How to Fight Subordination of a Leasehold

On the other hand, the lender is in the lending business, not in the business of operating a retail store, theater, restaurant or other use that the landlord relied upon being operated continuously in the tenant's premises for a given period. The lender will likely want to control the premises and have some chance of thereby realizing the benefit of its bargain associated with the imposition of the leasehold mortgage. It may propose a generic solution to the lease foreclosure issue, similar to the following:

In the event that Lender notifies Landlord of a default by Tenant in the performance of its obligations under the Loan Documents and of Lender's election to cause the transfer of Tenant's interest under the Lease to another party, Landlord will accept Lender, any designee or nominee of Lender, or the purchaser of Tenant's interest under the Lease at a foreclosure sale, or any assignee of Tenant's interest under the Lease in lieu of foreclosure, or any other party (any such party being referred to herein as the 'Successor Tenant') as the tenant under the Lease for the remainder of the term of the Lease. Such transfer of Tenant's interest under the Lease shall not be a default under the Lease. Notwithstanding the foregoing provisions, the Successor Tenant shall be liable only for the performance of those of Tenant's obligations to be performed from and after the date that the Successor Tenant becomes the tenant under the Lease. Tenant hereby authorizes Landlord to accept Successor Tenant as the tenant under the Lease, in lieu of Tenant.

Since the lender will also wish, in the event of foreclosing the tenant's interest, to have the flexibility to replace the lease with a lease under which the tenant's obligations can actually be performed by the lender, ie, broadening or eliminating any restrictions on use as well as any operating covenant, it may propose even broader rights to replace the defaulting tenant and reform the lease.

However, such proposals, while possibly applicable in some circumstances, do not address the foregoing concerns of the landlord in circumstances, in which the landlord has relied upon a particular use and compliance with an operating covenant, but is then faced with the replacement of a defaulting tenant by a lender. The landlord in such an instance has, for various reasons, bargained for and requires the continuing presence of a tenant conducting business, perhaps even a very specialized type of business, in the tenant's premises. The critical issues may be reduced to the question of how long the landlord will allow the space to be dark, and under the lender's control, before the landlord can regain control of the defaulting tenant's space and attempt to regain some measure of the lost benefit of its bargain.

A practical solution to this dilemma may be crafted with a two-fold process. First, the parties may agree to provide that, in the event of a foreclosure of the leasehold mortgage, the lender will have an initial period in which to obtain an acceptable replacement tenant, with some level of obligation for the lender to use good faith efforts to do so. Second, if the lender is unsuccessful in obtaining the replacement tenant within such period, the landlord will have the right (but not the obligation) to find its own replacement tenant and either to terminate the lease in favor of a new lease with such tenant or to require the lender to accept, as its subtenant, the replacement tenant identified by the landlord. An example of this solution is seen in the following provisions (starting with a variation of the generic, lender-oriented provision set forth above):

(a) In the event that Lender notifies Landlord of a default by Tenant in the performance of its obligations under the Loan Documents and of Lender's election to cause the transfer of Tenant's interest under the Lease to another party (the 'Transfer Notice'), Landlord will accept Lender, any designee or nominee of Lender, or the purchaser of Tenant's interest under the Lease at a foreclosure sale, or any assignee of Tenant's interest under the Lease in lieu of foreclosure, or any other party (any such party being referred to herein as the 'Successor Tenant') as the tenant under the Lease for the remainder of the term of the Lease, and Lender shall use its good faith best efforts to obtain a Successor Tenant in compliance herewith, but subject in all events to the further terms and conditions of this paragraph (a) and the terms and conditions of paragraphs (b) and (c) below. Such transfer of Tenant's interest under the Lease shall not be a default under the Lease; provided that i) the Successor Tenant is identified not later than _____ days after the Cessation Date (as defined in paragraph (c) below), ii) the Successor Tenant is acceptable to Lender in the commercially reasonable exercise of Lender's discretion, iii) in all events, unless otherwise agreed by Landlord in its sole discretion, the Successor Tenant shall only use the premises for a use permitted under the terms of the Lease without amendment thereof, iv) the Successor Tenant enters into an assumption agreement acceptable to Landlord not later than _____ days after the Cessation Date, and v) the Successor Tenant commences the operation of its business within the premises not later than _____ days after the Cessation Date. Subject to the foregoing provisions, the Successor Tenant shall be liable only for the performance of those of Tenant's obligations to be performed from and after the date that the Successor Tenant becomes the tenant under the Lease. Tenant hereby authorizes Landlord to accept the Successor Tenant as the tenant under the Lease, in lieu of Tenant.

