H O M E
When First Might Be Worse
The decision in Aviel v Ng (2008) 161 CA4th 809, 74 CR3d 200, reported at p 78, would be noteworthy only if it had gone the other way—if, for instance, it had held that a deed of trust is subject to different rules than is a mortgage; or that a mortgage (or deed of trust) that is prior to a lease does not terminate the lease when it is foreclosed; or that a mortgage that was executed after a lease is still not superior to it even though there was a subordination clause in the lease. Since this opinion was clearly “correct” in holding the opposite of all of those positions, there is really no need for attorneys to make any “midcourse corrections” in their drafting of these documents. This column is mainly to remind counsel to make sure that their clients really do want what they are fighting for when they deal with the lease versus loan priority issue.
The lease in Aviel was executed two years before the deed of trust on the same premises was signed. However, the lease contained a subordination clause, so the foreclosure of the deed of trust (five years later) inevitably terminated the leasehold, which otherwise might have continued for another 20 years. The tenants should properly berate themselves for having so carelessly agreed to this possible wipeout. That was the clear and foreseeable effect of the subordination clause.
But that fact represented a loss for the tenants (and a win for the trustee sale purchaser) because rental values had since gone up. (The trial court’s award of $125,000 damages for 20 months’ holdover seems to set a monthly rental value of over $6000, as opposed to monthly rent reserved under the lease of less than $5000.) Had rental values gone down instead, the tenants would have regarded themselves as winners because of the fortuitous termination of their lease by virtue of the trustee sale. In that case, the loser would be the foreclosing lender (who could now expect to sell for that much less), the debtor/landlord (who would get that much less surplus), or the trustee sale purchaser (unless it took that into account in its bid), because tenants paying an above-market rent after the sale was completed could not be made to stay after the foreclosure sale of a prior mortgage automatically ended their rent liability.
The Downside of Being First
With an unmitigated subordination clause in a lease, there is always a winner and loser—depending on which way the market goes. If it goes up, the lender is the winner because more rent can be demanded for letting the tenant stay. If the market goes down, the tenant is the winner because it can insist on a lower rent as a condition for staying. The same is true for those cases when the loan was prior to the lease because it was executed first, and the reverse is true when the lease came first and contained no subordination clause.
Subordination clauses are included in most leases because landlords put them there. Landlords put them there because they anticipate that later lenders will be more agreeable to making loans to them if they see such provisions there. A subordination clause makes the lender’s deed of trust first rather than second in priority. But is that always a good thing?
From a lender’s perspective, it is always better to be a first lender rather than a second lender. It gets paid first, and any shortfall hits the junior lenders instead. But when the priority issue is between a loan and a lease, the value of being first is not as clear. As this case holds, foreclosure of a senior loan automatically terminates a junior lease and lets any tenant whose rental obligations exceed the rental value of the premises—the very ones that the lender and foreclosure purchaser would most like to hold in that situation—walk away. But, on the other hand, had that loan not had priority over the lease, its termination by foreclosure would not have affected the existing lease, and that desirable tenant could not escape. Priority is not always best. (Everything said about the lender in this case is true—vice versa—for the tenant.)
I think concentrating on the presence or absence of a subordination clause in a lease is not what the parties should most be worrying about.
Who Wants to Be a Gambler?
Tenants who bargain for long-term leases obviously want assurances of stability: They wish to avoid the risks of renegotiating renewals and rents with their landlords too often thereafter. Since the nominal duration of a lease is meaningless if it can be prematurely terminated by a foreclosure sale, they should obviously be more careful than Ng was in signing a lease that includes a bald subordination clause.
But it may be no less true that lenders who finance rental property seek similar assurances of stability: They wish to avoid the risk that the income streams that currently justify the underwriting of their loans will vanish in the future—and would much prefer that those income streams survive any foreclosures they may have to conduct, which may make those properties more attractive to purchasers. Financing property that was currently subject to a subordinated lease may have been as careless on Aviel’s part as signing the lease was on Ng’s part. Both got chances of winning and losing, but neither got the kind of comfort they should have wanted. Both should have been more risk averse.
Forget the “S”; Go for the “NDA”
A tenant’s real concern should be whether its lease will survive the landlord’s mortgage default, not whether the lease is senior or inferior to that mortgage. If the tenant is asked to subordinate its lease to a later mortgage, agreeing to do so will not hurt as long as that subordination is conditioned by a nondisturbance provision in the lease, assuring that the foreclosure will not destroy the leasehold. (These agreements, combining subordination, nondisturbance, and attornment provisions, are commonly referred to as SNDAs.) Without the nondisturbance provision, the tenant will suffer Ng’s unhappy fate. Bargaining should be over the nondisturbance details as to how the tenant will have to behave to be sure that its rights under the old lease continue after a mortgage foreclosure.
Since a subordination clause in a prior lease can be equally risky for a lender (if the rental market goes down), the lender, too, should prefer to see it qualified. If the lender is satisfied with the current leasehold status, a nondisturbance provision protecting the tenant does the loan no harm. Because the lender’s greatest worry may be that the tenant will use the confusion of trustee sale proceedings as an occasion to quit the premises, what the lender should most want to see included in that prior lease is an attornment provision, compelling the tenant to acknowledge the lender and the foreclosure purchaser as the tenant’s new landlord, and guaranteeing the survival of the lease after the sale. Bargaining should be over the attornment details as to how the lender and purchaser will have to behave to be sure that their rights under the old lease continue after the foreclosure sale.
If those necessary nondisturbance and attornment provisions are in their documents, I think it will hardly matter whether there is or is not a subordination provision, nor indeed which interest would otherwise be prior to the other. Arguing over the features of the subordination clause is bickering over the least important issue. Using a lease that includes such a clause and nothing else—as happened here—is dangerous.
Aviel v Ng (2008) 161 CA4th 809, 74 CR3d 200
In September 1998, the Ngs entered into a commercial lease with their landlord that contained a clause subordinating the lease to future “mortgages” on the property. In December 2000, Aviel loaned money to a third party to purchase the property from the Ngs’ landlord. A deed of trust in favor of Aviel secured the loan. In March 2002, Aviel acquired the property through a trustee sale. Thereafter, he negotiated a new lease with each of the property’s tenants, except the Ngs. In June 2003, Aviel filed an unlawful detainer action against the Ngs. They vacated the property in November 2003 and Aviel converted the unlawful detainer into an action for reimbursement of reasonable rental value.
The Ngs cross-complained against Aviel, alleging numerous causes of action. Aviel moved for summary judgment on the claims for breach of contract, wrongful eviction, and specific performance, on the ground that each cause depended on a valid lease, but the lease was extinguished by the subordination clause at the time of the trustee sale. The Ngs argued that the subordination clause applied to “mortgages” and therefore the lease had not been extinguished by the trustee sale under the deed of trust. The trial court disagreed and Aviel prevailed on the rent claim, because once the lease expired, the Ngs, as holdover tenants, owed market rate rent. The Ngs prevailed only on a clam for conversion of their equipment, and then appealed the claims they lost.
The court of appeal affirmed the trial court judgment in its entirety, noting that it has long been settled that:
• Mortgages and deeds of trust are functionally and legally equivalent; and
• A lease otherwise senior to a deed of trust may be subordinated by agreement.
-Roger Bernhardt
Originally published in CEB's"Real Property Law Reporter", May 2008
Deficient Development Agreements
Introduction
In Neighbors in Support of Appropriate Land Use v County of Tuolumne (2007) 157 CA4th 997, 68 CR3d 882, reported on p 58, the Fifth District Court of Appeal threw out a development agreement (and the associated conditional use permit) between Tuolumne County and the Petersons because, the court held, it was inconsistent with the county’s zoning ordinance. The development agreement purported to permit the Petersons to host lawn parties and weddings on their 37-acre property.
Lawn party hosting was neither a permitted nor a conditionally allowed use under the 37-acre minimum lot size agricultural zoning classification the county had previously applied to the property. That made the conditional use permit (CUP) almost ipso facto invalid; a permit cannot be issued to cover what has never been declared an appropriate conditional use in the authorizing ordinance.
More important, issuance of the CUP could not be justified under the ordinance on which the development agreement was based, because that ordinance violated Govt C §65852, the uniformity requirement of the Planning and Zoning Law (Govt C §§65000–66499.58), which states that “all [zoning] regulations shall be uniform for each class or kind of building throughout each zone.”
The philosophic aspects of the controversy must have been deemed important, since the actual fight was more of the tempest-in-a-teapot variety. As far as the facts on the ground were concerned, this 37-acre parcel was bordered by two similarly zoned parcels to its west, but was flanked by 2- to 5-acre parcels on the north, south, and east (where I surmise that the challenged activity might have been allowed). Consequently, it might have required only the redrawing of a line on the zoning map to place the parcel into a different and more lenient classification. The county supervisors were considering a text amendment to the zoning ordinance that would have reclassified lawn parties as conditional uses in its 37-acre agricultural zones, which would have accomplished the same result. No one appeared to contend that either of those acts would have been invalid. In other words, the same result could have been reached, just by a different route, and the politics would probably have been the same, since the same procedural features (public notice, hearing, and vote) would have remained applicable—e.g., same public supporters and opponents, same supervisors. So why did it matter so much that the county attempted to achieve this result by development agreement rather than by zoning amendment?
Some background on two troublesome characteristics of land use regulations—uniformity and revisions—may help.
Uniformity Within a Zone
On their face, zoning laws would seem to violate the principle of equal protection: X is permitted to build a factory on his land because it is zoned industrial, whereas Y, a block away, can erect only a house on hers, because it is zoned residential instead. Endorsers of zoning dodge this problem by claiming that there is the necessary uniformity inside each zone, even if it is lacking outside each zone. Without that proposition, all zoning would fail.
But uniformity does not always make for good planning; it too easily leads to a ticky-tacky, monotonous neighborhood where no one wants to live, or even visit. As a consequence, combined with our two-value zoning rules—where every use should be either permitted or prohibited—are escape routes. Land use regulation includes mechanisms designed to reduce rigidity: amending zoning ordinances and maps, conditional uses, and (although not exactly intended to have that effect) variances.
While those devices have been part of the system since its start, more came along later: design review, planned unit developments, floating zones, and historic preservation. The departure from as-of-right zoning has become even more dramatic as the zoning process has become more like that of subdivision regulation, where predetermined rules that had set forth known predictable standards have been replaced by after-the-fact reaction and negotiation from local officials to development proposals that are initiated by developers rather than by planners. We may still pay lip service to the earlier notion of uniformity, but there is no longer much realism behind the idea that all properties are being treated equally now that each proposal is judged separately and independently. Flexibility has won out over equality.
Changing the Rules in Midstream
Among the many risks that land development entails is the danger that the legal climate that existed while the development was being planned will change for the worse before the project has been completed and taken off the developer’s books. If you have already purchased and paid for the land (and perhaps also for, e.g., the building plans), where will you be if the town alters its local height, space, or use limits before your construction has started?
The doctrine of vested rights is designed to protect the finished product from most changes that could materially hurt it thereafter; it is unlikely that a new height limit can have much effect on a completed and tenanted building (although, even then, there is the power to prohibit alteration of nonconforming structures, and the possible right to “amortize” them away over time). But at the front end of the calendar, a vested right generally does not come into being until after there has been substantial reliance upon the right building permit, which is an event that may not occur until after many millions of dollars have been spend on “preliminary” costs. See, e.g., Avco Community Developers, Inc. v South Coast Reg’l Comm’n (1976) 17 C3d 785, 132 CR 386, where $2.8 million had been spent before the rules changed.
Since any real estate development inevitably needs significant time from start to completion, a developer has to feel pretty certain that those horribles are unlikely to occur, and the local officials who want to increase their tax revenues through development need to make sufficient assurances to encourage the necessary risk-taking. How can a community cross its heart in that way?
The traditional legal answer was that it cannot be done. Binding assurances can’t be given because the police power cannot be bargained away. A local government cannot hamstring itself from passing new laws when new contingencies arise, or prevent its citizens from voting the rascals out of office in order to undo their machinations. But that rule, like the old-fashioned uniformity doctrine, is too detrimental to growth. Developers just cannot afford to take sought-for risks unless there is a way to fetter the police power to ensure that the rules don’t change.
Thus, in California (and some other jurisdictions), we now have the statutory Development Agreement Law (Govt C §§65864–65869.5) to provide a different solution to that problem. Government Code §65865.4 creates a way to give assurance to the developer that it may carry out its project in accordance with the rules operative at that time, “notwithstanding any change in any applicable general or specific plan, zoning, subdivision, or building regulation adopted” thereafter. The need to give assurances has prevailed over the sanctity of the police power and the inability to bargain it away.
Development Agreements and Flexibility
Since the purpose of the development agreement statutes is to give such agreements the unambiguous protection that developers need to eliminate the uncertainties inherent in the vested rights and sanctity of police powers doctrines (and the gap between them), it would not seem to require that the process also must include a way for allowing additional nonuniform flexibility into the real estate projects created under them. The developer makes sure, independently, that all of the other conditions of the governmental land use regulatory scheme are satisfied, and then seeks the development agreement to guarantee that this current compliance will not be rendered obsolete by a later rule or rule change.
The agreement reached in Tuolumne County, however, does not seem to have been intended to deal with any problem of developer risk; it is unlikely that lawn party hosting entails much start-up capital investment. Rather, it was contrived to overcome the fact that commercial lawn party hosting was not a permitted use for that property under the existing zoning ordinance. That puts it under the flexibility issues that I earlier discussed, rather than the stability issues. The county had in fact toyed with the idea of amending its zoning ordinance to make lawn parties conditional uses in the 37-acre agricultural zones, which would have had exactly the same effect. (The opinion said that a CUP would have been different because it would have allowed all other owners to make similar requests, although that danger could have easily been avoided by making one of the conditions for this activity a finding that no similar use was too close by.)
