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SECTOR IN-DEPTH
6 January 2016

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CMBS - US

The Top Two Ground Lease Financing Flaws: Deficient “New Lease” Clauses and Superior Fee Mortgages

Among credit-neutral protections are “new lease” provisions¹ that require the ground landlord to offer the leasehold lender a new ground lease if the ground lease terminates after a tenant default, even if the lender has failed to cure within its own separate, additional cure period. The new lease acts as an unambiguous no-fault “do-over” granted the lender. The equities of a catastrophic loss of the lender’s collateral far outweigh the burden to the ground landlord, especially because the destruction of the lender’s collateral would give the ground landlord a huge windfall by obtaining possession of the tenant’s improvements

possibly decades earlier than anticipated and free of the encumbrance of the ground lease. Credit-neutral new lease clauses require a new lease offer after a tenant default for any reason whatsoever and are not conditioned on terminations for particular reasons.

Some argue that extraordinarily robust lender cure rights can make up for the lack of a new lease clause. We disagree. The new lease clause mitigates three significant risks: first, ordinary operational failures and imperfections; second, the uncertainty, drama and loss of control that can arise when landlord and tenant litigate over what the lease requires; and third, the possibility of inadequate efforts to cure for whatever reason.

New Lease After Rejection in Bankruptcy

The incompleteness of even “termination for any cause” new lease provision may become evident if the ground tenant were to file for bankruptcy. Under §365(a) of the Bankruptcy Code (Code), a tenant may “reject” its unexpired ground lease.² When this occurs and the ground lease is rejected,³ is it terminated?

Bankruptcy courts have been inconsistent in their application of the term “reject.” Commentators have proposed that Congress should clarify the meaning of rejection,⁴ but in the meantime the ambiguity still exists.⁵ There is a strong school of thought in court decisions that a rejection merely breaches but does not terminate the ground lease. Under this theory, the leasehold estate is not terminated but merely, as one court put it, “placed…outside the bankruptcy administration without destroying the underlying estate and, therefore, the mortgage.”⁶ Courts have often relied on Code §365(g) – which applies to a landlord’s rejection of a lease and characterizes rejection of a lease as a breach without saying it is a termination – for this rationale. Other courts have disagreed,⁷ however, and there is no settled doctrine on the issue.

If the ground lease is rejected in bankruptcy and considered by the court as breached but not terminated, a provision calling for a new lease solely upon termination would not apply. This creates a problematic situation for the leasehold lender. The landlord could hold the desperate leasehold lender hostage by asking for additional payments before giving the lender its desired new lease, or it could completely refuse to give a new lease. While the lender may attempt to foreclose on the vestigial lease that may exist after rejection, subtenants, title insurers and potential purchasers may be skeptical of what the leasehold lender actually has. Maybe the lender still has a lien on whatever vestigial lease still remains after rejection. But that is a slender reed and no case law affirms this theory. The uncertainty could tie up the collateral in litigation for years.

Others argue that a provision calling for a new lease after termination following an event of default, where the “event of default” definition includes filing for bankruptcy, is sufficient. We disagree. Ipso facto clauses are unenforceable in bankruptcy, and in particular, Code §365(e)(1) says that such a provision in an unexpired lease is unenforceable. Basing a right to a new lease on an unenforceable clause is untenable. Moreover, any new lease clause has time limits, and a landlord would argue (and a court might agree) that they lapsed during the bankruptcy proceeding.

For all of these reasons, we believe that credit-neutral new lease provisions cover not only lease terminations under all circumstances but also expressly cover the rejection of a ground lease in bankruptcy.

Typically the fee mortgagee’s interest is subordinate in all cases to the ground lease.⁸ Because a fee lender’s collateral is solely the ground lease rental payments and the reversionary interest, and a leasehold lender’s collateral is its borrower’s possessory right to the land and to the improvements for the term of the ground lease subject to compliance with the terms of the ground lease, those interests, and those interests alone, are what each lender expects to separately acquire upon a foreclosure of its respective borrower’s

estate. Neither lender economically or legally expects to acquire the other party’s estate. The fee lender does not economically or legally need to extinguish the ground lease in any foreclosure of its fee interest.

There is a slight benefit to a fee mortgagee having a superior lien to the ground lease, thereby being able to wipe it out in a fee mortgage foreclosure: the advantage of time. It may be able to dispense with filing a landlord/tenant summary proceeding to evict a defaulting ground tenant after prevailing in its mortgage foreclosure, and it may directly name the ground tenant in its mortgage foreclosure action, saving a litigation step. But that is a small benefit against the larger harm that may befall a ground lease lender losing its entire collateral to the foreclosing fee lender.

Some feel that the existence of a Subordination, Nondisturbance and Attornment (SNDA) agreement negates any need for the landlord to subordinate its fee mortgage to the ground lease. An SNDA subordinates the tenant’s interest to the fee owner/landlord’s mortgage. In exchange, the fee lender agrees not to disturb the tenant’s leasehold interest and the tenant also agrees to “attorn” to the lender, that is, agrees to accept the fee lender or its assignee as its new landlord if the fee lender forecloses. Because the lender promises not to disturb the tenant, the argument goes, there should be no concern about the ground lease being extinguished in a fee foreclosure.

However, an SNDA does not sufficiently mitigate the risks inherent when fee financing is superior to the lease and leasehold mortgage. The SNDA may be deemed an executory contract that could be rejected under Code §365 by the fee lender in its own bankruptcy or declared unenforceable upon the fee lender’s insolvency and takeover by the Federal Deposit Insurance Corporation (FDIC) under 12 US Code §1823(e).⁹ Poorly drafted SNDAs may not mention or may mangle essential leasehold lender protections, such as the lenders’ ability to cure defaults. Also, the SNDA may not bind fee lenders to ground lease modifications or new ground leases (under the new lease provision described above) that are recorded subsequently.

Certain attempted workarounds in SNDAs may be insufficient, such as making the subordination to the fee mortgage operative “only so long as the SNDA is effective against the fee mortgagee and has not been rejected in bankruptcy.” For example, the foregoing provision itself may be unenforceable as an ipso facto clause and also rejectible as executory.

In summary, credit-neutral financeable ground leases are not subordinate to fee mortgages; neither an SNDA nor any other documentation or provision will generally mitigate a problematic, subordinate ground lease.

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