a trust deed lien or abstract of judgment, when:
- the lease agreement is recorded before the other interest (a trust deed) is recorded or, if unrecorded, is actually known to the person holding the other interest [Calif. Civil Code §1214]; or
- the tenant takes possession before the other interest (a trust deed) is recorded or the tenant’s right to possession is actually known to the person holding the other interest. [Gates Rubber Company v. Ulman (1989) 214 CA3d 356]
For example, a trust deed recorded junior in time to a tenant’s occupancy of the secured real estate is foreclosed. The tenant’s lease, being prior in time, is undisturbed by the foreclosure — the tenancy held by the tenant under terms contained in the lease agreement remains in full effect.
Thus, the buyer at the foreclosure sale of a junior trust deed acquires title “subject to” the lease. Since the lease held by tenant has priority, the buyer must perform the landlord’s obligations under the lease agreement if the tenant seeks to enforce them.
Now consider a lease acquired by a tenant after a trust deed or judgment lien is recorded on the property. Later, the trust deed or judgment lien is foreclosed.
Here, the tenant’s lease is wiped out by the foreclosure of the trust deed lien or judgment lien since the tenant’s leasehold interest in title is junior in time and subordinate to the lien.
On elimination of a junior lease by a foreclosure sale of the premises, the tenant loses his right to possession of the premises. [Hohn v. Riverside County Flood Control and Water Conservation District (1964) 228 CA2d 605]
After foreclosure by the senior lienholder, the tenant’s continued use and possession of the property is an unlawful detainer (UD) and the tenant can be evicted. A 3-day notice to quit due to foreclosure is required to be served and expire before a UD action can be filed and the occupant, should he remain in possession, be evicted. [See first tuesday Form 578]
Altering the priorities
A tenant can agree in a lease agreement to allow the landlord or the secured lender to act unilaterally in the future to alter the priority of the tenant’s lease and the lender’s trust deed liens on the property. [Dover Mobile Estates v. Fiber Form Products, Inc. (1990) 220 CA3d 1494]
Nonresidential lease agreements often contain boilerplate provisions, such as an attornment clause, a lender subordination clause, a future subordination clause and a nondisturbance clause. These provisions relate to the priority of the lease against trust deeds, present and future.
The attornment clause allows an owner-by-foreclosure to unilaterally avoid the automatic
elimination and unenforceability of a junior lease by a foreclosure sale.
The lender subordination clause gives a trust deed lender the right to unilaterally subordinate the lender’s trust deed to a previously junior lease by written notice to the tenant. Thus, the lease would not be wiped out by a foreclosure of the lender’s trust deed since the trust deed has been subordinated and the lease has priority.
Under a future subordination clause, the tenant agrees to subordinate his lease to a trust deed to be recorded in the future. Here, the tenant remains involved since he must sign a specific subordination agreement to give the trust deed priority to his lease.
The nondisturbance clause is coupled with the future subordination clause. The clause entitles the tenant to receive a signed writing from a new trust deed lender agreeing that the lease will remain in effect for its full term in spite of the fact the tenant concurrently signs a specific subordination agreement giving the lender’s trust deed priority.
Thus, by the nondisturbance agreement, the tenant will be restored with the rights he would otherwise lose on the lender’s foreclosure due to the subordination and will be able to enforce the lease agreement against the new lender.
Further, by a lender exercising its rights under the due-on clause in its trust deed, a lender is able to also control the terms of all future leasing of the property, except for those leases with a term of three years or less.
As a condition for the lender to give consent to each lease agreement entered into by the landlord, a knowledgeable lender will require the landlord’s lease agreements to include both a lender subordination clause and an attornment clause.
The attornment clause and foreclosure
Attornment is the tenant’s agreement to acknowledge the purchaser at a foreclosure
sale under a trust deed senior to his lease as a substitute landlord who may elect to enforce the tenant’s lease agreement.
To enforce a wiped-out lease, the owner-by-foreclosure notifies the tenant he has elected to be the substitute landlord under the tenant’s lease. However, the new owner need not do so, leaving the wiped-out tenant with no interest in the property.
A nonresidential landlord has good financial justification to include an attornment clause in a lease agreement. Should a senior trust deed lender foreclose, it is essential for the landlord to maintain the property’s value and reduce the potential of a deficiency judgment.
A financially advantageous lease agreement, enforceable by new owners after a foreclosure, will help maintain the value of the property. On the other hand, if a financially advantageous lease agreement does not contain an attornment clause, the property’s market value will be lower than it would be had the owner-by-foreclosure been able to enforce the lease.
If an owner-by-foreclosure elects to enforce a lease agreement containing an attornment clause, the lease agreement remains in full effect for the remainder of its term. Thus, the owner-by-foreclosure who makes the attornment election becomes the substitute landlord and must perform the obligations of the landlord under the lease. [Miscione, supra]
Before the foreclosing lender or other purchaser at a foreclosure sale substitutes himself as the successor landlord, he must consider whether the leases will generate rents at or above market rates.
To help make the attornment decision, the new owner should first:
- obtain the equivalent of a Tenant Estoppel Certificate (TEC) from each tenant to discover any breach of their lease agreement by the prior landlord [See Form 598 accompanying this article]; and
- inspect the property to be assured its physical condition is acceptable to the new owner.
Subleases and attornment
Lease agreements allowing a tenant to sublet portions of the property to occupants of separate spaces, also called subtenants, contain restraint-on-alienation clauses, also called transfer restrictions or assignment and subletting provisions.
The landlord’s consent is needed in order for the tenant to sublet. When setting up the guidelines for consenting to a subletting, the landlord should require an attornment provision to be included in the lease agreement with the subtenant. If the landlord ever terminates the master tenant’s right to possession under a three-day notice and forfeiture, a process that automatically eliminates the subtenant’s right to possession, the landlord may enforce the sublease agreement under the attornment clause.
The landlord electing to enforce the sublease agreement is substituted as the landlord (sublessor) under its attornment provision. Due to the election, the subtenant will continue paying rent as agreed, but to the new landlord.
No assurance of continued occupancy
Conversely, an attornment clause does not give the tenant the reciprocal right to enforce the lease agreement against the buyer at the foreclosure sale. The attornment agreed to by the tenant to recognize the buyer as his landlord is not exercised until the buyer elects to enforce the provisions.
Thus, a tenant who enters into a lease agreement with an attornment clause, whose lease is junior to a lender’s trust deed, has no assurance the lease will be restored or that he will be able to remain in possession after a foreclosure sale.
Yet tenants, when agreeing to an attornment clause as a provision in their lease agreements, believe the clause states the obvious — the tenant will perform on the lease for anyone who becomes the new owner of the property. The tenant views it as a nondisturbance agreement with the lender, but it is not. The lender is not a party to the lease agreement.
However, when a junior lease is eliminated at a foreclosure sale, the new owner is unlikely to elect to enforce the lease agreement if:
- the new owner acquired the property to occupy it as a user; or
- the rents due under the exhausted lease are significantly less than the rents available in the market.
Further, a tenant will regret the inclusion of an attornment clause if rents called for in the lease agreement exceed market rates at the time of foreclosure, or if the location or premises are no longer desirable for the tenant when a foreclosure sale occurs and the attornment clause is enforced to restore the lease.
All these events typically converge during economically depressed times for all involved.
For a tenant to avoid the unilateral adverse economic impact of an attornment clause upon entering into a long-term lease under an agreement containing the clause, the tenant should:
- obtain an abstract of title or lessee’s policy of title insurance to ascertain the trust deeds and other liens of record and the risk of loss they present to the tenant;
- obtain a beneficiaries statement on the loans/liens of record;
- record a Request for Notice of Default; and
- record a Request for Notice of Delinquency on the lender. [See first tuesday Form 412]
With the information from these documents, the tenant can take steps to protect his interest if the landlord defaults on senior liens or the underlying ground lease, long before any foreclosure sale occurs.
Notifying the tenant
A lender or other high bidder who acquires a property at a foreclosure sale, which wipes out a tenant’s leashould interest in the property, elects to enforce the tenant’s lease agreement under its attornment clause by giving the tenant a written notice:
- stating the owner-by-foreclosure is exercising his right to enforce the lease agreement provided him by the attornment clause; and
- instructing the tenant to make all future rent payments due under the lease agreement to the buyer. [Miscione, supra]
A specific time period should be stated in the attornment clause within which the owner-by-foreclosure must notify the tenant of his election to enforce the attornment agreement, such as within 30 days after the foreclosure sale.
The new owner loses the right to enforce the attornment clause if:
- no time period for enforcing recognition of the new owner as landlord is specified in the clause; and
- the new owner does not elect to enforce the lease within a reasonable period of time.
No right to continued occupy
The owner-by-foreclosure may choose not retain the extinguished nonresidential lease by enforcing the tenant’s lease agreement containing an attornment clause. Instead, he may cause the tenant to vacate. To notify the tenant to vacate and be able to evict him through an unlawful detainer action should he not vacate, a three- day notice to quit due to foreclosure must be served on the tenant. [Calif. Code of Civil Procedure §1161a(b); see first tuesday Form 578]
The three-day notice should be served as soon as possible to avoid conduct by the landlord or property manager that could be construed as an enforcement of the lease (by attornment) or the establishment of an unintended periodic tenancy.
For example, a new owner who elects not to enforce the lease should not accept rent from the tenant until he enters into a new written rental or lease agreement.
Accepting rent in the amount called for in the extinguished lease agreement may indicate the new owner intends to accept the lease under its attornment clause, regardless of the new owner’s actual intent. [Rubin v. Los Angeles Federal Savings and Loan Association (1984) 159 CA3d 292]
If the owner-by-foreclosure accepts rent payments from a tenant when an attornment clause does not exist in the extinguished lease, a periodic tenancy is created. As between themselves, neither the tenant nor the new owner can enforce the lease agreement since the lease has been extinguished. [Colyear v. Tobriner (1936) 7 C2d 735]
Lender subordination clauses
A nonresidential lender requiring an attornment clause in a lease agreement entered into by the owner after the lender’s trust deed is recorded will also require the owner to include a lender subordination clause in the lease agreement. The lender subordination clause allows the lender to elect, at any time during the life of its trust deed, to subordinate his trust deed lien to leases the landlord eners into with tenants after the trust deed is recorded.
A lease agreement containing both a lender subordination clause and a tenant attornment clause allows the lender the maximum flexibility for preserving an advantageous lease by either:
- electing to subordinate his trust deed to the lease before the foreclosure sale; or
- completing a foreclosure sale and electing to enforce the lease agreement within the attornment election period.
Some attornment clauses are worded to state the lender must acquire the premises “subject to” the lease at the time of the foreclosure sale.
However, while an attornment clause in a lease agreement may literally state the lender is to acquire the property “subject to” the lease, the attornment clause cannot automatically subordinate the trust deed to the lease when a foreclosure sale occurs since the lender is not a party to the lease agreement. The lender did not agree to the terms of the lease agreement, even if the lender previously reviewed it and waived his due-on clause enforcement by consenting to the lease.
When the lender notifies the tenant prior to the foreclosure sale of his election to subordinate his trust deed lien to the tenant’s lease, the election need not be recorded to give public notice. The change in priority only affects the lender, the tenant and their successors who are aware of the agreement since they are parties to it, not third parties. [CC §1217]
A trust deed that becomes senior to a lease by the lender’s election to subordinate gives the lease priority over the trust deed. Thus, the lease is not eliminated from title by the foreclosure sale.
If the lease is not wiped out at the foreclosure sale because of the lender’s prior election to subordinate, a later election under the attornment clause after foreclosure becomes unnecessary. When a lender elects to subordinate his trust deed to the lease, the high bidder at the foreclosure sale acquires the property “subject to” the lease since the lease has priority over the trust deed.
After the foreclosure sale, by either a prior election by the lender to subordinate or a later election to have the tenant attorn to the new owner, the lease agreement becomes enforceable by both the tenant and the new landlord. [Miscione, supra]
Electing to subordinate
Now consider a lender holding a first trust deed on nonresidential real estate. After the trust deed is recorded, the owner leases the property.
The lease agreement contains a lender subordination clause to satisfy the lender’s conditions for waiver of the due-on clause in his trust deed.
During the term of the lease, the owner defaults on the lender’s trust deed. The lender records a notice of default (NOD), initiating a trustee’s foreclosure sale. The lender has the property appraised and discovers the rent due over the remaining term of the tenant’s lease exceeds current prevailing rental rates.
For the same economic reasons that cause the lender wants to preserve the lease agreement, the tenant wants out of the lease agreement.
The lender hears of negotiations between the owner and the tenant to modify the lease agreement. The lender does not want the landlord to alter the agreement prior to foreclosure and an attornment. The lender serves written notice on the tenant of his election to subordinate his trust deed to the tenant’s lease, altering their priorities.
After receipt of the notice of subordination, the tenant and the landlord modify the lease agreement, granting the tenant the right to terminate the lease agreement at any time on 30 days’ written notice, in exchange for the tenant paying the landlord a modification fee.
The trustee’s sale is held and the lender acquires the property. The tenant is notified by the lender that he is now the owner of the property and all rent payments under the lease are to be made to the lender. The tenant notifies the lender in writing of his election to terminate the lease and cancel the lease agreement on 30 days’ notice.
The lender claims the tenant cannot terminate the lease or cancel the lease agreement since the modification agreement, but not the original lease agreement, was eliminated by the foreclosure sale.
Can the tenant terminate the lease by canceling the lease agreement under the conditions stated in the lease modification entered into prior to the owner’s loss of the property?
No! The original terms of the lease agreement remained unaffected by the foreclosure sale since the lender elected to subordinate the trust deed to the lease prior to the tenant entering into the lease modification agreement. Thus, the agreement modifying the lease became unenforceable by the tenant after the foreclosure sale. The modification agreement was junior in time to the subordination of the trust deed. Thus, the lease became a senior (unrecorded) encumbrance on title to the property with priority to the lender’s trust deed and could not be altered without the lender’s consent.
Thus, the modification of the lease agreement, but not the pre- existing lease agreement, was eliminated by the lender’s foreclosure. [In re 240 North Brand Partners, Ltd. (9th Cir. BAP 1996) 200 BR 653]
By subordination of the lender’s trust deed to the lease, the lender acted to maintain the property’s value based on rents under the lease. Subordination allows the lender to avoid the effect of any later modification of the lease prior to foreclosing and acquiring ownership at the trustee’s sale.
In the event the lender proceeds with a judicial foreclosure, the landlord would normally prefer the property to remain encumbered by a financially advantageous lease agreement following a judicial foreclosure sale to avoid a deficiency in the property’s value and its inability to satisfy the loan.
Thus, the risk of loss due to a deficiency in the value of the property at the time of the remaining judicial foreclosure sale is reduced for both the lender and the landlord, but the tenant must pay.
Future subordination clauses
A landlord’s ability to further encumber or refinance his property during the term of a lease is greatly diminished unless the lease agreement contains a future subordination clause.
Like the attornment clause and lender subordination clause, a future subordination clause is an agreement to alter priorities on title. Under a future subordination clause, the tenant agrees to subordinate his lease (right to possession) and the lease agreement to a trust deed to be recorded by the landlord sometime in the future.
Thus, the tenant agrees to place his lease in a financially lesser or worse position on title, whether or not the lease agreement is recorded, than he enjoyed at the time he enters into the lease agreement.
The tenant’s lease will be subordinated to a new trust deed loan based on the terms of a new loan agreed to in the future subordination clause.
