The Title Theory
• Originally, when a borrower (mortgagor) granted a
mortgage, the mortgagor conveyed to the lender
(mortgagee) a present estate in fee simple subject to
condition subsequent
– If loan repaid in timely fashion, mortgagor could exercise right
of entry and terminate mortgagee’s estate
– If loan not repaid in timely fashion, mortgagee’s title became
fee simple absolute
• Pure “title” theory of mortgage law is a thing of the past
• First, the concept of “foreclosure” arose in equity courts
as a means to protect the mortgagor against the harsh
consequences of forfeiture following default
– Following default, mortgagee must enforce mortgage by
foreclosure sale of the property (with any surplus proceeds
being returned to mortgagor or subordinate lienholders)
• Second, modern loan documents typically make clear
(even in jurisdictions still adhering to the “title” theory)
that Mortgagor has right to possession prior to default
Title Theory: Consequences
• Unless mortgage provided otherwise, mortgagee had
the legal right to possession of the land (even if the
mortgagee allowed the mortgagor to occupy it)
– Thus, the mortgagee was entitled to collect rents and profits
from the land (which allowed the mortgagee to earn a
return on the loan at a time when usury law prevented the
collection of interest)
The “Lien” Theory
• Today, about 2/3 of American states follow the lien
theory of the mortgage
– Under this approach, the granting of a mortgage does not
pass title to the mortgagee, but only a lien (security interest)
– Title (and the right to collect rents) passes to mortgagee
only if mortgagee purchases the land at a foreclosure sale
– Until that time, mortgagor has the right to collect rents
(unless rents are separately “assigned”)
• Today, the distinction between “title theory” and “lien
theory” states does not matter, as between mortgagor
and mortgagee, unless there is a “gap” in the terms of
the mortgage
– Reason: mortgagor/mortgagee contract to the “intermediate”
approach through an “Assignment of Rents and Leases”
– E.g., Prior to default, Mortgagor has the right to possession
and the right to collect rents; after default, Mortgagee has the
right to collect rents
Lender’s “Underwriting” or “Due Diligence”
• Mortgagee’s investigation prior to making a
mortgage loan focuses upon key criteria:
– Borrower’s creditworthiness (i.e., can the Borrower
make the mortgage payments?)
– The value and character of the mortgaged land
(which Mortgagee may have to acquire the land at a
foreclosure sale, if Borrower defaults!)
• However, the “title theory” or “lien theory” approach
can matter in cases where the court must resort to a
“default rule” b/c the parties’ agreement is silent
• E.g., X and Y own land as joint tenants with the right of
survivorship
– Without X’s knowledge, Y mortgages Y’s share to Bank
– Did that mortgage sever the joint tenancy and make X and
Y tenants in common? In title theory states, yes (unity of
title broken); in lien theory states, no
• For residential loans, Mortgagee’s investigation focuses
primarily on:
– 1) Borrower’s creditworthiness (can Borrower make the
monthly payments given his/her income and other debts?)
– 2) Borrower’s title (does Borrower have marketable title?)
– 3) Value of collateral (e.g., appraisal, usually based on prices
of recent sales of “comparable” properties)
• Similar criteria used for commercial mortgage loans on
mortgagor-occupied land (i.e., company headquarters)
• Lender’s due diligence for income-producing properties (office
buildings, apartments, shopping centers, industrial parks,
hotels) differs, b/c these are occupied by third parties under
leases or other occupancy contracts
• Further, the owner of these projects is usually a “single-asset”
entity (i.e., a limited liability entity that owns NO assets other
than the mortgaged property)
– Thus, “income” to pay mortgage will come solely from property
operations (i.e., rents paid by tenants)
– These mortgage loans are often “nonrecourse,” i.e., borrower has no
personal liability to repay debt, and mortgagee’s recourse is to the
land (foreclosure) and any guarantees
• 1) Will the leases produce enough
rents (after payment of operating
expenses) for borrower to repay
(or service) the mortgage debt?
– Lender will require a certain debt
service coverage ratio (e.g., 125% or
higher) before it will make the loan
• 2) Do leases contain provisions
that the Lender wouldn’t want to
accept, if it became Landlord?
Lease
Review
Commercial Loans
• Thus, on these transactions, lender’s due diligence
focuses heavily on the leases or other occupancy
contracts of the mortgaged property
– Borrower will repay the loan using cash flow from the
property (e.g., net rentals paid by tenants)
– Lender: “If I have to foreclose, I may become the owner of
the Property (thus the Landlord under the leases). Will the
leases generate enough cash flow (rents) to recover the
loan amount (either through operations or resale)?”
Concerns for the Mortgage Lender
• 1) What rights does the mortgagee have versus the
tenants, before and after a foreclosure sale?
• 2) What rights does the mortgagee have in rents from the
property, and what priority does it have in those rents
versus other creditors (such a junior mortgagees,
judgment lien creditors, or the bankruptcy trustee if
borrower goes bankrupt)?