(b) If Lender fails to obtain a Successor Tenant, in compliance with and subject to the terms and conditions of paragraph (a) above, not later than ____ days after the Cessation Date, then Landlord shall have the option, but not the obligation, to terminate Lender's right to seek a Successor Tenant (with such termination option exercised by written notice to Lender), following which Landlord shall have the exclusive right to seek a Successor Tenant. In the event that Lender exercises such right and thereafter obtains a Successor Tenant meeting the requirements of paragraph (a) above (but without regard to the periods set forth therein) or otherwise acceptable to Landlord, then Landlord shall have the further option (exercisable by written notice to Lender) to i) require Lender to accept such Successor Tenant as if such Successor Tenant had been obtained by Lender, or ii) terminate the Lease and all right, title and interest of Lender thereunder (except for any obligations of Lender arising prior to such termination) and to enter into such new lease with the Successor Tenant as Landlord shall desire. Nothing set forth herein shall be construed to prevent Landlord from seeking or obtaining a Successor Tenant prior to the expiration of the periods described in paragraph (a) above.

(c) As used herein, the term 'Cessation Date' shall mean the earlier to occur of i) the date of the Transfer Notice, or ii) the date upon which the original Tenant shall have ceased the operation of its business in the premises.

The actual periods to be set forth in these provisions will depend upon the requirements of the operating covenant, any related co-tenancy requirements, and similar considerations.

To reach agreement upon a consent document acceptable to all concerned in such a situation, the landlord, tenant and lender must each take into consideration the practical concerns of the other party. As with many aspects of documenting real estate transactions, the parties must plan for the day they all hope will never come, when the tenant has defaulted and gone dark, the lender has inherited the tenant's position, and the landlord is faced with empty, specialized space and other tenants threatening to depart unless the space is promptly filled with a solvent, thriving tenant whose use will complement theirs. All three parties have legitimate interests to be advanced and protected in the drafting process. Ultimately, though, the landlord must be vigilant in preventing the relatively routine act of consenting to a tenant's financing from placing the landlord in jeopardy if the tenant ultimately defaults and cannot be easily replaced under the restrictions and requirements of the subject lease and, perhaps, other leases critical to the operation and survival of the shopping center.

John H. Lewis is a partner in the Atlanta office of Hartman, Simons, Spielman & Wood, LLC.

Landlords are regularly asked to consent to a tenant's financing, secured by the tenant's equipment and other assets. Such consent proposals are typically accompanied by a further request for the landlord to waive or subordinate its interest in the tenant's personal property, if any, in favor of the claim and lien of the tenant's lender. Today, lenders often go so far as to seek the subordination of the landlord's interest in the lease itself to the interest of the lender under the financing. In response, landlords will routinely resist any subordination of the leasehold, and will require various protections such as excluding fixtures from the lender's collateral and providing that if the lender forecloses on, or takes possession of, the collateral, it will do so peaceably and in compliance with applicable legal process, without interference with the operations of the landlord's shopping center or the businesses of other tenants, and with an obligation by the lender to repair any damage to the premises resulting from the removal of the collateral.

