Estate Finance Notes
Lower inflation risk leads to lower long-term interest rates. Even though the Federal Reserve raises short-term interest rates, more confidence is created that there won’t be inflation long-term.
The balance of bargaining power
The Restatement of Mortgages § 4.1(a) sides with the lien theory states. § 4.1(b) says that generally mortgages can’t grant an enforceable right to possession in the future to the mortgagee. Why do you need both? You can’t make an agreement at the time the mortgage is being entered into that will give the mortgagee the right to possession. But later events can allow that to happen. The balance of power changes between the borrower and lender once the borrower has the money. When the borrower needs the money, the law presumes that they may agree to just about anything in order to get their hands on the money. So the law tries to protect these people due to their perceived lack of borrowing power. Once the borrower has the money and the lender wants to get it back, the borrower has the upper hand. So you can’t make an agreement like this at the outset as part of the loan transaction, but if certain events come up later, agreements with respect to possession will be enforced. This is a concept we’ll come back to again and again: the premise is that borrowers lack bargaining power at the outset, but not once the transaction is completed.
The mortgagor gives a mortgage, and is supposed to pay it in 10 equal installments. After three payments, the mortgagee discovers that the mortgagor is in financial difficulty and the remaining payments are unlikely to be made. The mortgagee sues to obtain possession. What’s the result? It doesn’t matter if you discover you’ve made a bad loan. You have no right to possession until something happens. So in this case, the mortgagee will lose. The worry that you won’t get paid in the future is every mortgagee’s worry to some extent, but it doesn’t authorize possession.
Now let’s say that the mortgagor defaults on the fourth payment. The mortgagee forecloses and seeks an order placing the mortgagee in possession. What happens now? Can the mortgagee get possession now? Nope. You can only get the property sold and get the money. But keep in mind that the (former) mortgagee could show up at the foreclosure sale and buy the property. In that case, the mortgagee is not entering into possession as a mortgagee, but rather as a purchaser. In a lien theory state, the mortgagee as mortgagee almost never has a right to possession.
What if the mortgage contains a provision that says the mortgagee will get possession on demand after default, and the mortgagee makes a demand for possession? This is unenforceable under the Restatement.
But should the mortgagee take possession? Is it advisable? Even if you have a right to possession as a mortgagee, it’s probably not a very good idea. The mortgagee is delegated a very strict fiduciary duty of accounting. Any rents or income you collect that are above the amount owed must be credited to the amount owed. You must act like a prudent owner, which may well mean you have to dig into your own pocket to take care of the property and make it productive. You may also be liable to third parties in tort. So this is a risky proposition, and there is a cleaner, easier route to take: the receivership. Finally, the mortgagee in possession will work just like a foreclosure as far as leases are concerned. If you want to go into possession to intercept the rents, but going into possession terminates the leases, then it’s not such a great idea to take possession. Lenders prefer to have a receiver appointed by the court. But there are costs and risks in this case too. The receivership may be expensive, and you’re not guaranteed a receiver who is competent. But all in all, it’s a better alternative than taking possession.
The effect of mortgages on lease obligations
In commercial mortgages, the lease obligations of tenants may be more important than the value of the real estate. Take a shopping center, for example. Easton and Northland both have buildings and land and stuff, but Northland is not worth nearly as much as Easton because the landlord gets paid by having a loan on productive property, that is, by having enough rent coming in to pay the mortgage. The lender goes into the transaction hoping to get repaid with interest. If the lender takes possession, however, the leases get terminated.
What about when a mortgage is foreclosed? It depends on the relative priority of the mortgage and the lease. The purchaser at foreclosure gets the title as it existed immediately before the mortgage being foreclosed was granted. If the lease was entered into before a mortgage and that mortgage forecloses, then the tenant is still bound under the lease. But if the lease came after an earlier mortgage, then the foreclosure of the mortgage will terminate the lease. So if the lease has priority, the tenant has no right to terminate the lease, and neither does the purchaser at foreclosure. The tenant must attorn to the foreclosure purchaser, meaning that the tenant must treat the purchaser just the same as they treated the original landlord.
If the foreclosure is going to terminate the lease, why does the lender care about the continuation of the leases anyway? If we represent lenders, we can protect ourselves up to the moment of foreclosure by having a receiver appointed instead of going into possession. Why does the lender care what happens after foreclosure? The purchaser at foreclosure is going to pay more for a productive property with lots of leases, which makes it more likely the lender will get their debt paid back.
So if the lease has priority, we know the legal result. But what if the mortgage has priority? If the tenant is a party to the foreclosure, the tenant’s lease is terminated. That means that even if the foreclosure purchase wants to keep the tenant, the tenant can walk away. Also, the tenant can’t force the purchaser at foreclosure to accept the tenant since the lease is terminated. In some states, the mortgagee can intentionally omit the tenant and keep the lease in effect, or in other words, pick and choose. If you don’t join a party and they don’t have notice, their rights can’t be adversely affected. The lawsuit won’t have an effect as to them. So if the lender doesn’t join the tenants they want to keep, their leases will not be terminated. (Come back to this, I’m a little unclear on it.)
lease is above market rate (unless there is some problem with Fiber Form). So
This deal was structured with “optional unsubordination”. It’s fine if it works right, but you could get a problem like we saw in this case. The Restatement says that you can’t have a subordination or unsubordination that “materially prejudices the person whose interest is advanced in priority without their consent”. Another way the deal could have been done is with an “attornment” clause in the lease, saying that the lessee agrees to attorn to the purchaser at foreclosure and their successors in interest. Finally, you could use a so-called “new lease” agreement. This is not automatic. But you could have a provision in the lease that in the event of a foreclosure or transfer, the tenant agrees to execute a new lease that is identical to the current lease with the subsequent purchaser. The problem is that it’s not self-executing, so the tenant might not make the new lease. Also, what if the tenant can’t execute the new lease. It might be difficult to get performance of this future act. From the mortgagee’s perspective, the attornment clause is the most desirable. The clause must be in the lease, or something else that the tenant has signed. It can’t be just in the mortgage.