Most leases give tenants the right to assign the lease to another tenant, subject to the landlord’s consent. Many leases also give the tenant a right to assign the lease without the landlord’s consent if the assignment is to an affiliate of the tenant. Some leases go a step further and give the tenant the right to encumber the lease to a lender if, for example, the lender loans the tenant money to purchase equipment, in which case the lease will typically allow the lender to foreclose on the leasehold interest and step into the shoes of the tenant in the event the tenant defaults on the loan. This has the same effect as an assignment of the lease to the lender. Regardless of the type of assignment that takes place, from the landlord’s perspective it is crucial that the incoming tenant be required to execute an assumption agreement whereby the new tenant agrees to assume the lease obligations in writing as a condition to taking possession of the property. In the recent case of BRE DDR BR Whittwood CA LLC v. Farmers & Merchants Bank of Long Beach (2017), a landlord learned the painful lesson of what happens when you do not obtain an assumption agreement from the succeeding tenant.

In BRE, a restaurant tenant was permitted by the lease to encumber its leasehold interest through a mortgage. The provision stated that if the lender foreclosed on its loan, it would be permitted to succeed to the tenant’s interest under the lease “. . . (in which event it shall assume all of Tenant’s obligations under this Lease) . . .” Because of this language, the landlord assumed that its interests were protected and that if foreclosure took place, the succeeding tenant would be bound by the lease obligations. But the landlord assumed wrong. The lender met the lease obligations, but then nine months after the lender foreclosed, it transferred the lease to a third party affiliate, who paid the rent for the next four years. Then, with nine years left on the term, the third party affiliate stopped paying rent and surrendered the premises back to the landlord. The landlord sued the lender.

The trial court sided with the landlord based on the language quoted above, but the victory was short-lived. On appeal, the court stated that, notwithstanding such language, the lender never actually assumed the liabilities under the lease and without a written assumption agreement, the lender was not liable under the lease once it surrendered the premises. The court relied on the distinction between privity of estate vs. privity of contract for its decision. When the lender held possession of the premises, privity of estate existed and the lender was bound by all covenants that ran with the land, including the obligation to pay rent. However, when the lender transferred its interest, that privity of estate was extinguished and it was no longer liable. Privity of estate existed only during that nine month period between foreclosure and transfer to the third party affiliate, during which time the lender was liable for payment of rent. If the landlord wished to keep the lender on the hook for rent for the entire term, it needed privity of contract—without a written assumption agreement, the lender was free.

The Court of Appeal concluded that “no express assumption can be found in this case. [The lender] was not a signatory to the lease. The contract between the [landlord] and Tenant contemplates engaging a mortgage lender, but the provisions cannot form a binding contract on a non-party to the lease. The foreclosure documents do not contain an express agreement to assume the lease. . . . We agree . . . that the language of the documents served to acknowledge the lease rather than assume its obligations.”

Recommendation

So, what does this mean for landlords? Even with language in a lease that states that the lender will assume the liabilities under the lease, a landlord’s rights are not protected. Privity of contract cannot be implied, nor agreed to by an assignor of the interest on behalf of the assignee. The Court of Appeal offered tips to landlords to best protect their interests: rather than merely stating that the lender will assume the liabilities under the lease, the landlord should insist that no lender shall have any rights under the lease without first providing a written assumption agreement to the landlord. The assumption agreement will create privity of contract, in which case the landlord can enforce the lease obligations regardless of whether the lender surrenders possession.