Can A Tenant Walk Out And Lawfully Stop Paying Rent When It Tires Of The Space?

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A restaurant’s lease permitted leasehold mortgages with the following proviso:

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.

Any such leasehold lender had the right under the lease to take over the tenant-borrower’s leasehold interest through a foreclosure.

[As to transfers of the tenant’s interest in the lease other than by way of a leasehold mortgage, to be valid, the assignment document needed to provide for “the assumption by the Transferee of all of the obligations and liabilities of Tenant” under the lease.]

The restaurant tenant recorded a memorandum of lease giving public notice of these transfer provisions.

Right after the lease was signed and the memorandum recorded, a bank lent construction money to the tenant relying on the tenant’s leasehold interest in the lease as collateral under a mortgage. The mortgage also assigned the tenant’s leasehold interest to the bank. Two years later, the restaurant tenant defaulted and the bank acquired the tenant’s interest in the lease by way of a foreclosure deed. It then re-deeded the lease to a subsidiary.

The bank’s subsidiary paid rent for about four years and then surrendered the leased space with the intent to terminate its leasehold estate, whereupon it stopped paying rent. The landlord wasn’t real pleased. So, it sued the bank and the subsidiary for rent. The legal issue raised was whether the bank (not its subsidiary) had an obligation to pay rent for the period beyond the surrender. [Later, we’ll explain why the subsidiary was treated differently.]

[And now a word from our sponsor – Ruminations. It’s time for a little law.]

Avid readers with decent memories and those well-schooled in the law will know that a lease is a hybrid of two legal branches – real property and contracts. A lease is both a “conveyance” of an interest in land giving rise to certain rights and obligations (under “conveyance theory”) and a different set of expressly agreed-upon rights and obligations (under “contract theory”). Under conveyance theory, a tenant’s successor only gets those rights and is only bound by those obligations that “run with the land.” Its “connection” to the landowner (think, landlord) is called “privity.” Since this privity arises not by reason of the terms of the lease itself, but rather though the fact that the successor actually took over the tenant’s leasehold interest in the real property, this kind of privity is called: “privity of estate.” The word “privity” means a relationship recognized by law. The word “estate” harkens back to the “land” or real property, being an interest in that land or real property. A tenant’s leasehold interest is such an “interest in real property.”

If, however, the successor expressly agrees to take over the “contractual” obligations of the tenant, then there arises a (kind of) new contract, this one being between the successor and landlord. That connection is also one of privity, this time “privity of contract.” The “new” contract recites all of the tenant’s, and thus the successor’s, expressly agreed-upon rights and obligations.

THIS IS NOT MERELY A HISTORIC ODDITY OF LAW. The dual nature of a lease – the differences between the two “privities” arising out of the landlord-tenant relationship – has consequences.

If there weren’t differences between the rights and obligations arising out of the two different privities, we wouldn’t have grist for today’s blog posting. Fortunately, there are.

One critical difference, and one that needs to be fully appreciated, is that under privity of estate, the successor is only “on the hook” while it is in possession of the premises. Once it transfers its right of possession, its “connection” ends; the “connection” is transferred to the next “tenant.” This is not the case for its “privity of contract” rights and obligations. There, to know which survive and which do not, the contract must be read. That’s because the “contractual” relationship between a tenant and its landlord is rooted in the words found in the lease.

Under privity of estate, rent is paid in exchange for possession. When possession ends, so does the rent. Under privity of contract, the express terms of the lease will dictate whether the tenant is obligated for future unpaid rent after assigning its interest in the lease.

We know that what we’ve written thus far might be little more than gobbledygook to some readers, so we’ll reproduce an explanation given in a 1920 California court decision. We do this because 100- year old law sits on a pretty good foundation and also to demonstrate that even in a state whose law is not based on English common law, the two “theories,” estate and contract, also apply. Here’s the quoted explanation:

An occupant of real property who holds by virtue of a bare assignment of the lease and without entering into any contract, either with his assignor or the lessor, affirmatively binding himself to fulfill the covenants of the lease, is subject only to such obligations as he impliedly assumes by entry and taking possession of the lease premises. [Citations.] … Where, however, the assignee expressly agrees in writing to be bound by the terms of the lease, there arises, as distinguished from any obligation resulting from mere occupancy, a new and different obligation … based upon privity of contract.

[We now return to our regularly scheduled program.]

Those readers who have gotten ahead of us might be asking why, other than for pedagogical reasons, Ruminations has bothered to dither about privities when the lease expressly said that a mortgagee (e.g., the bank-lender), upon taking over the tenant-borrower’s leasehold interest, “shall assume all of Tenant’s obligations under” the lease and the bank had actual notice (and, by reason of the recorded memorandum of lease, constructive notice) of this burden, i.e., assuming the tenant’s contractual obligations. Isn’t that the end of the story?

One clue that it is not, is that there is more to read today.

Continuing our “story,” there was no argument that the foreclosure deed made the bank into the tenant under the lease and this transfer of the tenancy was an assignment. The “conveyance” by deed constituted that transfer of an “interest in real property.” The relationship created was one of “privity of estate.” The question was whether this particular assignment also constituted an assumption of the tenant’s contractual obligations under the lease. Here, the landlord argued that because the deed of foreclosure referenced the lease itself, the deed also constituted an express assumption of those contractual terms. If so, the bank and the landlord would also have had the relationship described as a “privity of contract.”

Well, the landlord wasn’t happy with the outcome. That’s because for such a relationship to be created, the bank would have had to “expressly agree[] in writing to be bound by the terms of the lease.” And, since the only document of “assignment” was the foreclosure deed, there was no such express agreement to be bound by the contractual provisions of the lease. More directly, while a contractual obligation might obligate a tenant to pay rent until the end of a lease term, under the conveyance portion of a lease, rent stops when possession is surrendered.

A much simpler way to explain this is to point out that the bank did not take possession of the leased space by virtue of the lease; it took possession by virtue of the foreclosure deed. It was not a signatory to the lease. Nothing in the words of the lease was incorporated into the terms of the foreclosure deed even though the lease itself was referenced in the deed.

The landlord could have protected itself by including, in the lease itself, a requirement that the bank sign the lease itself or sign an express agreement to assume the tenant’s obligations, either being a condition to allowing leasehold financing in the first place. That’s why there was no issue that the bank’s subsidiary, as its parent’s assignee of the lease, was not dragged into this legal battle. The subsidiary had executed an estoppel agreement in which it expressly assumed the obligations of the tenant under the lease. Presumably, the subsidiary had no assets and that’s why the landlord chased the bank.

How does Ruminations know all of this about the tenant-borrower, the bank-lender, the bank’s subsidiary, and the landlord? We know this because of an August 29, 2017 decision from the Court of Appeals of California Readers can see that decision by clicking: HERE.

A question that arises, but one beyond the scope of today’s treatment, is whether the landlord had any contractual obligations to the bank after the foreclosure other than those arising out of the privity of estate, i.e., the obligation to give possession in return for rent. We don’t know if we’ll ever deal with that topic, keeping in mind that “don’t know” means “maybe.”

Here’s a heads-up, by reason of a calendar conflict, our next blog posting will be the night of May 21 or the morning of May 22.

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Comments

  1. Peggy Israel says:

    Talking about the privity of estate v privity of contract and the need for assumption agreements always gets me brownie points with clients who feel they know enough to mark up documents without a lawyer’s input. This is one of those “big consequences” real world issues that comes up again and again.

    • As someone who’s not an attorney, it seems like privy of estate is unnecessary . . . until another party gets involved. The problem is . . . another party ALWAYS gets involved. (Just another example of why I consult the pros.)

  2. Jeremy J. Deeken says:

    While it is a principle of contract law that a non-party to an agreement can have rights under that agreement as a third party beneficiary, their is not any corresponding principle of non party obligor status without some affirmative act of the non party assenting to the obligation. The language in the lease requiring a non party to assume the lease is not that uncommon, but it commonly creates false expectations and confusion down the road.

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