The documentation described above is fairly routine. However, what if the tenant's financing is secured not only by the tenant's personal property, but by a mortgage of the tenant's leasehold as well? In this case, the landlord and the lender will grapple with issues such as notice to the lender and a right to cure any tenant default. The lender will often request (and the landlord will typically resist) an additional cure period beyond any such period applicable to the tenant, together with a right to foreclose on the leasehold mortgage and step into the shoes of the tenant, while also attempting to limit or eliminate the lender's responsibility for the sins of the tenant (with the landlord again resisting such efforts).

Now let's take this scenario a step or two farther. What if the tenant's lender takes a security interest in the personal property of the tenant and a mortgage on the leasehold, and the tenant's lease includes a restrictive use clause and an operating covenant? How do the parties work to facilitate the financing, yet protect the legitimate concerns of the landlord? The tenant in such circumstances may conduct a specialized business, critical to the tenant mix in the center, and with unique space and leasehold improvements not readily adaptable to other uses. The landlord may have co-tenancy requirements in other leases dependent upon the subject tenant's compliance with the operating covenant.

On the other hand, the lender is in the lending business, not in the business of operating a retail store, theater, restaurant or other use that the landlord relied upon being operated continuously in the tenant's premises for a given period. The lender will likely want to control the premises and have some chance of thereby realizing the benefit of its bargain associated with the imposition of the leasehold mortgage. It may propose a generic solution to the lease foreclosure issue, similar to the following:

In the event that Lender notifies Landlord of a default by Tenant in the performance of its obligations under the Loan Documents and of Lender's election to cause the transfer of Tenant's interest under the Lease to another party, Landlord will accept Lender, any designee or nominee of Lender, or the purchaser of Tenant's interest under the Lease at a foreclosure sale, or any assignee of Tenant's interest under the Lease in lieu of foreclosure, or any other party (any such party being referred to herein as the 'Successor Tenant') as the tenant under the Lease for the remainder of the term of the Lease. Such transfer of Tenant's interest under the Lease shall not be a default under the Lease. Notwithstanding the foregoing provisions, the Successor Tenant shall be liable only for the performance of those of Tenant's obligations to be performed from and after the date that the Successor Tenant becomes the tenant under the Lease. Tenant hereby authorizes Landlord to accept Successor Tenant as the tenant under the Lease, in lieu of Tenant.

Since the lender will also wish, in the event of foreclosing the tenant's interest, to have the flexibility to replace the lease with a lease under which the tenant's obligations can actually be performed by the lender, ie, broadening or eliminating any restrictions on use as well as any operating covenant, it may propose even broader rights to replace the defaulting tenant and reform the lease.

However, such proposals, while possibly applicable in some circumstances, do not address the foregoing concerns of the landlord in circumstances, in which the landlord has relied upon a particular use and compliance with an operating covenant, but is then faced with the replacement of a defaulting tenant by a lender. The landlord in such an instance has, for various reasons, bargained for and requires the continuing presence of a tenant conducting business, perhaps even a very specialized type of business, in the tenant's premises. The critical issues may be reduced to the question of how long the landlord will allow the space to be dark, and under the lender's control, before the landlord can regain control of the defaulting tenant's space and attempt to regain some measure of the lost benefit of its bargain.

A practical solution to this dilemma may be crafted with a two-fold process. First, the parties may agree to provide that, in the event of a foreclosure of the leasehold mortgage, the lender will have an initial period in which to obtain an acceptable replacement tenant, with some level of obligation for the lender to use good faith efforts to do so. Second, if the lender is unsuccessful in obtaining the replacement tenant within such period, the landlord will have the right (but not the obligation) to find its own replacement tenant and either to terminate the lease in favor of a new lease with such tenant or to require the lender to accept, as its subtenant, the replacement tenant identified by the landlord. An example of this solution is seen in the following provisions (starting with a variation of the generic, lender-oriented provision set forth above):

