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UNDERSTANDING THE SUBORDINATION CLAUSE
By: Jane M. Myers, Esq.
Most leases contain a subordination clause, yet it’s frequently overlooked – not necessarily without cause. In the commonly-used Standard Form of Office Lease published by The Real Estate Board of New York, Inc. the clause is comprised of a mere three sentences. The clause does, however, have significant ramifications for a tenant. What it provides is that the lease will be subject and subordinate to all underlying leases and mortgages affecting the property. What this means is that if, for example, the owner of a shopping center is also the lessee of the entire shopping center under a ground lease and then defaults so that the ground lease is terminated, then all leases covering the individual stores will be terminated as well. That is quite a perilous position for a business owner to be in. Similarly, if the landlord is the owner of the property, but has a mortgage on the property and subsequently defaults on the mortgage, then the tenant’s lease will be subject to foreclosure by the bank. In many cases, the lessor cannot remove this clause because there is a ground lease or mortgage in place which requires that the clause be included in all leases, however the clause can be modified to afford some protection to the tenant without any substantial adverse effect on the lessor.
This is accomplished by adding a non-disturbance provision, which is exactly what it sounds like. In the example involving a ground lease, a default by the lessor might result in the termination of the ground lease by the property owner, but with a non-disturbance agreement the owner would allow the tenant to remain in possession and continue as a direct tenant of the owner. In the case of a lessor who is the owner of the property but defaults under the terms of a mortgage on the property, the bank might well commence a foreclosure action but would not name the tenant as a defendant in the lawsuit. Generally, the holder of a mortgage which is being foreclosed is free to determine whether, in addition to foreclosing (extinguishing) the rights of the owner, it wishes to foreclose the interest of a particular tenant or to allow that tenant to remain unaffected by the foreclosure. For example, a bank holding a mortgage on a shopping center that includes a valuable anchor tenant might decide to omit that tenant from the foreclosure action, believing that the property will bring a better price at auction with the anchor tenant remaining in place. Given a non-disturbance agreement, the bank no longer has the option and the tenant is protected.
One point for the tenant to keep in mind is that the lessor is often not in a position to simply grant a non-disturbance provision, but rather, must ask that the owner and/or one or more mortgage holders agree. As a result, a lease will often contain language to the effect that the lessor will use its best efforts to obtain non-disturbance agreements in favor of the tenant.
Although only three sentences long, the subordination clause can be devastating for a tenant if overlooked during lease negotiations.
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Please note that this article is intended only as a general discussion of issues pertaining to the preparation of a lease and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation. Circumstances and the applicable legal principles vary and you should consult with an attorney in order to prepare a lease appropriate for your particular needs.