Staying Alive! How New Lease and Other Leasehold Mortgagee Protection Provisions Really Work When the Ground Lessee Defaults

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1 Staying Alive! How New Lease and Other Leasehold Mortgagee Protection Provisions Really Work When the Ground Lessee Defaults By: Janet M. Johnson 1 When entering into a long-term ground lease with a ground lessee (referred to in this paper as the Lessee ) that requires financing for a project the Lessee intends to develop on the ground leased parcel, sophisticated ground lessors (referred to in this paper as the Lessor ) will not agree to encumber the underlying fee estate by the security interests granted in connection with the Lessee s financing. 2 What this means, as a practical matter, is that an uncured default on the part of the Lessee under the ground lease will permit the Lessor to terminate the ground lease, thereby terminating or extinguishing the security interest of the Lessee s lender (referred to in this paper as the Leasehold Mortgagee ) 3 in the Lessee s leasehold estate (the Leasehold Mortgagee s security interest is referred to in this paper as the Leasehold Mortgage), 4 including the Lessee s title to any improvements the Lessee may have constructed on the premises or otherwise acquired that revert to the Lessor upon termination of the ground lease. Where the Lessor and Lessee are sophisticated parties, they will anticipate the concerns of the Lessee s future Leasehold Mortgagee in negotiating the terms of the ground lease, even if the Lessee has not selected its Leasehold Mortgagee until after the ground lease has been fully negotiated or even signed. If so, the ground lease typically will contain protections for the Leasehold Mortgagee to ensure that the lien of its Leasehold Mortgage will not be Janet M. Johnson. Ms. Johnson is a partner at Schiff Hardin LLP in its Chicago, Illinois office. She wishes to thank Joshua Stein of Joshua Stein PLLC, New York, New York, who provided the three different sample Leasehold Mortgagee Protection Provisions included in Appendix B, Appendix C and Appendix D to this paper. 2 This paper addresses only Leasehold Mortgages that are on so-called unsubordinated ground leases. This term is really a misnomer because it is not the ground lease that is subordinated in a subordinated ground lease transaction; rather in a so-called subordinated ground lease transaction, the Lessor either joins in the Leasehold Mortgage in a manner that subjects its fee estate to the lien of the Leasehold Mortgage, or executes a separate instrument that is recorded under which it agrees that the fee estate is subject and subordinate to the lien of the Leasehold Mortgage. 3 In states where deeds of trust, deeds to secured debt or other forms of security documents are used, the term Leasehold Mortgagee is meant to refer to the holder of the underlying debt, regardless of the type of security document used to secure the holder s debt. See footnote 35 and Part B.4 of this paper for information on the effect of the termination of the underlying ground lease on the Leasehold Mortgage. 4 The Leasehold Mortgagee s primary security instrument is called a Leasehold Mortgage in this paper regardless of whether it takes the form of a mortgage, deed of trust, deed to secure debt or other similar instrument customarily filed or recorded to perfect the Leasehold Mortgagee s security interest in the Lessee s leasehold estate under the laws of the jurisdiction where the premises are located. Space does not permit discussion of the process by which the trustee under a deed of trust or deed to secure debt exercises its remedies, including a power of sale, but the terms foreclose or foreclosure as used in this paper intend to refer to that process as well. The sample forms attached as Appendices to this paper are for use in states where foreclosure is the anticipated legal remedy to be exercised by a Leasehold Mortgagee, but even in those states, the specific state law should be reviewed to make sure there are no state specific provisions that should be added. -1-

