Real Estate Leases and Effects of Foreclosure

Missouri, along with a majority of jurisdictions, holds that the foreclosure of a deed of trust or mortgage1 upon a parcel of real estate terminates interests, including leases, created subsequent to the recording of the deed of trust.

This rule subjects two parties who typically are not the cause of the default and resulting foreclosure, the mortgagee and the lessee, to numerous risks which they may not have contemplated when entering the loan or lease transaction. The mortgagee faces risks in foreclosing upon a property and releasing tenants from their obligations to pay rent and occupy the property. In locations with high vacancy or plummeting rental rates, such foreclosure presents an obvious financial hazard for the mortgagee. The lessee may have invested large sums of money in infill and improvements or may have a business identity closely associated with the location. Such a lessee may face an increase in its rental rate or a forced move that could result in significant loss if the lease is terminated ahead of schedule.

This article will discuss the theories behind the general rule of law which provides for the termination of junior leases upon foreclosure, the theories which courts in other jurisdictions have used to create exceptions to the general rule, and methods by which mortgagees and lessees may protect themselves from early termination of leases due to foreclosure.

It is the well-settled rule in this state and elsewhere that the foreclosure of leased premises, under a mortgage antedating the lease, nullifies and extinguishes the lease.2 It also appears to be well settled that the rights of a lessee under a lease given prior to execution of a mortgage are not extinguished by a foreclosure of the mortgage. The logical reason for this distinction is that, in the latter situation, the purchaser at the foreclosure sale acquires no greater interest than the mortgagor had, and becomes the landlord of the lessee.3

Foreclosure of a prior deed of trust also has the effect of nullifying junior easements and other junior liens and encumbrances.4 Missouri cases have even held foreclosure of a prior deed of trust to nullify subdivision plats and the dedication of streets.5

One reason for these results is the theory that a conveyance made under a foreclosure passes title to the purchaser as of the date of the deed of trust and uproots any contract of lease or other encumbrance made subsequent to that date.6 Another reason is that no privity of estate or contract exists between a mortgagee and the lessee of mortgagor to bind either. When the estate which the lessor held at the time of making a lease is terminated or defeated, the lease is extinguished with it.7

Missouri courts have not recognized any exception to the general rule discussed above; however, the courts of other jurisdictions have found exceptions where the conduct of the lessor or its agents was suspect.

Courts have held that a lease containing a covenant of quiet enjoyment prevents a landlord from ejecting its tenant following a foreclosure sale where the landlord intentionally defaulted under a deed of trust in order to terminate the tenancy. In American Welding Co. v. William H. Haskell Mfg. Co.,8 the tenant, American Welding, held possession of certain property under a lease from a prior owner. The prior owner had subjected the property to a mortgage for $25,000 held by the Slater Trust Company. The landlord, William H. Haskell Mfg. Co., had acquired the property from the prior owner, subject to the mortgage, but nothing was said about payment of the mortgage being assumed by the landlord.

At the time of the purchase of the property, William H. Haskell Mfg. Co. was informed of the leases on the property and American Welding attorned to it, proceeding to pay rent to the landlord in accordance with the terms of the lease with the prior owner. Thereafter, the landlord sought to induce American Welding to terminate the lease, but the parties could not reach agreement. The court noted that in the course of the negotiations, William H. Haskell Mfg. Co. informed American Welding that if they did not reach agreement, then the landlord could allow the mortgage on the property to be foreclosed and the lease would be destroyed.

When the interest on the mortgage fell due, the landlord refused to pay it and the mortgagee thereupon proceeded to advertise the property under the power of sale in the mortgage, eventually selling it at auction to the landlord, the highest bidder, for $26,000. On the same day, the landlord paid to the mortgagee $26,000 and received back from the mortgagee the balance, after deducting the amount of the mortgage, interest and expenses. Thereafter, the landlord gave notice to the tenant of its intent to evict it from the leased premises and commenced an action of ejectment.

The American Welding court agreed with the lower court's finding of an implied obligation on the part of the landlord to assume the mortgage and pay the mortgage debt. According to the court, under the covenant of quiet enjoyment and possession in the tenant's lease, it was the landlord's duty toward the tenant to do nothing directly or indirectly with the deliberate intent of disturbing the tenant in its quiet enjoyment of the leased premises.9

The American Welding court found it significant that the landlord had previously called attention to the fact that it could destroy the tenant's lease by allowing the mortgage to be foreclosed:

In thus deliberately planning and setting in motion the proceedings aimed at the destruction of the complainant's lease, said corporation was endeavoring to disturb the complainant's possession which it was obligated to protect. It was doing so as plainly and unequivocally as if it had sent its servants to eject the complainant and to bar him from the premises. It could with perfect safety to its continued ownership of the mortgaged premises procure them to be sold under the mortgage; for neither the complainant nor any other person could at the auction compete with it on equal terms. Whatever might be the amount of the respondent's successful bid, the balance over the mortgage debt and expenses would be returned to it.10

