Thomas B. Mitchell is a partner in and A. Rachel Rothman and Jennifer W. Haddad are associates of Pepe & Hazard LLP in Hartford, Connecticut.
Subordination, Nondisturbance and Attornment Agreements (SNDAs), an integral part of commercial mortgage loan transactions, are also a source of tension among lenders, their borrowers, and tenants. SNDA negotiations can—and often do—become lengthy and expensive. Given that lenders today operate in a highly competitive environment, now may be a good time to consider whether what they are getting is worth the effort. A lender that finds a way to adopt a more flexible approach to SNDAs without significantly increasing the risk to its portfolio may gain an advantage in the marketplace by closing loans in less time and at less cost.
The Origins of SNDAs
In theory, SNDAs serve to solidify the rights and obligations of lenders and tenants in the event of a foreclosure of the lender’s mortgage. Historically, SNDAs have comprised three interconnected pieces: subordination—an agreement by the tenant to subordinate its leasehold interest to the lien of the lender’s mortgage; nondisturbance—an agreement by the lender not to disturb the tenant’s right of possession after foreclosure; and attornment—an agreement by the tenant to recognize the lender as its rightful landlord when the lender takes the place of the original landlord after foreclosure.
Subordination and attornment originated hundreds of years ago in feudal England when vassals paid homage to lords and serfs attorned to landowners. Subordination positions the interest of a subsequent lienholder in front of the tenant’s possessory interest in the property and ensures that any conflicts between the lease and the lien instrument will be resolved in favor of the lienholder. In old English law, attornment referred to the tenant’s acceptance of a transfer by a lord of the tenant’s services to the grantee of the lord’s interest in the property.
Nondisturbance is a newer concept by which tenants have sought to protect their rights under a lease even though they have subordinated to a mortgage. Nondisturbance requires the lender, upon foreclosure, to recognize the tenant’s leasehold interest and allows the tenant to continue in possession despite the foreclosure proceedings.
In view of their deep roots in English common law, it is surprising that the concepts of subordination, nondisturbance, and attornment have not developed in a more uniform manner in the United States. Variation in treatment of these issues from state to state is one of the key reasons for the emergence of SNDAs as a common feature of commercial mortgage loans. Lenders want to dictate procedure and clarify each party’s rights and obligations in the event of foreclosure rather than depend upon inconsistent common law principles and statutory frameworks. As a growing number of lenders become involved in multistate loan transactions, they rely on a standard form of SNDA rather than track laws that vary from jurisdiction to jurisdiction.
Today, there is little disagreement between lender and tenant over the basic concepts of subordination, nondisturbance, and attornment. But today’s SNDAs go far beyond the basic concepts. SNDAs have evolved into lengthy, detailed documents that attempt to establish ground rules and clarify potentially inconsistent provisions between the lease and the mortgage documents, such as liability for defaults by the landlord, notice to the lender of defaults by the landlord and additional rights to cure, termination of and amendments and modifications to the lease, and application of insurance proceeds.
Lender’s Liability for Landlord’s Defaults
One of the primary sticking points between the lender and the tenant revolves around the following question: if the lender takes over the property, will it become liable to the tenant for acts taken by or omissions of the prior landlord? Lenders take the position that they should have no liability for anything that occurs before foreclosure and, therefore, should not be subject to any setoff, abatement, or other rights that the tenant may have against the prior landlord. The lender, having no ability to control the landlord, should not be responsible for the landlord’s actions. The tenant should, therefore, look to the landlord, not the lender, for satisfaction of its claims. The tenant, on the other hand, takes the position that, having signed a lease, it is entitled to the benefit of its bargain, regardless of the landlord. The tenant’s real concern is that once its landlord is gone it will have a harder time recovering from the dispossessed landlord than from its new, deep-pocket successor.
There really are two issues at stake here. First, if the tenant has a claim in tort against the landlord, it should look to the landlord for satisfaction of that claim, not the lender, who had nothing to do with the landlord’s negligence or fault. In fact, the lender should have no legal liability for the landlord’s actions unless the lender expressly agrees to assume that liability or is deemed to have succeeded to that liability under a theory of corporate succession. Because the lender generally does not agree to assume such liability and corporate succession issues rarely come into play, the second, real issue is whether the lender should be responsible for curing a default created by the landlord that continues to exist after the lender takes over the property. For example, if the landlord failed to provide a service or make a repair required under the lease, a tenant would contend that the lender should remedy such failure after it takes over the property. A common compromise position is for the lender to agree to cure any defaults that continue after the lender assumes control of the property and for the tenant to allow the lender time to cure those defaults before exercising setoff or abatement rights.
Default Notices and Cure Rights
Another commonly negotiated point is whether the tenant must provide the lender with notice of a default by the landlord and, if so, how much time the lender should have to cure the landlord’s default before the tenant can exercise its remedies. Although most tenants will agree to provide the lender with notice of a default by the landlord, many object to an elongated cure period. From the lender’s point of view, the key is to have enough time to effect a cure so the tenant cannot exercise abatement or self-help rights or terminate the lease. In some cases, the tenant will agree to extend the lender’s cure rights so long as the lender “diligently pursues” the action necessary to cure the default. In other cases, the lender must negotiate the longest cure period it can—typically between 30 and 90 days. Within the extended cure period, the lender hopes it can either force the landlord to cure the default, enter the property and cure the default itself, or else get a receiver appointed fast enough to save the day. Before becoming bogged down in a protracted negotiation of cure rights, however, the lender should take the time to understand the tenant’s rights and obligations under the lease. In many cases, the lender may find that the lease obligates the tenant to provide notice and a cure period or that the tenant’s abatement, self-help, or termination rights are already limited. If so, the lender can compromise on cure rights, close the loan without taking any significant risk, and benefit from an enhanced relationship with its borrower.
