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What can Happen When a Lender Forecloses a Lease, and How the Lessor Can Protect Itself – Privity of Contract vs Privity of Estate

In larger commercial real estate leases, the tenant occasionally needs a loan to build the premises or finance major transactions. The tenant does not own the real property, but has the lease, which is both an interest in real property and a contract. This results in two sets of rights and obligations – those from the interest in the property (“privity of estate”), and those provided in the lease (“privity of contract”). If the tenant allows another party to take possession of the premises, that party has privity of estate with the landlord, but is not responsible for the obligations of the lease. This is why the lessor requires, in the lease, that any assignment be approved and the new tenant sign an acceptance of the assignment and the obligations of the lease contract. The Lessor will also require that any lender secured by the lease agrees to assume all the obligations of the Lease if it forecloses.

But what happens when the leasehold lender forecloses, but nobody makes sure that the Lender actually assumed all the lease obligations? That was the issue in a recent decision when the lender foreclosed on a lease in a shopping center

Sacramento-privity-of-estate-attorneyIn BRE DDR BR Whittwood Ca LLC v. Farmers & Merchants Bank of Long Beach, a shopping center tenant needed a loan to finance construction. The lease allowed the Tenant to encumber its leasehold interest through a mortgage, but presumed that a mortgage lender who succeeded to Tenant’s interest assumed Tenant’s obligations. The lease stated:

“Tenant shall have the right … to encumber Tenant’s leasehold interest under this Lease … through a Mortgage (‘Leasehold Mortgage’) with an institutional lender…. Landlord agrees that in the event the Leasehold Mortgagee succeeds to Tenant’s interest under this Lease (in which event it shall assume all of Tenant’s obligations under this Lease), Landlord shall, at the time of such succession, recognize such mortgagee, trustee or lender as the then Tenant under this Lease upon the same terms and conditions contained in this Lease and for the then unexpired portion of the Term.”

Another section of the lease applied to transfers other than leasehold mortgages. These transfers required Tenant to submit a transfer document providing for “the assumption by the Transferee of all of the obligations and liabilities of Tenant” under the lease.

Sacramento-privity-of-estate-lawyerThe Tenant obtained a construction loan which was secured by the Leasehold. The Tenant defaulted and the Lender foreclosed, taking back its security – the lease itself. The Lender transferred the Lease to a new Tenant. The new Tenant stopped paying rent and surrendered possession. The landlord sued the Lender for breach of contract, claiming that as successor to the original tenant it was responsible for the Lease. The Lender said no – it never intended to nor did ever assume the Lease.

A mortgagee who takes possession of the premises from the lessee is considered an assignee. But the assignee’s liability to the landlord depends on the nature of the assignment. If the assignee takes possession of the premises but no more, privity of estate exists and he is bound by all lease covenants which run with the land. Upon a subsequent assignment, privity of estate ends and, with it, all obligation to the landlord.

There is a different result if the assignee “expressly agrees with the assignor to assume the obligations of the lease, far different consequences attend. The assumption agreement creates a new privity of contract between landlord and assignee, enforceable by the landlord as a third party beneficiary, regardless of whether the landlord was a party to the assumption agreement. As a consequence, the assuming assignee is required to perform all covenants of the lease for the remainder of its term, absent a release by the landlord.”

Sacramento-privity-of-contract-attorneyAn express assumption of a real property lease requires specific affirmation by the assignee to bind itself to the lease obligations. The court cited a case involving a written assignment agreement. The document was signed by the defendant, as assignee, and the assignor. The document concluded, “ ‘It being understood that said Assignee … is to accept, assume and agree to perform all of the terms, conditions and limitations contained in said lease.’ ‘The undersigned, [defendant], hereby accepts, assumes and agrees to perform all of the terms, conditions and limitations contained in the aforementioned lease to be kept and performed by said lessee.’

The Supreme Court has distinguished a “bare assignment” from an “express agreement” to assume obligations in a lease: “An occupant of real property who holds by virtue of a bare assignment of the lease and without entering into any contract affirmatively binding himself to fulfill the covenants of the lease, is subject only to such obligations as he impliedly assumes by entry and taking possession of the lease premises. .. Where, however, the assignee expressly agrees in writing to be bound by the terms of the lease, there arises, as distinguished from any obligation resulting from mere occupancy, a new and different obligation … based upon privity of contract.

Here, the Lessor was asleep when the Lender recorded the deed of trust without agreeing to assume the Lease obligations. The court found that there was no privity of contract, and the Lender was off the hook.