In negotiating or reviewing any ground lease, one always wants to see a set of provisions that collectively makes the ground lease “financeable.” That agenda has become fairly standard. The rating agencies have memorialized it in the criteria that determine whether, or how favorably, a loan can be securitized.
Even against that backdrop, two issues of financeability have drawn discussion. Both are fairly technical. One relates to a factual circumstance that, to my knowledge, has never actually arisen.
In a recent report, Moody’s Investors Services made clear that if a ground lease does not handle those two issues right, Moody’s will regard that as a “flaw” in the lease. That could mean higher subordination levels or conceivably even make a leasehold loan ineligible for securitization—though the consequences of these “flaws” are not entirely clear.
The first of these issues relates to the relative priorities among the rights of a landlord, a tenant, the landlord’s lenders and the tenant’s lenders. In an earlier column, I said there is only one right way to put together that puzzle. The lease and the tenant should have priority over any mortgages created by the landlord. The tenant’s mortgages should attach only to the leasehold so a foreclosure can’t affect the landlord’s interest. And the landlord’s mortgages should attach only to the landlord’s interest, subject to the lease, so a foreclosure can’t affect the tenant’s interest.
Sometimes great minds try to come up with other ways to align those four interests in real property. In its recent report, Moody’s rejected such creativity. The various players simply need to line up their interests as the previous paragraph and my previous column suggest. Failure to do that will result in rating agency issues in any securitization. And nonsecuritized lenders will probably follow Moody’s lead—hardly a new or pioneering position—on this issue.
The second issue in the Moody’s report is even more technical. It involves the hypothetical possibility that a leasehold borrower will file bankruptcy and “reject” the ground lease—something that bankruptcy law allows but that doesn’t happen much or ever in ground-lease financing. As a practical matter, nonrecourse carveout guarantees have largely eliminated these bankruptcies anyway.
If a leasehold borrower ever did file bankruptcy and reject the ground lease, this would create a big problem because the ground lease was collateral for a leasehold loan. After rejection, what happens to the lender’s collateral? It might just vanish.
Many ground leases say, if the lease “terminates,” the landlord must offer the lender a new lease. That’s good. But some cases say a “rejection” is different from a “termination,” so some vestigial shred of the ground lease remains after rejection—so it hasn’t “terminated.” In that case, “rejection” might not entitle the leasehold lender to a new lease, creating confusion and uncertainty.
Moody’s therefore says a ground lease should entitle the lender to a new lease if the ground lease is “rejected”—not just “terminated.” If the ground lease doesn’t say that, the resulting uncertainty creates a major concern for Moody’s in any securitization.
One could say, though, that if some shred of the ground lease remains after rejection, then the leasehold lender’s mortgage sticks to that shred, and if nothing remains, then the lease has terminated, and the lender should get a new one. A lender might take comfort from the idea that bankruptcy courts are “courts of equity”—they’re supposed to “do the right thing”—and if the lender properly raises its concerns, the court should protect the lender even after a rejection driven, for example, by borrower vindictiveness.
No historical basis exists to think a court would accept these great arguments. Few or no reported cases exist. That leaves uncertainty but also shows how rarely these issues actually arise. They could require years of litigation, first in bankruptcy court, then in state court, to resolve. The lender would probably win, but it could cost a lot; lenders wisely never rely on bankruptcy judges to protect lenders; and during litigation the lender would need to write checks to preserve its collateral.
Because of all this, Moody’s suggests that if a “new lease” clause omits the crucial reference to a “rejection,” then this creates a serious problem and could even make a loan nonsecuritizable.
Must the outcome be so binary? Perhaps one can estimate the likelihood the lender will eventually prevail (high) and also estimate how long any litigation should take, quantify the cost of that delay, discount everything by its improbability of ever occurring and develop a simple formula for how much to “penalize” a leasehold loan for lack of “rejection” language. A “penalty” calculated on that basis should not be high.
In the meantime, anyone negotiating a ground lease should keep in mind the importance that Moody’s attaches to these issues.
Joshua Stein is the principal of Joshua Stein PLLC. He can be reached at email@example.com.