Who’s on First? Understanding SNDAs

January 2016

A typical real estate transaction begins with a buyer/landlord obtaining a loan from a lender to help pay for the purchase price. In some cases, during the time of ownership, the landlord may also obtain a new loan in connection with a refinance of the property. To make the loan in either situation, the lender requires the landlord to provide the lender with a security interest in the property. The security interest (documented by a deed of trust or mortgage) provides the lender with a right to foreclose on the property and become the new owner if the landlord fails to pay back the loan. A foreclosure, however, may result in the termination of existing leases. Terminating existing leases could be beneficial or harmful to a lender or a tenant, depending on the circumstances. For example, a tenant that is paying below market rents will not want to have its lease terminated; and a lender will not want to have the property’s leases terminated and lose out on the income generated through rents. To avoid risks to either side, the parties negotiate SNDA agreements to address their rights and obligations following foreclosures. SNDAs consist of three major covenants: (1) subordination (S); (2) non-disturbance (ND); and (3) attornment (A). This article contains a brief overview of what these covenants mean.

Subordination
A subordination covenant determines the priority of a property interest (such as a lease) relative to other existing or future interests in the property (such as a mortgage). The priority of interests is important because the general rule in California is that a buyer at a foreclosure sale takes the property free and clear of all subordinate interests, while all superior interests remain in place. Said differently, if a foreclosure occurs, all interests on the property that have a lower priority than the interest being foreclosed upon are extinguished by the operation of law.

California uses the “first in time, first in right” system to determine the priority of different conveyances of interest in real estate. Under this system, a conveyance recorded first (such as an initial mortgage used to help pay for the purchase price) has priority over all other conveyances that come after it (such as a lease signed by the new owner of a property following a purchase).

A typical subordination covenant will alter this “first in time, first in right” system by requiring a tenant to agree that its leasehold interest in the property will be subordinate to all security instruments that exist at the time of the agreement or that are placed on the property in the future. This subordination ensures that a tenant’s lease will always be inferior (or subordinate) to any mortgage or other security interest placed on the property, no matter when such security interest is attached. As a result, a lender will be able to foreclose on the property and terminate all the leases. To protect against unwanted lease terminations, the lender and tenant negotiate for additional protections in the form of non-disturbance and attornment covenants.

Non-Disturbance
A non-disturbance covenant requires a lender to agree not to disturb a subordinate interest in the event of a foreclosure, i.e., the lender must allow the property interest to continue in place as though the foreclosure did not occur. Thus, even if a tenant has agreed to subordinate its interest to all future security interests, a non-disturbance covenant prevents a tenant’s lease from being extinguished by the operation of law during a foreclosure. Lenders typically require that a non-disturbance covenant be made conditional upon the tenant not being in default at the time of the foreclosure in order to be effective.

Attornment
A covenant of attornment requires a tenant to agree to recognize a new party as its landlord. Attornment benefits a lender because it provides assurance that a tenant whose lease remains in place after a foreclosure must recognize the lender as its new landlord. Attornment also establishes direct privity between the lender and tenant, which binds the parties to the lease and guarantees the lender can enforce the lease and receive benefits as the landlord (such as receiving payments of rent). Lenders generally attempt to limit their liability to tenants for the acts or omissions of the previous landlord by inserting specific provisions regarding the pre-payment of rent, payment of tenant improvement allowances, return of security deposits, etc., which should be specifically negotiated by the parties in the SNDA.

Combining the Covenants
The three major SNDA covenants work collectively to protect the interests of lenders and tenants in the event of a foreclosure. Subordination guarantees a lender that its interest will remain senior to a tenant’s interest, but is generally provided on the condition that the lender agrees not to disturb the tenant’s lease upon foreclosure. Finally, attornment establishes privity between the lender and tenant, and allows the parties to enforce the terms of the lease as though the lender was the original landlord.