The court went on to state that, in view of all of the circumstances and the obligation of the landlord toward the tenant, the mortgage sale brought about by the landlord and the landlord's purchase of the premises must be considered to constitute mere payment of the mortgage debt and discharge of the mortgage lien.11 The landlord should thus be enjoined from prosecuting its action of ejectment against the tenant.12

Other jurisdictions have also held that a situation in which a landlord acquires a pre-existing deed of trust on its own property and later forecloses upon the deed of trust creates a further exception to the general rule terminating junior leases. In the case of Raker v. G.C. Murphy Co.,13 the owner of a property had created a mortgage upon it and then leased the store portion of the property to a tenant. After the owner's death, his two sons and several other individuals inherited the reversion. The sons procured an assignment of the mortgage, foreclosed upon it, and brought proceedings to evict the tenant. The Supreme Court of Pennsylvania called the attempt "contrary to both law and morals" and refused to allow it to succeed.14

The Raker court again discussed the importance of the covenant of quiet enjoyment, as had the court in the American Welding case. However, the Raker court found that even though in that particular case there had been a formal covenant of quiet enjoyment, even if it had not been expressed, such a covenant would have been implied.15 The court also provided an alternative reasoning for its outcome, stating that the mortgage foreclosure proceedings did not change in any way the ownership of the property.16

Further, the Raker court discussed the intent of the landlord in much the same manner as discussed by the American Welding court:

Since the Raker heirs could not, prior to their acquisition of the mortgage, have disaffirmed the lease and evicted the tenant, they could not accomplish that same result by the transparent device of acquiring the mortgage, foreclosing it, buying in the property, and then claiming that their rights were paramount to those of the lessee because of the original priority of the mortgage over the lease in point of time. That all the proceedings they instituted were designed for the sole purpose of freeing themselves from the Murphy Company lease is so obvious as to preclude the necessity of discussion. Having paid off the mortgage to the Bank there could have been no other reason for their failure to have it cancelled and satisfied of record instead of taking it over by way of assignment and then foreclosing it against themselves.17

Finally, the court discussed the remedies available to a tenant in such a situation. It held that where a landlord deliberately obtained the foreclosure of a mortgage on his property, and the purchaser evicted the tenant, that the landlord would be liable to the tenant for the full value of the leasehold because of the breach of the covenant of quiet enjoyment. It further held that if a landlord himself purchased a prior mortgage and attempted to evict the lessee, then the tenant's rights to remain in undisturbed possession for the term of the lease would be protected.18

The same result has occurred where a landlord arranged for a third party to act at its bequest to obtain a prior lien on the property and foreclose upon it in order to terminate a junior lease. Such a finding was reached by a New York appellate court in the case of Brookhaven Rialto Theater Corp. v. Feiger.19 The court summarized the facts of that case as follows:

The complaint alleges, in substance, that defendants, LoPiccolo, Feiger and Suozzo, acting in concert, secured a conveyance, from the landlord of premises demised in a lease to the plaintiff, to defendant LoPiccolo, and that Lo Piccolo is the alter ego of defendant Suozzo. It also alleges that defendant Feiger, acting at the instigation of Suozzo and on his behalf, purchased a judgment which was a lien on the demised premises senior to the plaintiff's lease; that she caused execution to be issued thereon; that the premises were sold by the sheriff to satisfy said execution, and that she bid the premises in, acting at all times as the agent of Suozzo.20

The court found that the lease in question contained a covenant of quiet enjoyment and that the allegations of the complaint, if established, were sufficient to entitle the plaintiff to a judgment declaring its lease superior to the title acquired by the defendant under the sheriff's deed.21

The Brookhaven Rialto court also dis-cussed the fact that the ownership of the property did not change through the foreclosure process, a principle recognized by the court in its following finding:

Assuming, as we must from the allegations of the complaint, that both LoPiccolo and Feiger were acting as the alter ego of defendant Suozzo, he is the owner not only of the reversion through the deed from the plaintiff's lessor, but also under the deed given by the sheriff to defendant Feiger. As such owner he will not be permitted to disturb the quiet enjoyment of the plaintiff by means of acquiring a title superior to that of the plaintiff's lease.22

While the common law rule is that a lease is terminated upon the foreclosure of a prior deed of trust or mortgage, it is permissible for the parties to contract for a different result.23