Dover Mobile Estates [p. 380]
• Saratoga S&L makes a loan to Old Town Properties (OTP),
secured by mortgage on OTP’s building (occupied by tenant,
Fiber Form Products, on a 5-year lease)
• When OTP defaulted, Saratoga foreclosed; building was sold
at a foreclosure sale to Dover
• Dover tried to enforce lease and collect rent from Fiber Form
• Fiber Form argues: foreclosure terminated our lease
• Fiber Form had already entered into its
lease at the time OTP granted the
mortgage to Saratoga
• Thus, Fiber Form’s lease appears to
have been prior to Saratoga’s
mortgage
• What basis, then, does Fiber Form
have for arguing that their lease had
been terminated by the foreclosure?
Effect of Foreclosure
• Buyer at a foreclosure sale gets title to the mortgaged
land of the same quality as existed on the date that the
mortgage was granted
– Foreclosure extinguishes the mortgage being foreclosed, and
any subordinate interests in the land (any interests that arose
after the mortgage was granted)
– But, interests that pre-date (are senior to) the mortgage are
not affected by the foreclosure sale
[FIBER FORM’S LEASE] § 21.1. Subordination of Lease to
Loans. Tenant agrees that this Lease shall be subordinate to
any mortgages or deeds of trust in the nature of mortgages that
may hereafter be placed upon the premises, to any and all
advances made or to be made under them, to the interest on all
obligations secured by them, and to all renewals, replacements,
and extensions of them; provided, that if any mortgage or
beneficiary elects to have this Lease superior to its mortgage or
deed of trust and gives notice of its election to Tenant, then this
Lease shall be superior to the lien of any such mortgage or
deed of trust and all renewals, replacements and extensions
thereof, whether this Lease is dated or recorded before or after
the mortgage or deed of trust.
Dover Mobile Estates [p. 380]
• Although Fiber Form’s lease did pre-date Saratoga’s
mortgage (and thus would’ve been senior to Saratoga’s
mortgage), Fiber Form’s lease had a subordination
clause in it [§ 21.1]
– Under this clause [p. 382], Fiber Form subordinated its
interest to any mortgage lien on the property, even
subsequently granted mortgage liens such as Saratoga’s!
– Thus, Fiber Form’s lease was actually junior to Saratoga’s lien
and was extinguished by foreclosure sale!
• Why would Mortgagee want a tenant’s
lease to be subordinate to its mortgage?
– By the time of a later foreclosure, the rent
amount may no longer be favorable to the
landlord
– If so, foreclosure sale buyer might prefer to
find a new tenant to pay market rent (or to
require the existing tenant to agree to a rent
increase to be able to stay on)
– Subordination of the lease would allow a
foreclosing lender to wipe out or renegotiate a
lease that has become unfavorable over time
• Why would Fiber Form have signed a
lease w/§ 21.1 in it?
– It had no choice!
– Commercial leases commonly include such
a “subordination clause”
– Mortgage lender will require that leases be
subordinate to the mortgage lien, as a
condition of making mortgage loan
– Landlord thus puts such a clause in its
leases, so Landlord can get financing or
refinancing w/out Tenant interference
• In the Dover case, having agreed to subordinate its
lease ended up working out fine for Fiber Form
– Rental value of the land had actually gone DOWN during the
lease term, which meant that Dover wanted to be able to
enforce the lease (which was Landlord-favorable)
– Instead, foreclosure terminated Fiber Form’s subordinate
lease, meaning Fiber Form can now vacate the property, or
negotiate a lower rent if Dover wants them to stay!
• What should Dover (the foreclosure sale buyer) have
done differently?
• Under § 21.1 [p. 382], Saratoga had the option to
“resubordinate” its mortgage lien to the Fiber Form lease
• Dover should’ve insisted that Saratoga exercise that
option before it foreclosed the OTP mortgage!
• Subordination clause in § 21.1 of Fiber Form Products lease
operates optimally for a mortgage lender
• In most states, this would be effective
– Court’s language in Dover, however, suggests that CA law
• A tenant with no bargaining power may be stuck agreeing
• But sophisticated, knowledgeable tenants (esp. on a longterm lease) want “nondisturbance” agreement
– If so, at time of foreclosure sale, Fiber Form’s lease would’ve
been senior and thus unaffected by the foreclosure sale, and
Dover could have enforced the lease, as successor landlord
would’ve allowed Dover to terminate lease anyway [p. 383]
SNDA Agreements (pp. 387-388)
• Lenders usually require, as a condition of the loan, that
all existing tenants enter SNDA agreements DIRECTLY
w/Lender (creating clear privity of K)
• Agreements can have three basic functions
– Subordination: Tenant agrees that its lease is subordinate to
the mortgage lien
– Attornment: Tenant agrees to recognize foreclosure sale buyer
as its landlord, as per the lease terms, following foreclosure
– Nondisturbance: Lender agrees not to evict Tenant after
foreclosure, if Tenant is not in default under lease
– It would let the mortgage lender “pick and choose” which leases to
keep or terminate in a foreclosure sale
– For leases advantageous to mortgagee, lender could “resubordinate,” so that foreclosure sale would not affect the lease
(and foreclosure sale buyer could enforce the lease vs. tenant)
– For leases unfavorable to mortgagee (below market rent),
foreclosure sale would extinguish them!