SNDAs: a great planning tool for lenders (and tenants)

Believe it or not, the law in many states is a real mess on some real estate issues.  (I know, a lawyer saying a legal issue is not clear brings to mind the joke about the lawyer who, when asked a question, always started with “On one hand . . . “ and continued with, “on the other hand. . . .” until his client finally told him he had too many hands.)

One of these messy legal issues that affects real estate sporadically (only in bad times) is whether a foreclosing lender can keep a tenant in place after it forecloses on a defaulting borrower.

The black letter law of real estate priorities in most states is that a mortgage (or deed of trust) recorded in the public records after a notice or memorandum of lease is recorded, is junior in priority to the lease.  That means even if the lender forecloses, the lease stays in place.  But most real estate lenders don’t like having any interests senior to their mortgages, as they usually don’t want any risk that an entity with a senior claim could possibly prime, and ultimately foreclose out, their mortgages.  So they usually want all leases to be subordinated to their mortgage lien.  Frequently they do so in good times, without thinking through how this approach might backfire in bad times.

Generally if a memorandum or notice of a lease is recorded after a mortgage is recorded, or a lease is expressly subordinated to a mortgage lien, the lease is junior to the mortgage.  That usually means the lease will be wiped out in a foreclosure.  If a junior priority lease is terminated by the foreclosure, the tenant is no longer obligated under the lease, and the purchaser at foreclosure gets title to the property, but risks losing the junior tenant – or having to renegotiate a new lease with the tenant.  Guess what? That’s exactly what the foreclosing lender doesn’t want, especially when lease rates are going down.

[Just to make life confusing, however, in some states a tenant in possession is senior to the lender, or has some protections even if the lender records its mortgage and the tenant's lease is not recorded.  In these states, if a mortgage junior to a lease is foreclosed, the lease typically remains in effect and the purchaser at the foreclosure sale (usually the foreclosing lender) takes title to the property subject to the lease terms.]

Basically, this area of law is a mess in many states.  Including California. (And no, this is not a full and complete discussion of the law in all states.) 

So, how does a lender get around this?  And, by the way, how does a tenant protect itself against the risk of its landlord being foreclosed?

Contractually, of course. 

One of the delights of the American system is that no matter how incredibly stupid the law, or our duly elected leaders, may be (and it is only with great exercise of willpower that I am refraining from making a number of uncivil comments about the egregious stupidity and reckless disregard by Congress of the economic consequences of the whole federal government’s debt ceiling charade --  which, of course, could have been avoided by Congress’ passing a balanced budget in the first place), we mere citizens can generally agree to anything we want on a consensual basis, so long as the agreement is not illegal.  All we need to do is enter into a contract.  (And it’s much easier to enforce if the contract is in writing; because, as film mogul Samuel Goldwyn allegedly said, an oral contract isn’t worth the paper it’s written on.)  

The type of contract that solves this problem is called a subordination, nondisturbance and attornment agreement ("SNDA").  It contractually establishes what will happen to the leases if the lender forecloses.

These SNDAs are easy to understand if the three key concepts ("subordination," "nondisturbance" and "attornment") contained in each SNDA are defined separately. 

"Subordination" is an agreement to allow another's interest in certain real property to have priority over one's own interest.  As noted, usually lenders require that tenants subordinate their interests to the lien of a first mortgage. 

"Nondisturbance" means an agreement by the lender to recognize the tenant's rights under the lease after a foreclosure.  Usually this agreement is conditioned on the tenant performing its obligations and paying its rent under the lease.

"Attornment" is simply a fancy, rather medieval word that means the tenant acknowledges its obligation to a new, substituted landlord after any transfer of the landlord's interest.  Lenders want to make sure that a tenant will attorn to a purchaser of the landlord's interest (usually the foreclosing lender) after a foreclosure of the mortgage.

How an SNDA Works.  An SNDA replaces the current uncertainty in the law about the obligations of a tenant and a lender/successor landlord after a foreclosure with an agreement between the two parties (and often the landlord as well) which spells out their rights after a foreclosure. 

Usually an SNDA provides that the lease will be subordinated to the loan either (a) if lender so elects, or (b) automatically.  A lender will generally want to have the option to elect to subordinate the lease in question, but if the lender does not so subordinate the lease before foreclosure actually occurs, the purchaser at the foreclosure sale will end up taking title to the property subject to the lease.  Either option is acceptable so long as the lender carefully considers what it wants to do. 

The SNDA agreement should provide that the lender will not disturb the rights of the tenant under the lease if at the time of the foreclosure the tenant is not in default. 

Since most foreclosures happen in a falling real estate rental market, most lenders should not worry about delivering such a nondisturbance agreement to a tenant as long as the cash flow from that lease is adequate at lease commencement, and as long as each lender obtains in exchange the agreement of the tenant to attorn to it or any other successful bidder after a foreclosure.

Typically, a lender's lawyer will draft the SNDA to provide that a purchaser at foreclosure or the foreclosing lender will not be liable for a prior landlord's defaults under the lease before foreclosure, and to limit the foreclosing lender's liability for performance of its obligations as successor landlord to the lender's equity in the property. 

In addition, the lender's lawyer may try to negotiate an SNDA pursuant to which the successor landlord after a foreclosure will not be liable for any extraordinary or unusually burdensome agreements of the original landlord, such as exclusive and restrictive covenants, obligations to pay tenant's rent under its prior lease, indirect or consequential damages, or construction or other warranties (e.g., concerning zoning, title, or compliance of the premises with applicable laws) given by the original landlord. 

A typical SNDA will also provide that the lender does not have to return to the tenant any security deposits that the lender has not actually received from the prior landlord.

A SNDA should provide that the tenant will send to the lender copies of all notices of defaults of the landlord, and will give the lender an additional time to cure such defaults. 

As part of this agreement, the tenant should agree to accept performance of the lender in place of the original landlord, since borrowers facing foreclosure often stop performing their obligations as landlord under their leases, leading to a steep slide in the value of their properties, and giving the tenants opportunities to terminate their leases for breach.

So, a SNDA is good for lenders, and for tenants.  The owner of the building, the borrower under the loan, is not typically a party, but is not harmed by the SNDA, because its rights are not affected by the SNDA.  Bottom line, a SNDA is a great tool to create rational outcomes in advance of hotly disputed disputes – usually long before a problem arises at a property.  I can only dream that our elected leaders might one day apply some of that same rationality, and forethought, to our governmental budgeting processes.