Priorities Between Mortgagees and Tenants

In evaluating the risk associated with lending to a particular debtor who is offering a rental property as collateral security for the debt, a lender will often look at the type of tenant renting the property and attempt to evaluate the strength of the relationship between the landlord and the tenant. An anchor tenant is always more valuable and a lender will seek to insure that the tenant remains on the property and continues to pay rent even when the mortgagor goes into default under the loan.

The general law of priorities between landlords and mortgagees is well settled. The priorities can be divided into two distinct categories: where the lease has been entered into prior to the mortgage and secondly where the lease has been entered into subsequent to the mortgage.

Lease Before Mortgage
Where the lease has been entered into prior to the mortgage the lease will have priority over the mortgage in the sense that the mortgagee takes the property subject to the lease. The mortgagee has no power to evict the tenant and therefore must allow the tenant to remain in possession until the lease expires or is terminated. Until the tenant receives a notice from the mortgagee the tenant is entitled to make all rental payments to the mortgagor. However once notice has been given to the tenant, the tenant must pay all sums to the mortgagee which are payable on or after the date when the mortgagee took possession of the property. Once the mortgagee becomes entitled to possession as landlord, the mortgagee has the ordinary rights of a landlord in terms of requiring that rent be paid to it. There is no requirement that the tenant and mortgagee have previously entered into what is commonly known as an attornment agreement. The relationship between the mortgagee and the tenant arises automatically once the mortgagee takes possession of the property.

Lease Subsequent to Mortgage
Where the lease is entered into after the mortgage has been registered, the mortgagee is entitled to evict the tenant once it takes possession of the property. In addition the tenant is also entitled to treat the tenancy as at an end when the mortgagee takes possession of the property. The tenant is not required to pay rent to the mortgagee. Nor can the mortgagee require rent to be paid. The mortgagee's only available course of action is to evict the tenant and claim damages for any rent which accrued while the tenant remained in possession but failed to pay rent. Therefore, absent any agreement to the contrary, once the mortgagee is entitled to take possession the tenancy relationship automatically terminates.

The question therefore becomes what is a sufficient agreement to the contrary to enable either the mortgagee or the tenant to require the other to honour the tenancy relationship where the lease has been entered into subsequent to the mortgage. It is generally accepted that privity of contract must be established between the mortgagee and the tenant. Privity of contract is a legal principal which states that a person who is not a party to a contract can not enforce it. For example, if X and Y enter into a contract whereby X agrees to pay Z a certain sum of money, but Z is not a party to the contract, Z can not force X to make payments under the contract.

The traditional documents used to create privity of contract between the mortgagee and the tenant have been attornment and non-disturbance agreements. In an attornment agreement the tenant agrees that upon default under a loan by the landlord the tenant will continue to treat the tenancy relationship as in existence and will treat the mortgagee as landlord. A non-disturbance agreement provides that upon default by the landlord under a loan, the mortgagee will allow the tenant to remain in possession of the premises.

General assignments of rent and assignments of leases have also be used with the expectation that they created privity of contract. It was assumed that since the mortgagee was assigned all of the landlord's rights under the general assignment of rents and leases, that the tenant would be required to honour the lease upon the landlord's default under the loan.

However the Ontario Court of Appeal in re: Goodyear Canada Inc. vs. Burnhamthorpe Square Inc. held in an October, 1998 decision that a tenant was not required to pay rent to a mortgagee despite the fact that the mortgagee had obtained an assignment of the rents and leases from the mortgagor.

The facts of this case are as follows. The landlord provided a mortgage and a general assignment of rents and leases. Subsequent to the registration of the mortgage it entered into a lease with the tenant, Goodyear Canada. Although both the landlord and the tenant intended to have the mortgagee execute a non-disturbance agreement, the agreement was never executed. The landlord went into default under the mortgage and the mortgagee took possession of the property. The mortgagee served notice on the tenant to pay rents to the mortgagee. The tenant did in fact pay rent to the mortgagee and delivered an estoppel certificate or what is commonly known as a lease acknowledgment. The lease acknowledgment stated that the lease was in full force and effect subject to whatever legal effect the possession by the mortgagee had on the lease.

The Court considered whether privity of contract existed between the mortgagee and the tenant. The Court looked at the mortgage and the assignment of rents and leases. The Court noted that the mortgage stated that it was an absolute assignment. However, the Court ruled that the assignment was intended as security only. This means that the mortgage and assignments of rents were not true assignments because they did not assign the landlord's obligations to the mortgagee. In other words, the mortgagee was entitled to all of the rights of the landlord under them such as payment of rent, but the mortgagee did not become obligated through these agreements to perform the landlord's duties. In fact, the assignment of rents specifically stated that: "the mortgagee shall not by reason of this assignment of leases and rents or the exercise of any right granted herein be obligated to perform any obligation of the landlord".