A recent Missouri case highlights the mortgagee's ability to take advantage of contractual provisions to avoid the common law outcome. In the case of H.B. Oppenheimer & Co. v. Prudential,24 the Prudential Insurance Company held a deed of trust on property which included City Center Square in Kansas City. The owner of the property, M.L.H., subsequently entered into a 10-year lease with Oppenheimer & Co., Inc. The lease contained the following provisions:

18. (a) This Lease and Tenants' interests and rights hereunder are and shall be subject and subordinate at all times to the lien of any first mortgage now existing or hereafter created on or against the Premises, the Building and/ or the Tract, and all amendments, restatements, renewals, modifications, consolidations, assignments and extensions thereof, without the necessity of any further instrument or act on the part of Tenant. Tenant agrees, at the election of the holder of any such mortgage, to attorn to any such holder. Tenant agrees upon demand to execute, acknowledge and deliver such instruments confirming such subordination and such instruments of attornment as shall be required by any such holder. Tenant hereby appoints Landlord as attorney-in-fact for Tenant irrevocably (such power of attorney being coupled with an interest) to execute, acknowledge and deliver any such instrument to be recorded. Notwithstanding the foregoing any such holder may at any time subordinate its mortgage to this lease without Tenants' consent by notice in writing to Tenant, and thereupon this Lease shall be deemed prior to such mortgage without regard to their respective dates of execution, delivery or recording and in that event such mortgagee shall have the same rights with respect to this Lease as though the Lease had been executed prior to the execution, delivery and recording of such mortgage and had been assigned to such mortgagee.

(b) Tenant agrees that neither any foreclosure of any such mortgage nor the institution of any such action or proceeding against Landlord, or any foreclosure or dispossess proceeding brought by the holder of any such mortgage to recover possession of the Premises, Building and/or Tract, shall by operation of law or otherwise except at the express election of the holder result in the cancellation or termination of this Lease or the obligations of Tenant hereunder and upon the request of any such holder of any such mortgage Tenant covenants and agrees to execute an instrument in writing satisfactory to such party or parties or to the purchaser of the mortgaged premises in foreclosure whereby Tenant attorneys to such successor in interest.25

M.L.H. later defaulted in the payment of its promissory note to Prudential, and Prudential purchased the property at its foreclosure sale on March 12, 1991.

Oppenheimer, seeking to escape its obligations under the remainder of the lease agreement, took the position that the lease obligations only continued when the lender, in accordance with § 18(a), had exercised its option to subordinate the deed of trust to the lease prior to the foreclosure. However, the court agreed with Prudential that § 18(b) applied, and that the lease provisions effectively gave the purchaser at the foreclosure sale an option as to whether to terminate the tenant's lease.26 This allowed the purchaser to choose the option which worked to its advantage, for instance by terminating the lease if rentals reserved by the lease were below market value, and leaving it in place if the rentals were above current market levels.27

A tenant presented with a lease clause like the one described in Oppenheimer, which gives the foreclosure purchaser the option of maintaining or terminating the lease, may be dissatisfied with leaving that option up to the new landlord. To protect the tenant's interest in a foreclosure situation, the tenant would be well-advised to request a contractual arrangement with the mortgagee commonly known as a non-disturbance agreement, prior to entering into the lease. The non-disturbance agreement is a contract between mortgagee and tenant by which the mortgagee agrees that, in the event of purchase at a foreclosure sale by it or any of its assigns, the tenant's possession will not be disturbed as long as the tenant remains in compliance with its obligations under the lease. This agreement directly between mortgagee and tenant creates the privity of contract which the Missouri courts deemed to be missing in cases discussing the general rule of termination of junior leases upon foreclosure.

When requested from a mortgagee, the submission of a non-disturbance agreement often results in the mortgagee's request for additional provisions by which the tenant agrees to subordinate its lease to the deed of trust and any additional refinancing, and to attorn to, or recognize as its new landlord, any purchaser at the mortgagee's foreclosure sale. The end result is often a document commonly known as a subordination, non-disturbance and attornment agreement, which addresses the concerns of the mortgagee and the tenant in the event of a foreclosure upon the leased premises.28

While common law may provide some protection from the affirmative efforts of unscrupulous landlords to terminate unwanted leases, in the absence of such efforts the mortgagee and tenant still run the risk of termination of the lease in the event of foreclosure of a prior existing mortgage. Mortgagees may contractually protect themselves from such a result by requiring their landlord borrowers to include in all of their leases express language which gives the foreclosure purchaser the option of continuing the leases upon purchase at a foreclosure sale. Tenants, in particular those who are investing their own funds in tenant improvements and infill, would be well-advised to negotiate a non-disturbance agreement with the mortgagee, so as to not risk forfeiture of its investment in infill or provide the purchaser with the option of terminating its lease if the current lease rate is below market levels.

© 1997, Randell D. Wallace