May 21, 2001

The California Court of Appeal for the Fourth Appellate District held in favor of a ground lessor seeking to hold a leasehold lender’s affiliate liable for the balance of the ground lessee’s obligations by virtue of such affiliate’s assumption of the ground lease during a loan workout, notwithstanding the lender’s subsequent foreclosure of its leasehold deed of trust. Vallely Investments, L.P. v. BancAmerica Commercial Corporation (May 1, 2001).

FACTS
Balboa ground leased land from Vallely and obtained a leasehold loan from BA Mortgage, secured by a leasehold deed of trust. After Balboa defaulted on the loan, BA Mortgage commenced foreclosure. Balboa filed for Chapter 11 bankruptcy protection. Balboa and BA Mortgage negotiated a workout and ultimately stipulated, with bankruptcy court approval, that Balboa would assign the ground lease to an affiliate of BA Mortgage, BancAmerica Commercial Corporation (BACC). BA Mortgage sought the lease assignment to BACC in order to maintain the property until foreclosure, and desired foreclosure in order to terminate mechanics’ liens. Balboa executed an assignment to BACC containing assumption language, as required by the ground lease. BA Mortgage foreclosed and acquired the leasehold at the foreclosure. Years later, BA Mortgage sold the leasehold to Edgewater but, shortly thereafter, Edgewater defaulted on the lease. When Vallely sued Edgewater for breach of the lease, Edgewater filed for bankruptcy. The ground lease was ultimately rejected in bankruptcy. Vallely brought an action for declaratory relief against BACC, seeking to hold BACC liable for rent for the balance of the lease term. The trial court granted summary judgment in favor of BACC on the theory that BA Mortgage’s foreclosure extinguished the ground lease and BACC’s obligations thereunder.

COURT OF APPEALS
The appellate court reversed the trial court’s decision, and instead granted summary judgment in favor of Vallely, holding BACC liable by virtue of its ground lease assumption. BACC raised numerous arguments to avoid contractual liability, but failed across the board. The court described the trial court’s foreclosure rationale as “mistaken”, and distinguished this foreclosure from a typical foreclosure on a fee interest, which terminates subordinate liens and leases. