Landlords, Beware The Naked Assignment

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It’s been a while since we’ve pointed out that, using the words employed by a California court in 2001, “[a] lease of real property is both a conveyance of an estate in land (a leasehold) and a contract. It gives rise to two sets of rights and obligations – those arising by virtue of the transfer of an estate in land to the tenant (privity of estate), and those existing by virtue of the parties’ express agreements in the lease (privity of contract).”

Should anyone care? Yes. And, here’s an example that should concern some landlords and benefit some tenants. It deals with a lease assignment.

We’ll lift the words used by two other California courts to explain two different paths by which an assignee takes on liability as the “tenant.” The first is from 1983 and the second from 1937:

An assignee’s liability to the landlord turns on the nature of the assignment. If the assignee takes possession of the premises but no more, privity of estate exists and he is bound by all lease covenants which run with the land. Upon a subsequent assignment, privity of estate ends and, with it, all obligation to the landlord.

This is the liability that arises out of the “conveyance” aspect of a lease. If all a party does is take occupancy without entering into an agreement with the landlord, then when it goes out of occupancy (yields back the premises), it owes nothing further. When that occupancy came through a prior tenant, you have a “naked” assignee (or assignment).

If, however, the assignee expressly agrees with the assignor to assume the obligations of the lease, far different consequences attend. The assumption agreement creates a new privity of contract between landlord and assignee, enforceable by the landlord as a third party beneficiary, regardless of whether the landlord was a party to the assumption agreement. As a consequence, the assuming assignee is required to perform all covenants of the lease for the remainder of its term, absent a release by the landlord.

Here, the law differs from state to state, but if a landlord is looking to avoid litigation, win or lose, following California law would be an intelligently conservative approach – get an express assumption of the contractual aspect of the lease. Other jurisdictions might bind an assignee to the contractual “side” of a lease by implying “acceptance” based on auxiliary documents (to which the landlord is not a party) or on the behavior of the assignee, but that invites an iffy, fact-sensitive dispute, one that can be avoided through careful landlording.

We should make it crystal clear why this is important to a landlord, and why failure to get an express assumption of the lease offers an assignee a way to bail out of a bad location. Again, in the words of a California court:

[T]here must be an express assumption of the contractual obligations of a real property lease to hold an assignee liable for the lease obligations. … Lease covenants that run with the land bind and inure an assignee only as long as it remains in possession of the premises. … As long as he remains in possession the nonassuming lessee is bound to pay the rent, maintain the insurance, make repairs, and pay taxes, if the lease so provides. However, these obligations terminate when the assignee terminates his possession.

Put simply, a “naked” assignee (aka a “bare” assignee) is only bound by the lease covenants that run with the land. Its relationship with the land’s owner is “through” the land. When a naked assignee is no longer “on” the land, that relationship ends. On the other hand, an “express” assignee is one who has entered into a contractual relationship with the land’s owner. That relationship, while arising out of the parties’ mutual interest in a certain piece of land, does not end when the assignee-tenant leaves that land. The assignee-tenant remains obligated under the “contract” (read that: lease) even if it leaves the land.

Now, for those readers who have made it this far down the page, here’s a story about a permitted assignment that didn’t rise to the level of an express assignment. In this story, an assignee was able to give back the keys and avoid future liability.

Though a lease required the landlord’s consent to a tenant’s assignment, it permitted an assignment by way of a leasehold mortgage. Here’s an edited version of that lease’s leasehold mortgage provision:

Tenant shall have the right … to encumber Tenant’s leasehold interest under this Lease … through a Mortgage (‘Leasehold Mortgage’) with an institutional lender … Landlord agrees that in the event the Leasehold Mortgagee succeeds to Tenant’s interest under this Lease (in which event it shall assume all of Tenant’s obligations under this Lease), Landlord shall, at the time of such succession, recognize such mortgagee, trustee or lender as the then Tenant under this Lease upon the same terms and conditions contained in this Lease and for the then unexpired portion of the Term.

The leasehold mortgagee had the right under the lease to acquire and succeed to the tenant’s interest through a foreclosure sale.

Assignments by means other than through a leasehold mortgage required the assignee, in writing, to expressly assume all of the tenant’s obligations and liabilities under the lease.

As readers have successfully guessed, the original tenant in the case we looked at granted a leasehold mortgage and that mortgage was foreclosed. The foreclosing lender (later placing the lease into a newly created subsidiary) was the successful bidder in the foreclosure sale and thus became the tenant. It never expressly assumed the lease. [Remember, the lease did not require such an assignee to do so.] The lender-tenant paid the rent and observed the lease’s terms until it stopped doing so. That was when it “walked out” of the space, yielding the premises back to the landlord.

The landlord (unsuccessfully) argued that the lender-tenant had actually assumed the “contractual” aspects of the lease. It pointed to the public notice provided by a recorded memorandum of lease, in particular this excerpt:

All of the rights and obligations of the Parties under the Lease shall bind and inure to the benefit of their respective heirs, successors and assigns; provided, however, that nothing [i]n this Section 9 shall be construed to limit or waive the provisions concerning restrictions on Transfer set forth [i]n Article 8 of the lease.

The lender-tenant also replied to an inquiry from the landlord, saying that its interest in the lease “continues to be held … via an LLC in which [the lender was] the majority member.”

Lastly, the landlord obtained a tenant estoppel certificate certifying that it was the successor in interest to the original named tenant. That certificate recited the lease’s 2023 expiration date. This certificate came from a party to whom the lender-tenant desired to further assign the lease. Though the landlord rejected this proposed assignee as financially unworthy, presumably the lender-tenant, though not a signatory, was involved in the certificate-obtaining process. [Note: we think this was a “Hail Mary” argument by the landlord, but you go with what you got.]

Nonetheless, despite the “warning” in the recorded memorandum of lease, the written statement from the lender-tenant that it held an interest in the lease, and the estoppel certificate that acknowledged the lease ran into 2023, an appellate court could not find the “magic” express assumption. Consequently, the lender-tenant’s obligation to pay rent ran only to the date it gave up possession of the premises. Here’s how the court said that:

We adhere to the reasoning set forth in [an earlier case] and conclude no express assumption can be found in this case. [The lender-tenant] was not a signatory to the lease. The contract between the original owner 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. The deed of trust, notice of trustee’s sale, and deed upon sale reference the memorandum of lease, but do not provide any express terms by which [the lender-tenant] agreed to uphold the lease covenants or provisions in the memorandum of lease. We agree with the rationale set forth in [our prior case law] that the language of the documents served to acknowledge the lease rather than assume its obligations.

[The lender-tenant] was not a signatory to the tenant estoppel certificate. [It] executed the tenant estoppel certificate, but no fresh contract was entered into with [it], because Landlord refused to consent to [the lender-tenant] as assignee. The evidence establishes nothing more than a “naked assignment” to [the lender-tenant]. [The lender-tenant] never assumed the lease obligations and was required to pay rent only until it surrendered possession of the premises.

The landlord “could have protected itself by requiring the mortgage lender to sign the lease or a document assuming the lease obligations. It did not do so.” The landlord, “as a signatory to the initial lease, was in the best position to protect itself by including provisions in the lease requiring consent and assumption. … The lease did not direct Tenant to obtain an assumption from the mortgage lender as it did in the event of a transfer under the lease.”

So, if it hasn’t been clear enough yet, the lender-tenant was nothing more than a naked assignee, never assumed the lease obligations, and only had to pay rent until it surrendered the premises.

Forewarned is forearmed.

For those desiring a more comprehensive understanding of the court’s decision driving today’s blog posting, all you have to do is to click: HERE.

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