Any commercial real estate tenant worries that the landlord’s lender might foreclose and boot the tenant, especially if the rent is below market and the lease is thus particularly desirable to the tenant or burdensome to the landlord.
If a tenant holds a long-term ground lease as a development or investment asset, usually the tenant insists that the landlord’s mortgage be subordinate to the lease from the beginning. That way, a foreclosure can’t possibly affect the lease. A tenant for occupancy usually settles for something less: an agreement that the landlord’s mortgage is prior and superior to the lease — hence he could in theory terminate the lease if the lender ever foreclosed — but the landlord’s lender agrees not to disturb the tenant’s possession after foreclosure (a “non-disturbance agreement”). Tenants under ground leases typically won’t accept non-disturbance agreements, partly for fear they might somehow go wrong.
A recent left-field case in Texas, Kimzey Wash LLC v LG Auto Laundry LP, demonstrated one new and unexpected way that non-disturbance agreements can go wrong. The case shows that a ground tenant’s concern about these agreements goes beyond just free-floating anxiety. In fact, these agreements can fail. The case presented a form of failure that people had not previously considered. It should lead tenants of all types to reject non-disturbance agreements and insist on having absolute priority over the landlord’s mortgages hardwired into the loan documents. But no such groundswell seems to have occurred. The case nevertheless creates a risk for tenants that far exceeds some other risks that real estate documents address at great length.
In the Texas case, a long-term tenant signed a non-disturbance agreement with a bank that held a mortgage on the property. When the bank failed, the Federal Deposit Insurance Corporation (FDIC) took it over and transferred its assets, including the loan, to a new bank. That new bank foreclosed, ignored the non-disturbance agreement and wiped out the tenant’s lease. The tenant sued, claiming a right to not be disturbed in its possession after foreclosure because of the non-disturbance agreement.
The court ruled that the non-disturbance agreement didn’t bind the bank that acquired the mortgage through the FDIC and foreclosed. The tenant was out of luck. That happened because when the FDIC takes over a failed bank, it can set aside any agreement of that bank unless, in relevant part, the agreement is: signed by the bank simultaneously with its “acquisition” of the mortgage (presumably origination), approved by the bank’s board or loan committee, reflected in meeting minutes and continuously listed on the bank’s official records. The Texas court decided that the tenant’s non-disturbance agreement flunked at least one of those tests and thus could be set aside.
This particular tenant’s sad sequence of facts may sound unusual and unlikely to recur. In fact, however, it could recur whenever a federally insured bank signs a non-disturbance agreement for a pre-existing loan or acquires an existing mortgage that includes a non-disturbance agreement. In each such case, the insured bank could fail, the FDIC could take it over and, depending on nuances of federal law, the FDIC or the bank acquiring the loan could ignore the non-disturbance agreement.
How can a tenant protect itself? First, the tenant should try to avoid non-disturbance agreements and instead insist that its lease have absolute priority over mortgages. If, however, the tenant’s lease would otherwise not be prior and instead the tenant achieves priority through a separate agreement with the lender, might the FDIC or a successor bank also set aside that separate agreement? Why is it any safer than a non-disturbance agreement? Maybe the tenant must go a step further and insist that the loan documents themselves recognize the tenant’s priority.
The tenant might also look behind the federal statute on the FDIC’s powers and figure out what can be done to assure that the tenant’s protective agreement will survive an FDIC takeover of whatever bank holds the landlord’s mortgage. That may not be so easy. It certainly lies far outside the scope of ordinary negotiations of leases and agreements between tenants and lenders.
One would expect all of this to cause significant concern to tenants. But no one seems to care. Maybe that’s because it only happened once, to the author’s knowledge, in the reported cases. But the fact that it happened at all proves that it can happen.
Joshua Stein
Joshua Stein PLLC
501 Madison Avenue, Suite 402
New York, NY 10022
joshua@joshuastein.com
joshuastein.com