2 extinguished or terminated by reason of uncured defaults on the part of the Lessee, or at least provide ample opportunity for the Leasehold Mortgagee to react so as to avoid the risk that its Leasehold Mortgage will be extinguished or terminated as a result of any such uncured default. If the Leasehold Mortgagee is not involved at the time the ground lease is negotiated and it does not contain such provisions, when the Leasehold Mortgagee reviews the ground lease, it will either request an amendment to the ground lease to include such provisions, or will ask the Lessor to enter into a separate agreement that incorporates the protections the Leasehold Mortgagee requires. Regardless of where these provisions are ultimately incorporated into the ground lease, such provisions are referred to in this paper as Leasehold Mortgagee protections or Leasehold Mortgagee protective clauses. Most parties anticipate the project will succeed and that these Leasehold Mortgagee protections or protective clauses will not need to be invoked. Of course, that is not always the case, as has been true in the recent and past economic downturns. This paper focuses on what is typically included in ground lease Leasehold Mortgagee protection provisions and how, as a practical matter, those provisions operate when the Lessee defaults. Issues from both the Lessor s and the Leasehold Mortgagee s points of view are addressed. Sample ground lease provisions from both the Lessor s and the Lessee s/leasehold Mortgagee s perspective are provided in the attached Appendices and analyzed. Finally, real world experiences when a Lessee defaults (or is in danger of defaulting) under a ground lease are analyzed. A. Leasehold Mortgagee Protective Provisions in Leasehold Mortgages Required for a Financeable Ground Lease Ground leases can range from the very simple to the very complex, depending on the nature of the project to be developed or redeveloped on the premises, the sophistication of the parties and their counsel, and the motives and goals of the Lessor and Lessee. Where the Lessee has a commitment for a Leasehold Mortgage in hand, 5 counsel for the Leasehold Mortgagee will also have input into the ground lease form, particularly the provisions dealing with the rights of a Leasehold Mortgagee before, during and after a default on the part of the Lessee in the performance of its obligations under the ground lease. Where the ground lease is signed before the Lessee has financing, or at the time the Lessee seeks refinancing of a completed project from 5 Experience would suggest a Lessor would be well advised not enter into a ground lease with a prospective Lessee unless and until the Lessee has obtained the necessary financial commitments to complete the project. Most prospective Lessees (particularly the single member LLC or other single purpose entities traditionally used by real estate developers) lack sufficient wherewithal to complete a project without some sort of third-party financing (the exception being build-to-suit projects for large corporate users). Even if a prospective Lessee does have sufficient assets to complete a project without third-party financing, the Lessee often seeks such financing in order to increase the internal rate of return on the portion of the project funds it must invest in the project (i.e., the equity). Under the laws in most states, although a lease often may include a Lessor s right to terminate the lease upon the Lessee s default, the use of self-help to evict a Lessee that refuses to vacate the premises is almost always prohibited. This means the Lessor generally must first follow the local ordinance or statutory requirements to give legal notice to a defaulting tenant and then file a forcible entry and detainer or other proceeding in court to obtain a court order requiring the Lessee to vacate as of a specific date. This takes time and money, especially if the Lessee contests the eviction, which means a Lessor may sit for many months without the ability to re-lease the property to another party. -2-

3 a new Leasehold Mortgagee, the Lessor and Lessee should anticipate what a future Leasehold Mortgagee will seek in the way of protections in order to minimize the delays in closing on the financing for the project. Including such protective provisions in a ground lease is what is commonly called making the ground lease financeable. The following discussion describes and explains the most commonly required and important provisions that should be included in a ground lease to make it financeable. There may be other provisions a Leasehold Mortgagee will insist upon in a particular situation, but these are almost always required. 1. Right to Mortgage the Leasehold. Every Lessee should insist on a provision in the ground lease that permits it to mortgage its leasehold estate without the Lessor s consent. Each of the sample Leasehold Mortgagee Protection provisions in Appendix A, Appendix B, Appendix C, and Appendix D contains such a right. See Section of Appendix A (p. A-1); paragraph 1 of Appendix B (p. B-1); Section 7 of Appendix C (p. C-4); and Section IV.A of Appendix D (p. D-18). Each of the sample provisions includes slightly different conditions on the Lessee s right to mortgage its leasehold estate. Each one should be considered to determine the most appropriate provision for any particular transaction. For example, Section of Appendix A is taken from a ground lease drafted specifically for the situation in which the Lessee will be constructing a new project on the leased premises. It provides that a foreclosing Leasehold Mortgagee or the party acquiring the property in a foreclosure proceeding will be deemed to have assumed the obligations of the Lessee and conditions the further assignment (if the project has not yet been substantially completed) on having a new guarantor of completion for the project. 