But does the fact that a development agreement looks like an inappropriate method to deal with an “inflexible” zoning ordinance make it also an illegal method? Under Govt C §65866, all other land use rules continue to apply in the case of a development agreement “unless otherwise provided,” which might make one think that the agreement could thus otherwise provide as to a zoning rule. Government Code §65867.5 mandates that a development agreement can be approved only if it complies with the “general plan and any specific plan,” which also does not appear to require compliance with zoning ordinances. Given those provisions, is the legislature really prohibiting a development agreement that carries its own zoning regime with it?
The Development Agreement Manual published by the Institute for Local Government, the research arm of the League of California Cities, takes it for granted that a development agreement may constitute its own charter and may “contain provisions that vary from otherwise applicable zoning standards.” Inst. for Local Gov’t, Development Agreement Manual: Collaboration in Pursuit of Community Interest 9 (2002). Indeed, that publication goes on to advise that
attorneys need to decide what language to use in the event the parties agree to allow land uses that are inconsistent with the otherwise applicable zoning requirements in existence at the time the development agreement was negotiated. One approach is to include language saying that the then-existing zoning ordinance governs, but only to the extent it is not inconsistent with any provision of the agreement....
Development Agreement Manual 54.
... But Not Here
Given these authorities, it is no wonder that Tuolumne County planning staff, and perhaps even county counsel, thought the development agreement was a lawful alternative at the time the deal was drafted.
But none of that persuaded the court in this case. A development agreement could not be its own source of zoning regulations. In order to get around all of the contrary authorities just mentioned, the court had to dance around the statutes and dismiss the Development Agreement Manual on the ground that it contained no legal arguments, even though it was drafted by lawyers.
The chief reason given by the court for refusing to treat a development agreement as an independent source of land use authority (despite a special enabling statute) was the uniformity requirement I earlier discussed: Allowing a parcel to be regulated by a development agreement rather than a zoning ordinance would give its owners a benefit not shared by the owners of other properties similarly zoned. The fact that this already occurs whenever neighboring owners are differently zoned, or a single parcel is rezoned, or a conditional use permit (or variance) is granted to one but not another, was not enough to persuade it to abandon that principle. The fact that such outcomes are also upheld in contract zoning and conditional zoning situations fared no better—those cases were cited by the court, but distinguished away. The rules must be uniform within a district, despite all of these examples to the contrary. Flexibility can go only so far in vanquishing equality.
Can We Live With This?
For the parties involved in this case, the outcome seems hardly devastating; it should take but a small restructuring of techniques to reach the outcome that the owners and some county officials want. (Although some neighbors clearly disliked the idea, they apparently lacked the clout to stop it at the political level.)
For everybody else, i.e., the rest of us, the holding merely instructs that to get what the client wants, one still must play the game by the oldest of all the old rules—the zoning has to match the activity. Get all of the entitlements the same as always, and use a development agreement to make them stick, not to make them different.
County grant of ad hoc exception to zoning ordinance disguised as development agreement violates uniformity requirement of Govt C §65852.
Neighbors in Support of Appropriate Land Use v County of Tuolumne (2007) 157 CA4th 997, 68 CR3d 882
The Petersons submitted an application to use their property, which was zoned for exclusive agricultural use, to host weddings and similar events. Under the existing zoning ordinance, such commercial use was not permitted with or without a conditional use permit (CUP). After public opposition surfaced, county staff and the county planning commission recommended denial and the Petersons withdrew their application. The Petersons next submitted a revised application and a request for a CUP, relying on proposed amendments to a zoning ordinance then pending before the Tuolumne County Board of Supervisors. The board did not adopt the proposed amendments. Instead, acting on staff recommendation, the board granted the proposed use as an ad hoc exception to the zoning ordinance, by adopting a development agreement purportedly under Govt C §§65864–65869.5. Neighbors in Support of Appropriate Land Use petitioned for writ of mandate.
The trial court ruled that the board’s actions violated the Planning and Zoning Law (Govt C §§65000–66499.58) because the use granted to the Petersons was not permitted under existing zoning ordinances; therefore, the adoption of the development agreement was an ultra vires act and void ab initio. Tuolumne County appealed.
The court of appeal affirmed, emphasizing that the uniformity rule of Govt C §65852 requires that all zoning regulations are uniform as to use throughout each zone, even though the regulation in one zone may differ from that in another type of zone. By according the Petersons’ property an “ad hoc exception,” the board of supervisors violated the principal of uniformity.
-Roger Bernhardt
Originally
published in CEB's"Real Property Law Reporter", March
2008
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