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Smyth vs. Littlebrook Airpark Condominium Association vs. Sweet Peas, LLC (ME Sup. Ct.) – Unauthorized Modification of Commercial Lease is Extinguished When Holder of Senior Mortgage Forecloses on Landlord’s Interest in Property

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

The Supreme Judicial Court of Maine has held that an unauthorized modification of a commercial lease was extinguished when the holder of the senior mortgage foreclosed on the landlord’s interest in the property. [Littlebrook Airpark Condominium Association vs. Sweet Peas, LLC, 2019 Westlaw 123599 (Maine).]

Facts: The owner of an airport entered into a 20 year lease with a commercial tenant, which was granted the right to develop 10 condominium units on the leased property. After the landlord died, his widow sold the property, subject to the lease, to a new owner, an LLC. As part of that transaction, the new owner executed a purchase money mortgage in favor of the vendor. That mortgage contained a clause forbidding the new owner from modifying any of the leases without the vendor’s prior written consent.

Five years later, without obtaining the consent of the mortgagee, the new owner executed amendments to the leases, extending them to 40 years, instead of 20 years. In addition, the tenants were also granted the use of the airport runway without a fee.

When the new owner of the property defaulted on the purchase money mortgage, the property was conveyed back to the vendor, the original owner’s widow, under a deed in lieu of foreclosure. She later conducted a sale of the property, purchased it herself, and eventually transferred it to a third party purchaser.

The condominium association, on behalf of all of the tenants, filed an action for declaratory relief, seeking to establish their rights under the lease amendments. The trial court granted summary judgment for the condominium association, but the Supreme Judicial Court of Maine reversed and vacated the judgment.

Reasoning: The court held that the foreclosure had extinguished the amendment, which was junior to the lien of the mortgage. The tenants argued that since the lease itself predated the mortgage, the amendment to the lease took priority over the mortgage. But the court reasoned that the title of the foreclosure purchaser relates back to the state of title as of the date of the execution of the mortgage.

Quoting R-Ranch Markets # 2, Inc. v. Old Stone Bank, 16 Cal.App.4th 1323, 21 Cal.Rptr.2d 21, 24 (1993), the court explained the policy behind the rule:

[I]f the rule were different, lending institutions would be discouraged from making loans since they would have no assurances that the borrower and senior leaseholder would not drastically reduce the value of the lease, thereby reducing the value of the property and security.

Author’s Comment: The court is right on the law, but I have doubts about how the rule was applied to these facts. The court’s description of the facts is a little confusing: first, the mortgagor conveyed the property to the mortgagee under a deed in lieu of foreclosure. Then, the mortgagee later conducted a sale of the property to herself.

If that is an accurate description, then the lease modifications, which would have been extinguished in an ordinary foreclosure, were not extinguished by a deed in lieu of foreclosure. See, e.g., Moloney v. Boston Five Cents Sav. Bank FSB, 422 Mass. 431, 435, 663 N.E.2d 811, 814 (Mass. 1996): “[F]ormal [foreclosure] procedures eliminate junior liens, and deeds in lieu do not.”

See also, Dunaway, Law of Distressed Real Estate, §9:5:

One of the principle advantages of foreclosing instead of using a deed in lieu of foreclosure is that, by operation of law, when a senior mortgage is foreclosed, all junior liens and mortgages are extinguished (with some exceptions such as some government liens). Thus, if there are subordinate liens such as junior mortgages, junior judgment liens, or junior mechanic liens, and the lender takes title to the property through a deed in lieu of foreclosure, these junior liens remain on the property.

I know what you are thinking – “yes, there was a deed in lieu, but the mortgagee did conduct a foreclosure sale later, thus extinguishing the junior interests.” But the problem with that reasoning is that once the deed in lieu had been executed to the mortgagee, the lien of her mortgage was arguably extinguished under the doctrine of merger of title. Her fee interest under the deed in lieu, a greater estate, subsumed the lesser estate of her lien. If that is true, then her subsequent foreclosure was a nullity, since the lien no longer existed.

The transactional message is simply not to use deeds in lieu unless the mortgagee is very certain that there are no lurking junior interests. If there is any doubt, the mortgagee should foreclose, thus terminating those junior parties.

The other message is that a lessee seeking a modifications of the leases should make sure to obtain a subordination, nondisturbance, and attornment agreement (“SNDA”) from any creditor holding a senior mortgage on the landlord’s underlying estate.

For discussions of cases dealing with related issues, see:

  • 28 Comm. Fin. News. NL 56, Acceptance of Deed in Lieu of Foreclosure By Senior Lienor Does Not Destroy Senior Lien Due to Merger When Junior Lien Intervenes.
  • 2014-23 Comm. Fin. News. NL 47, Sale “Free and Clear” of Bankrupt Commercial Lessor’s Property Preserves Subordinate Lessee’s Possessory Rights, Despite State Foreclosure Law That Extinguishes Junior Interests.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.

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