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Dissecting Subordination

Almost without exception, shopping center leases contain subordination provisions stating that the rights of the tenants under the leases will be subject to the rights of any lender whose mortgage affects the shopping center. However, the tenant that agrees to subordinate its leasehold interest without reviewing the lease language carefully -- with an eye toward both the applicable law and the options available to it -- may find its lease terminated in the event of a foreclosure without any fault on the tenant's part.

A tenant is rarely in a position simply to refuse to subordinate its lease to one or more mortgages; however, the savvy tenant can reduce the risk of an unpleasant surprise in the event of foreclosure.

What does a subordination clause do? Generally, if the lease is recorded, or if the tenant takes possession of the premises prior to the recordation of a mortgage on the property of which the leased premises is a part, the lien of the lease has "priority" over the lien of the mortgage.

A subordination provision changes the priority: The tenant agrees that the lien of its lease will be subordinate to the lien of a mortgage. A landlord generally includes subordination language in its lease in anticipation of the requirement of its lenders.

Consequences of foreclosure. In some states, if the lender's mortgage has priority and the lender forecloses, the lease terminates automatically, even if the lender does not want the lease to be terminated. In other states ("option" states), the lender has the option to do what is most profitable, either cutting off the lease in foreclosure and then evicting the tenant, or confirming the lease. If rent values have increased, it can evict the tenant; if rent values have decreased, it can hold the tenant to the lease. These scenarios are extremely unappealing to the tenant.

Nondisturbance and attornment. An alert tenant can protect itself by insisting that it not be required to subordinate its lease unless the lender executes a nondisturbance and attornment agreement with the tenant.

The most basic form of nondisturbance and attornment agreement assures the tenant that the mortgage holder will not disturb the tenant's possession as long as the tenant is not in default under its lease and the tenant agrees to recognize and treat the lender (or other owner after a foreclosure sale) as landlord, i.e. "attorn."

It is to both the tenant and the lender's benefit to negotiate a nondisturbance and attornment agreement that is broader than a mere agreement not to dispossess the tenant. The nondisturbance and attornment agreement should spell out the rights of the parties as specifically as possible.

The lender typically does not want to be bound by certain substantial obligations of the landlord, e.g., obligations to complete construction of the shopping center. The agreement should describe what will happen if the lender refuses to perform such obligations. (For example, the tenant could request a right to terminate the lease.)

Lenders also frequently refuse to be bound by rent payments made to the former landlord more than 30 days in advance, by offsets or defenses that the tenant may have against the former landlord, by defaults of the former landlord, or by amendments to the lease made without the lender's consent.

The tenant should attempt to include language in the nondisturbance and attornment agreement setting forth what happens if a default continues after a lender forecloses and becomes the landlord. For instance, in the event the landlord has failed to fix a leaky roof, the lender would not be willing to assume liability for past damages, but might be willing to agree to fix the roof after it becomes the landlord.

The tenant also should be wary of the risks of subordination arising prior to foreclosure and should, for example, seek to have the lender recognize the tenant's rights in the lease with respect to application of insurance proceeds and condemnation awards.

Prior to entering into the lease, the tenant should determine if the leased premises are subject to the lien of any mortgage by obtaining a title report or a warranty of the landlord.

A tenant with bargaining power may be able to insist that the existing lender execute a nondisturbance agreement as a condition to the tenant's execution of the lease or reserve the right to cancel its lease if the landlord does not deliver a nondisturbance agreement from the existing lender within a reasonable time after the lease is executed.

Sheldon A. Halpern is a partner and Jane E. Rudofsky is an associate with Los Angeles-based Pircher, Nichols & Meeks.

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