The Court held on the facts of the case that privity of contract between the tenant and the mortgagee did not result from the assignment of rents given the substantial remaining rights and obligations on both sides of the lease agreement which were not assigned by the landlord or accepted by the mortgagee. In fact, the Court quoted from the Supreme Court of Canada that an absolute assignment can not function as a means of securing the payment of debts since there would be no basis for the debtor to recover anything which had been assigned. In other words an absolute assignment is irrevocable while an assignment as security only is not.

The Court referred to the non-disturbance agreement which the landlord and the tenant expected the mortgagee to execute. As stated earlier, this non-disturbance agreement was in fact never executed. However the Court stated that if it had been executed there would have been no doubt that it created privity of contract between the tenant and the mortgagee. Consequently, the tenant would have been required to continue to pay rent to the mortgagee and to honour the lease even after the mortgagee took possession of the property.

After the mortgagee took possession of the property, Goodyear Canada did execute an estoppel certificate or what is also known as a lease acknowledgment. The important point to note is that this document was executed after the mortgagee took possession. Goodyear Canada specifically acknowledged that the lease was in full force and effect subject to whatever legal effect the possession by the mortgagee had on the lease. Therefore the tenant acknowledged that the lease was valid even after the mortgagee took possession. However this acknowledgment was specifically limited. Consequently, due to the limitation, the estoppel certificate did not create a relationship between the mortgagee and the tenant.

Although the Court found that the tenant was not bound by the original lease entered into by it and the landlord, the Court did find that a year to year tenancy had been created between the mortgagee and the tenant. This is because once a mortgagee sends notice to a tenant that the tenant is required to pay rent to it and the tenant does actually in fact remain in possession of the premises and pays rent to the mortgagee, a year to year tenancy will result by operation of law. This means that a verbal lease agreement is entered into between the tenant and the mortgagee. A year to year tenancy may only be terminated upon six months notice. Therefore even where a lease is entered into after a mortgage, if the tenant does in fact pay rent to the mortgagee after the mortgagee goes into possession, then the tenant must give six months prior notice before the tenancy can be terminated.

To summarize this case, therefore, an agreement must be entered into between the mortgagee and the tenant whereby the tenant agrees that upon default by the landlord, the tenant will continue to treat the lease as if in full force and effect and will continue to make payments to the mortgagee even after the mortgagee goes into possession of the premises. An assignment of rents and leases is not sufficient.

We have reviewed the standard lease acknowledgment generally used when rental based security is taken from a borrower. The tenant is required to make the following statement in the lease acknowledgment We understand that the lender has or will have a mortgage registered against the property and we confirm that upon receipt of written notice from the lender we will immediately commence paying to the lender the rent due under the lease and we confirm that any receipt by the lender of rent will not make the lender liable as landlord pursuant to the lease or any way impose the obligations of a landlord. We confirm that our interest in the property is subordinated to the mortgage in favour of the lender and any extensions, renewals or amendments.

Therefore the important question is whether this statement provided by a tenant before the landlord has gone into default under the mortgage is sufficient to obligate the tenant to honour the lease even when the mortgagee goes into possession. It is our opinion that this wording is not satisfactory. It would be preferable for the tenant to specifically acknowledge that it will attorn to the mortgagee as landlord. In contrast, the acknowledgment merely states that the tenant will pay rent due under the lease. This could be interpreted as requiring the tenant to only pay rent which has accrued while the tenant has been in possession but which the tenant has not yet paid. In light of the decision in Goodyear Canada Inc. a cautious approach should be taken and more explicit language should be drafted into the lease acknowledgment or estoppel certificate. In addition, whether a lease acknowledgment can create privity of contract between the mortgagee and the tenant has not been tested by the courts as of yet. Therefore where the lease has been entered into after the mortgage, a document such as an attornment agreement or non-disturbance agreement should be utilized.

The Court in Goodyear Canada Inc. did state however that where a lender appoints a receiver to manage the property and take rents from the tenants, the lease is not terminated. Therefore the lease will only be terminated when the mortgagee takes possession of the premises itself but not through a receiver.

The ramifications of this case are not limited to situations involving assignments of leases. The reasoning of the case will apply wherever an assignment is taken from a debtor as security. If the assignment agreement states that the secured party only obtains an assignment of the debtor's rights under the agreement but not the debtor's obligations under the agreement, then the secured party would have no standing to enforce the agreement if the debtor chose not to. Therefore whenever an assignment is being taken as security, the other party to the agreement pursuant to which the assignment is taking place, should execute a consent to the secured party taking the assignment.

Prepared May 10, 1999 by Danielle Iampietro, Associate
Commentary is of a general nature and is not intended as legal advice. Specific advice should be sought with respect to each specific case.

© Scarfone Hawkins LLP, 1999
Priorities between Mortgagees and Tenants