6 The Appendix B and Appendix C forms would be more appropriate for a transaction that does not contemplate new construction, and perhaps for smaller projects with ground leases having shorter terms. Appendix D contains much more Leasehold Mortgagee oriented protective provisions and provides very broad rights to transfer the Leasehold Mortgage, and does not limit the amount that can be borrowed or the purposes for which the Lessee may borrow the funds. 2. Notices of Lessee Defaults and Opportunities to Cure; New Lease for Incurable Lessee Defaults. Leasehold mortgagees will insist upon being provided copies of notices of default given to the Lessee and a right to cure those defaults (without an obligation to do so). In order for this to be feasible, the Lessor must have notice of the existence of the Leasehold Mortgage and an address to which such notices must be sent. Many such provisions make notices of default ineffective if not given to the Leasehold Mortgagee. The Leasehold Mortgagee Protection provisions in Appendix C (see Paragraph 9 on page C-4) are written in this manner. However, Lessors should resist provisions that make a notice to the Lessee ineffective if notice is not given to the Leasehold Mortgagee at the same time the notice is given to the Lessee; otherwise it effectively extends the Lessee s cure period for the period of time between the time notice is given to the Lessee and the time it is given to the Leasehold Mortgagee. 6 It also prohibits the initial Lessee from assigning its interest in the ground lease without the Lessor s consent prior to substantial completion of the project. The reason for this prohibition is discussed in Part A.3 below. -3-

4 Instead, the Lessor can agree that the cure period for the Leasehold Mortgagee only will not begin until the Leasehold Mortgagee has received the notice. This will protect the Lessor from an inadvertent failure to provide notice of a Lessee s default to the Leasehold Mortgagee when it provides notice to the Lessee. The Leasehold Mortgagee Protection provision in Appendix A (see Section 25.1, p. A-8) and Appendix B (see paragraphs 4 and 5, p. B-1) are written in this manner. This should be acceptable to a Leasehold Mortgagee. The Leasehold Mortgagee is typically a third party with a vested interest in curing the Lessee s defaults in order to preserve the lien of its Leasehold Mortgage and the Lessor normally will have an incentive to provide notice to the Leasehold Mortgagee as soon as possible so as to increase the chances this third party will intervene and cure at least the monetary defaults. 7 The time period for a cure by the Leasehold Mortgagee should extend beyond the time period to cure afforded the Lessee in order to allow time for the Lessee to cure before the Leasehold Mortgagee is forced to step in. The maximum Leasehold Mortgagee Protection provisions in Appendix D (see Section VI.A, p. D-24 and related definition of Tenant s Cure Period Expiration Period, p. D-13) go one step further and require another notice be given specifically to the Leasehold Mortgagee before the cure period afforded the Leasehold Mortgagee will commence. This notice advises Leasehold Mortgagee that the Lessee has defaulted and the Lessee s cure period has expired without the Lessee having cured the default, and specifies the nature of the default and the period of time the Leasehold Mortgagee will have to cure the Lessee s default. It contemplates this notice will go to all Leasehold Mortgagees. In contrast, the provisions of Section 25.1 on page A-8 of Appendix A contemplate a notice of the Lessee s default will be sent to the Leasehold Mortgagee at some time prior to the end of the Lessee s cure period (but without being ineffective if it is not sent at the same time as notice to the Lessee). The notice is required to commence the Leasehold Mortgagee s time period to cure, but if it is sent at the same time as notice to the Lessee, the Leasehold Mortgagee s time period to cure will automatically commence at the end of the Lessee s cure period. The reason for provisions requiring notice and an opportunity to cure to Leasehold Mortgagees at the same time as a notice is given to the Lessee is to maximize the likelihood that one of the Leasehold Mortgagees (if there are multiple ones) will intervene with the Lessee sooner rather than later to see that the Lessee cures the default. However, if the Lessee does not cure the