Changes to the Lease
Modification of the lease is another key area of concern to a lender. The lender reviewed and approved the lease when the loan was made and does not want to find, after taking over the property by foreclosure, that the landlord and the tenant have modified the lease to its detriment. Therefore, the lender takes the position that no change to the lease will be binding upon it without its consent. Tenants, fearing delay and unnecessary meddling, often object to having to deal with the lender on every lease modification. In many cases, this logjam can be resolved if the lender limits its consent to changes that are important to its interests, such as rent, term, expansion or purchase options, maintenance obligations, and operating expenses. A thorough review of the lease will help the lender identify other areas that should be subject to the lender’s approval before modification. If no agreement can be reached with the tenant on this point, a lender can protect itself by making it a default under the loan documents if the borrower modifies the lease without the lender’s prior consent. In addition, in a nonrecourse loan the lender can require unpermitted modifications to be an exception from nonrecourse protection for the borrower.
Use of Insurance Proceeds
Another area of tension involves the use of insurance proceeds. A tenant that plans to stay on the property for many years and that may have made a significant investment in improvements wants to know that funds will be available for repair if the leased premises are damaged. Therefore, many leases require that insurance proceeds be used for repair if the loss is not total or can be repaired within a relatively short period of time. But the lender’s loan documents may provide that the lender has the option, in its sole discretion, to either apply insurance proceeds to repair the property or pay down the loan. The lender’s position is that if the property is damaged its collateral value and income stream will be impaired and its loan will, in effect, become a construction loan, which has more risk and usually carries a higher interest rate. Therefore, most SNDA forms used by lenders provide that insurance proceeds will be used as provided in the mortgage, not the lease.
The dispute over insurance proceeds is an area in which the lender’s evaluation of the risk may be overstated. The lender’s goal is having a performing loan and receiving the bargained-for return on its investment so that in most instances the lender would want the damage repaired. But, because most casualty losses are partial, not total, with repairs usually taking weeks, not months or years, the risk to the lender is usually short term. The lender can further mitigate its risk by requiring the borrower to carry rental loss insurance, which will replace the rental stream if rent payments abate during construction. In addition, the lease may provide that there is no abatement of rent during rebuilding, eliminating the risk to the lender. Finally, if the loss is a “material” or total loss, the lease will usually allow either the tenant or the landlord to terminate and excuse the landlord from the obligation to rebuild. In that event, the proceeds will be available to the lender to pay off the loan. The trend today is for lenders to allow insurance proceeds to be used for repair so long as the borrower continues to make the monthly loan payments, no other event of default occurs, the leases are not terminated, the proceeds are sufficient to pay for the repairs, and there is time to complete the repairs before the loan matures.
Are SNDAs Necessary?
On the surface, the idea of subordination seems like a good idea to lenders. If the lease is subordinate to the lender’s mortgage and the lender forecloses, the lease terminates. The lender can then bring in a new tenant, which is an attractive option if the lease has a below market rent. If the lease is not subordinated, the lender must wait for the tenant to default before it can evict. But if the tenant is not in default when the lender forecloses, would not most lenders want the tenant to stay? Even if the rent is below market, isn’t having a paying tenant better than having no tenant at all? The income stream from the tenant can be used to offset the lender’s expenses and reduce the loan balance. The lease may also make the property more attractive to potential purchasers.
And what about nondisturbance? Does that not effectively undo the subordination and put the tenant back in a position superior to the lender? Yes. By agreeing to nondisturbance, the lender gives up its ability to remove the tenant when a default occurs under the loan unless the tenant is in default under its lease at the same time. At that point, the only benefit to the lender of the SNDA is that if the tenant is in default at the time of foreclosure the lease can be terminated as a result of the foreclosure.
Finally, what about the “A” part of the SNDA? Doesn’t a lender need the tenant to agree to be bound by the terms of the lease if the lender takes over the property? Yes. But in many cases, the lease itself obligates the tenant to recognize the lender as its landlord pursuant to specific attornment language. Thus the attornment provision may be redundant.
What does that leave us with? If the lease is well drafted, it will already address the issues described above. It will provide for subordination and attornment; it will require the tenant to give the lender notice of defaults and an opportunity to cure; it will provide that material modifications and amendments to the lease will not be binding on the lender without its consent; it will acknowledge that the landlord (and any successor) is liable only for its own acts during the time it is the landlord; and it will require the landlord to use insurance proceeds to rebuild only to the extent the lender makes those proceeds available to the landlord. Such a lease will probably also require nondisturbance from the lender. But with appropriate mortgage protection language in the lease, does the lender need an SNDA at all?
Although there is some question as to whether SNDAs provide a benefit that outweighs the investment of time and money often required to negotiate them, lenders will probably not abandon the requirement for SNDAs anytime soon. In today’s competitive lending environment, however, lenders should recognize that a situation-oriented, flexible approach to the content or even the necessity of an SNDA will give them an edge in the marketplace, allow them to improve their relationships with existing borrowers, and turn new borrowers into repeat customers, without significant additional risk.