A recent California court case underscores the need for a landlord to insist that a tenant’s lender assume the lease following foreclosure, and simultaneously highlights an opportunity for a lender foreclosing on a leasehold to limit its liability under the lease.

In BRE DDR BR Whittwood CA LLC v. Farmers & Merchants Bank of Long Beach, a California appellate court considered a case involving a loan secured by a tenant’s interest in a lease. The lease stated that the tenant’s lender would be required to assume the lease following foreclosure, but the lender did not in fact sign any documentation affirmatively assuming the tenant’s obligations under the lease, either at the time the loan was made or later when it foreclosed under the leasehold mortgage. After taking title to the leasehold interest through the foreclosure sale, the lender transferred the leasehold to an affiliated LLC. The LLC later ceased making rent payments under the lease.

In suing both the lender and its affiliated LLC for breach of the lease, the landlord maintained that both parties by becoming assignees of the lease had impliedly agreed to assume the obligations of the original tenant. The trial court agreed, but was overturned by the appellate court, which held that only an express assumption of the lease by an assignee would make the assignee become liable for all of the tenant’s obligations under the lease. Without such an express assumption, an assignee is only liable for the obligations of the tenant that accrue during the assignee’s possession of the premises. If the assignee ceases its possession without having assumed the lease, therefore, the assignee has no further obligations under the lease.

The appellate court pointed out that the landlord could have protected itself by requiring that the foreclosing lender assume the lease. It is quite common to have a three-party agreement between the landlord, the tenant, and the tenant’s lender in a leasehold mortgage situation that includes assumption provisions. These agreements typically provide, however, for the lender’s right to be released from further liability under the lease once it assigns the lease to a third party (the lender’s typical goal following a foreclosure), and to provide enhanced rights for the lender to assign the lease. These provisions serve to limit the lender’s exposure to not much more than that of an assignee who does not assume the lease.

Lenders should bear these principles in mind when signing documents relating to their rights under a leasehold mortgage and the lease it covers. Of course, lenders should also consider using a subsidiary entity in foreclosing - as lenders often do - as another handy way to limit their liability in taking title to property (leasehold or otherwise).