default, Section of Appendix A only requires a second notice that the Lessor intends to terminate the ground lease to go to the Leasehold Mortgagee with the first lien position, and only that Leasehold Mortgagee will be entitled to exercise the right to a new ground lease (a New Lease ). The Appendix B provision (see paragraph 6, p. B-2) also allows such right only to the most senior Leasehold Mortgagee, but the Appendix C provision (see Section 18, p. C-6) and Appendix D provision (see Section VIII.A, p. D-29) both allow all Leasehold Mortgagees to exercise this right, but in order of their priority, each one s right being based on a failure to exercise the right to cure on the part of the one immediately senior to it. The rationale (from the Lessor s point of view) is that those Leasehold Mortgagees with lower priority generally have less invested and their interests can be extinguished by a foreclosure of 7 The most common situations in which the Lessor might prefer to have the ground lease and Leasehold Mortgage terminated would be where the ground rent being paid is below market for the premises or the premises could be redeveloped for a more financially lucrative use. -4-

5 the first Leasehold Mortgage. If they want to preserve their liens they can acquire the first Leasehold Mortgagee s position. There may be Lessee defaults that cannot be cured by the Leasehold Mortgagee either at all (e.g., bankruptcy of the Lessee) or without obtaining possession of the premises (e.g., repair obligations). The Leasehold Mortgagee needs time to obtain possession of the premises (or to have a receiver appointed for the premises) in order for repair defaults to be cured. Reasonable periods of time should be afforded to the Leasehold Mortgagee to obtain the necessary possession before it must cure such defaults. Most provisions do not call for a specific number of days because it is very hard to predict how long it will take the Leasehold Mortgagee to obtain possession. The ground lease might expressly grant the Leasehold Mortgagee the right to take possession of the leased premises even prior to the appointment of a receiver or completion of the foreclosure process in order to cure defaults or commence collection of rents from occupancy tenants, but state law may prohibit such action on the part of a Leasehold Mortgagee. 8 If the default is not capable of being cured by the Leasehold Mortgagee (either by the payment of money or by obtaining possession of the premises) and the Lessor elects to terminate the ground lease as a result, the ground lease should provide for a right on the part of the Leasehold Mortgagee to obtain a New Lease from the Lessor on the same terms as existed under the original ground lease for the remainder of the term. Typically this right to a New Lease will be conditioned upon the Leasehold Mortgagee curing all monetary defaults on the part of the Lessee, as well as all defaults that are capable of being cured by the Leasehold Mortgagee. Even this provision may not fully protect a Leasehold Mortgagee because it is possible (if the Lessor files for bankruptcy) that the court may find the obligation on the part of the Lessor to provide a New Lease may itself be an executory contract that can be rejected by the Lessor s trustee in bankruptcy by rejecting the ground lease. On the other hand, theoretically it is less likely a 8 See Comerica Bank-Illinois v. Harris Bank Hinsdale, 673 N.E.2d 380, 284 Ill. App. 3d 1030, 220 Ill. Dec.468 (Ill. App. Ct., 1st Dist. 1996) ( a mortgagee... needs to obtain a court s authorization before he may collect rents without taking possession.... actual or constructive possession of the property is required before a mortgagee may collect rents. Because [the mortgagee s] assignment of rents permitted [the mortgagee] to collect rents in contravention of Illinois public policy, we refuse to recognize that provision of the agreement.... the mere filing of the foreclosure action or request for a receiver is not sufficient to trigger the mortgagee s right to collect rents.... rather [it is] the trial court s affirmative ruling on such filings which entitles the mortgagee to the rents.... The rents in dispute were collected during the time the mortgagor was in possession of the property but before the receiver was appointed. Therefore, we find that the trial court was correct in ruling that the rents collected properly belong to the mortgagor. ). See also In re Randall Plaza Center Associates, L.P., 326 B.R. 133 (Bkrtcy N.D. Ill. 2005) ( The Assignment of Rents and Profits clause in the Mortgage... created a valid lien on these rents which [the lender] properly enforced by seeking a receiver and foreclosing on the Property. ) The Randall Plaza court held the lender was entitled to the rents for the time periods from