(a) In the event that Lender notifies Landlord of a default by Tenant in the performance of its obligations under the Loan Documents and of Lender's election to cause the transfer of Tenant's interest under the Lease to another party (the 'Transfer Notice'), Landlord will accept Lender, any designee or nominee of Lender, or the purchaser of Tenant's interest under the Lease at a foreclosure sale, or any assignee of Tenant's interest under the Lease in lieu of foreclosure, or any other party (any such party being referred to herein as the 'Successor Tenant') as the tenant under the Lease for the remainder of the term of the Lease, and Lender shall use its good faith best efforts to obtain a Successor Tenant in compliance herewith, but subject in all events to the further terms and conditions of this paragraph (a) and the terms and conditions of paragraphs (b) and (c) below. Such transfer of Tenant's interest under the Lease shall not be a default under the Lease; provided that i) the Successor Tenant is identified not later than _____ days after the Cessation Date (as defined in paragraph (c) below), ii) the Successor Tenant is acceptable to Lender in the commercially reasonable exercise of Lender's discretion, iii) in all events, unless otherwise agreed by Landlord in its sole discretion, the Successor Tenant shall only use the premises for a use permitted under the terms of the Lease without amendment thereof, iv) the Successor Tenant enters into an assumption agreement acceptable to Landlord not later than _____ days after the Cessation Date, and v) the Successor Tenant commences the operation of its business within the premises not later than _____ days after the Cessation Date. Subject to the foregoing provisions, the Successor Tenant shall be liable only for the performance of those of Tenant's obligations to be performed from and after the date that the Successor Tenant becomes the tenant under the Lease. Tenant hereby authorizes Landlord to accept the Successor Tenant as the tenant under the Lease, in lieu of Tenant.

(b) If Lender fails to obtain a Successor Tenant, in compliance with and subject to the terms and conditions of paragraph (a) above, not later than ____ days after the Cessation Date, then Landlord shall have the option, but not the obligation, to terminate Lender's right to seek a Successor Tenant (with such termination option exercised by written notice to Lender), following which Landlord shall have the exclusive right to seek a Successor Tenant. In the event that Lender exercises such right and thereafter obtains a Successor Tenant meeting the requirements of paragraph (a) above (but without regard to the periods set forth therein) or otherwise acceptable to Landlord, then Landlord shall have the further option (exercisable by written notice to Lender) to i) require Lender to accept such Successor Tenant as if such Successor Tenant had been obtained by Lender, or ii) terminate the Lease and all right, title and interest of Lender thereunder (except for any obligations of Lender arising prior to such termination) and to enter into such new lease with the Successor Tenant as Landlord shall desire. Nothing set forth herein shall be construed to prevent Landlord from seeking or obtaining a Successor Tenant prior to the expiration of the periods described in paragraph (a) above.

(c) As used herein, the term 'Cessation Date' shall mean the earlier to occur of i) the date of the Transfer Notice, or ii) the date upon which the original Tenant shall have ceased the operation of its business in the premises.

The actual periods to be set forth in these provisions will depend upon the requirements of the operating covenant, any related co-tenancy requirements, and similar considerations.

To reach agreement upon a consent document acceptable to all concerned in such a situation, the landlord, tenant and lender must each take into consideration the practical concerns of the other party. As with many aspects of documenting real estate transactions, the parties must plan for the day they all hope will never come, when the tenant has defaulted and gone dark, the lender has inherited the tenant's position, and the landlord is faced with empty, specialized space and other tenants threatening to depart unless the space is promptly filled with a solvent, thriving tenant whose use will complement theirs. All three parties have legitimate interests to be advanced and protected in the drafting process. Ultimately, though, the landlord must be vigilant in preventing the relatively routine act of consenting to a tenant's financing from placing the landlord in jeopardy if the tenant ultimately defaults and cannot be easily replaced under the restrictions and requirements of the subject lease and, perhaps, other leases critical to the operation and survival of the shopping center.

John H. Lewis is a partner in the Atlanta office of Hartman, Simons, Spielman & Wood, LLC.