April 2007

You have decided to provide financing to the owner/developer ("Mortgagor") of a single tenanted real estate development ("Realty").  Your loan agreement/commitment letter agreement with the Mortgagor obligates the Mortgagor to provide you with a mortgage charging the Realty and a security assignment of the Mortgagor's from time to time existing rights as landlord under its lease ("Lease") of the Realty to the tenant thereof ("Tenant"), including the Mortgagor's right to the payment of rental.

From a "security" point of view, what you now hope and expect you would have to cover potential losses in the situation where the Mortgagor fails to repay the loan would be:

(i)            the right to sell the Realty (with the Lease) and thus recoup the loan indebtedness, in whole or in part, and if in part only, a continuing right to claim against the Mortgagor - and perhaps under other securities including guarantees - for any shortfall, and, if there was no meaningful "market" for a sale of the Realty, the right to foreclose upon and become the absolute owner of the Realty; and

(ii)           under the security assignment covering the Mortgagor's rights and claims under the Lease ("Security Assignment"), the right to collect the rents payable under the Lease, and the right to "step into the shoes" of the Mortgagor as landlord under the Lease and thus hold the Tenant to all of its from time to time existing obligations under the Lease (including the obligation to pay rent).

You would also (typically) want an understanding with the Tenant whereby, in essence, the Tenant agrees to subordinate its rights and interests in the Realty under the Lease in favour of your rights in the Realty under the Mortgage.  In exchange therefor, you would undertake to the Tenant that if you realized your security (including by way of mortgage sale proceedings, taking possession or by way of foreclosure) consequent upon default by the Mortgagor, neither you nor any mortgage purchaser from you would (notwithstanding your priority under your mortgage with respect to the Realty) extinguish/terminate the Lease, provided that the Tenant continued to fulfill its obligations under the Lease.  In other words, you would enter into what is commonly known as a "postponement and non-disturbance agreement" ("PNDA") with the Tenant.  Now assume that, some time after advancing the loan, the Mortgagor defaults in its loan obligations to you.  You demand repayment in full (having given an acceleration notice to the Mortgagor), start mortgage realization proceedings, and, in order to try to maintain some cash inflow from your investment, you notify the Tenant that you are proceeding to realize your security (including under your Security Assignment) and that you now require the Tenant to immediately commence to pay its rentals to you, rather than to the Mortgagor.

Imagine your shock, dismay - and perhaps disgust - when the Tenant responds by advising you that its obligation to pay rent under the Lease must be set off against a judgment previously obtained by the Tenant against the Mortgagor ("Judgment").  The Judgment is for a very substantial amount of money and arose out certain previous outrageously bad conduct of the Mortgagor as landlord under the Lease.

The foregoing is almost exactly what happened to the mortgage lender (the "Mortgagee") in a Ontario Court of Appeal decision (the "TDL Case", judgment rendered July 27, 2006).  Unfortunately for the Mortgagee, the Court agreed with the Tenant's position, with the result that the Mortgagee was unable to collect rent from the Tenant. 

It is interesting to note (in the context of the discussion which follows below) that the Security Assignment in the TDL Case - unlike the one described in the hypothetical situation set forth above - was not an assignment of all of the Mortgagor's rights and claims as landlord under the Lease; rather it merely covered the Landlord's right and claim to the rentals payable by the Tenant.  It is also interesting to note that the Lease - which established a contractual relationship between the Mortgagor and the Tenant - specified that the Tenant was to pay rental "without any set off" (with one minor exception).

The Mortgagee's problem here was the wording in the PNDA.  Obviously, the Mortgagee would have preferred that the Court hold that its relationship with the Tenant was governed by the terms of the Lease  which negatived the possibility of the Tenant setting-off any claims it had against its landlord, against the rental.  However, the Court noted that - unlike the Lease, which established a contractual relationship between the Mortgagor/landlord and the Tenant - the PNDA established a contractual relationship between the Mortgagee and the Tenant, and it was this contractual relationship which governed the Mortgagee's claim to rentals.  In particular, under the PNDA, the Mortgagee promised the Tenant that if the Mortgagee realized its security and "stepped into the shoes" of the Mortgagor/landlord under the Lease, then the Mortgagee (in the Court's words) "simply took over the landlord's position under the Lease, (and), absent an agreement to the contrary, the Mortgagee was bound by the state of accounts between (the Tenant) and (the Mortgagor/landlord), which included (the Tenant's) right of set-off".  Unlike what is included in many similar agreements between mortgagees and tenants, the PNDA did not contain a promise by the Tenant that it would not be entitled to set-off its Lease related claims against the rent that it would otherwise be obliged to pay to the Mortgagee.

There is a suggestion in the TDL Case that had the Mortgagee taken a Security Assignment which covered not just the rentals payable under the Lease, but also all of the Landlord's rights under the Lease - and presumably, did not enter into the PNDA - the Mortgagee might well have been able to claim rents from the Tenant and enforce the Tenant's Lease promise or agreement not to set off.  Nevertheless, it is the absence in the PNDA of a provision prohibiting the Tenant from setting off which really did in the Mortgagee here.  The Court noted that the PNDA was in the Tenant's form, and that it appeared that the Mortgagee (and/or its advisors) did not attempt to modify the contents of the PNDA.  The Court also observed that "…both sides were represented by experienced commercial lawyers…".

Also, the language of the PNDA was not ambiguous, so there was no room for the Court to employ the rule of interpretation which requires a contractual ambiguity to be resolved against the interest or position of the party who drafted the contract.

An even more frightening scenario from a mortgagee's point of view would be a situation in which the PNDA not only failed to prohibit set-off by the tenant, but also - perhaps inadvertently - obligated the mortgagee to completely honour all of the mortgagor/landlord's obligations under or by virtue of the lease existing at the time that the mortgagee starts to realize its security and, in effect, "steps into the shoes" of the mortgagor/landlord.  What if, given such an arrangement, the tenant then had a claim - whether in the form of a judgment or some other claim such as a right to reimbursement for leasehold improvements - which exceeded all of the rentals payable under the lease for the balance of its term?  Arguably, the mortgagee would not only lose the benefit of rental, but would also be liable to the tenant for the excess of its claim over the rental!

What should mortgagees do to protect themselves from the problems encountered by the Mortgagee in the TDL Case?  Consider the following:

1. Ensure that any PNDA entered into with a tenant makes it clear that the tenant must, following the mortgagee's "stepping in", continue to fulfill the tenant's ongoing obligations under the lease, including its obligation to pay rent, without any set-off, and notwithstanding the occurrence of any pre-existing default or defaults by the mortgagor/landlord under the lease.
2. Ensure that the lease clearly provides that the tenant's promise to pay rental is buttressed by a further promise not to set-off any claims which the tenant may have against the landlord against the tenant's rent obligation, and, take an assignment of all of the mortgagor/landlord's rights, claims and entitlements under the lease, not just an assignment of the rentals payable, and, make sure that the security assignment makes it clear that the benefit of the tenant's agreement not to set-off is included in the assignment.
3. Ensure that the PNDA includes a promise by the tenant to periodically provide the mortgagee with written statements (commonly called "estoppel certificates") advising as to the estate of accounts between the mortgagor/landlord and the tenant.  Depending on the frequency with which the mortgagee obtains such information from the tenant, these statements will probably alert the mortgagee to a recently developing problem in the landlord - tenant relationship.  However, if a long time passes between when the mortgagee obtains these statements, by the time it does get a current one, a full-blown problem may have arisen and "matured".