For a future subordination clause to be enforceable at the time the landlord arranges a new trust deed loan, the clause must specify:
the use of the loan proceeds, such as refinancing existing encumbrances or improving the property;
the dollar amount of the loan on the loan-to-value ratio of the financing;
the payment schedule;
the interest rate; and
the due date. [Handy v. Gordon (1967) 65 C2d 578]
The clause must also contain any other terms that might be unique to the future financing that would, if agreed to by the tenant, further impair the tenant’s lease.
When the landlord later arranges financing for the property on terms within the parameters agreed to in the subordination clause, the tenant is obligated to sign a specific subordination agreement. A title company will not insure the priority of the new trust deed over the tenant’s lease without the tenant executing an agreement setting out the specifics of the loan and the subordination.
However, the tenant may refuse to sign a subordination agreement if the financing terms are not substantially similar or within the parameters of the subordination clause in his lease agreement. The tenant has not agreed to subject his lease to the uncertainties of a greater risk of loss than the risks established by the terms of the subordination clause.
Editor’s note — When the landlord wants to record a new trust deed to secure a loan and the tenant refuses to sign a specific subordination agreement, the landlord’s primary recourse is to serve a 3-day notice to perform or quit. If performance is not forthcoming, rather than evict, the landlord may file an action against the tenant for declaratory relief and specific performance of the future subordination clause in the tenant’s lease agreement.
Nondisturbance and subordination clauses
A nondisturbance clause gives the tenant the right to require a new trust deed lender to enter into a written agreement with the tenant, called a nondisturbance agreement. The agreement states the tenant’s lease agreement will remain in effect for its full term after the lease is subordinated to a new loan.
A nondisturbance clause is included in a lease agreement only if the lease agreement also contains a future subordination clause. The tenant is the primary beneficiary of the nondisturbance clause.
A nondisturbance clause is typically used by the landlord and leasing agents to avoid negotiating the terms of a subordination clause with the tenant while hammering out the terms of the lease.
When the nondisturbance clause and an enforceable future subordination clause are included in a lease agreement, the tenant can refuse to sign a subordination agreement unless the lender provides the tenant with a nondisturbance agreement. Any standoff between the tenant and the lender would pose a serious problem for the landlord’s attempt to record financing.
Informed lenders are not likely to provide a tenant with a nondisturbance agreement when originating a loan secured by a first trust deed on property.
A nondisturbance agreement negates the effect of the subordination agreement by reversing the very priorities agreed to by subordinating the lease to the trust deed, a sort of self-destruct provision. The lease will not in effect be subordinate to the lender’s trust deed if the lender agrees to recognize the continued existence of the lease after a foreclosure of the trust deed.
A knowledgeable landlord, contrary to the needs of a tenant, does not want a nondisturbance clause in his lease agreements — he wants an enforceable future subordination clause.
Unlike the purpose of an attornment clause, a lease that is subject to a nondisturbance agreement
will not be eliminated by foreclosure nor need to be later restored by election of the owner-by-foreclosure. The nondisturbance agreement states the lease will remain in effect for its full term without regard to foreclosure.
Since the lease by agreement with the lender cannot be extinguished by foreclosure, it cannot also be junior to the trust deed.
Thus, a subordination of the lease to the trust deed never truly occurs because of the lender’s concurrent entry into a nondisturbance agreement.
Also, when a lender executes a nondisturbance agreement, an attornment clause serves no purpose. Like many clauses in some lease agreements, it becomes superfluous.
The tenant’s possession and lease agreement when subject to a nondisturbance agreement remains undisturbed and continuously enforceable by both the tenant and the new owner after the foreclosure sale.
By entering into a nondisturbance agreement, the lender is forced to become the landlord under the lease if the lender forecloses and acquires the property.
However, a prudent lender probably wants the choices afforded him by the lender’s loan subordination and attornment clauses, to accept or reject the lease either prior to or after the foreclosure.
Here, the landlord eliminates the need for a nondisturbance clause in a lease agreement by negotiating an enforceable future subordination clause outlining the loan parameters acceptable to both the landlord and the tenant when entering into the lease.