the date of the notice of default under the mortgage given by the lender to the mortgagor up through and including the dates the receiver was appointed, the lender became the successful bidder at the foreclosure sale and thereafter. Neither the Comerica nor the Randall Plaza cases involved Leasehold Mortgages. The application of the law with respect to the allocation of underlying occupancy tenant rents from a project between the Leasehold Mortgagee for application toward the payment of the indebtedness due under a Leasehold Mortgage and the Lessor for application toward the payment of ground rent due under a ground lease when there is a default under both the Leasehold Mortgage and the ground lease is discussed in detail in the case study in Part B.2 below. The Cook 1 Case opinion discussed there contains an extensive analysis of these issues under the laws of a number of states. -5-

6 Lessor s trustee in bankruptcy would reject a ground lease than another type of lease because typically the Lessor has very few obligations under the ground lease and the rents that are paid are net to the Lessor. Section X of Appendix D contains the extensive provision dealing with the bankruptcy of both the Lessee and the Lessor in an attempt to address these concerns. The risk of a Lessor s bankruptcy exists even if there is no default on the part of the Lessee, but should be minimal as long as the Lessee continues to pay its required ground rent to the Lessor. 3. Right to Assign the Leasehold Estate. Lessees will seek assignment rights as broad as possible in order to avoid having to obtain the Lessor s consent. Without broad provisions allowing assignment, a Leasehold Mortgagee will be concerned about the difficulty in finding a replacement Lessee should it foreclose on its Leasehold Mortgage and be the successful bidder at the foreclosure sale, or the difficulty in finding bidders at the foreclosure sale if the ground lease cannot be assigned to the successful bidder. If it agrees to a broad assignment provision, the Lessor should insist on a requirement that the assignee assume all of the obligations of the Lessee under the ground lease effective as of the effective date of the assignment. Section of Appendix A does require this, but Section VI.G of Appendix D, which is more favorable to the Leasehold Mortgagee, does not. Where the ground lease contemplates construction of a new project, and the project has not been substantially completed, Section of the Appendix A provision requires a subsequent assignee that is not the Leasehold Mortgagee to provide a guarantor for completion of the project unless the initial guarantor of those obligations under the original ground lease is honoring its guaranty to complete the project. Under this provision, the Lessee s right to assign its interest (other than to a Leasehold Mortgagee) prior to substantially completing the project is considerably more limited and requires the Lessor s consent. The intent is to preserve the relationship between the Lessor and the original Lessee because, presumably, that Lessee was chosen by the Lessor due to its expertise in developing projects of the type to be developed under the ground lease. The Appendix B provision (see paragraph 1, p. B-1) and the Appendix C provision (see Section 7, p. C-4) both allow the Leasehold Mortgagee to freely transfer the ground lease after a foreclosure sale or other similar type of event by which the Lessee is divested of its interest in the leasehold estate. 4. Limitation on the Liability of a Leasehold Mortgagee Succeeding to the Interest of the Lessee. Leasehold mortgagees do not want to be liable for the defaults of the Lessee, and generally seek to be responsible only for obligations under the ground lease that arise during the period of time the Leasehold Mortgagee actually possesses the leasehold estate. Lessors will seek to have all monetary obligations on the part of the Lessee cured as a condition to the Leasehold Mortgagee succeeding to the interest of the Lessee, as well as any continuing defaults that can be cured once the Leasehold Mortgagee actually takes possession, such as a failure to properly maintain the improvements on the premises. However, those defaults on the part of the Lessee that cannot be cured are either expressly or impliedly waived for those succeeding to the former Lessee s leasehold estate. Typically, the Leasehold Mortgagee will seek to limit its liability under the ground lease to only the period of time when it actually acts as the Lessee under the ground lease, but the Lessor will want to release the Leasehold Mortgagee only if the new assignee Lessee assumes those obligations. For the various way those issues are dealt with in the sample provisions, see Section of Appendix A (p. A-10); paragraph 4 of Appendix -6-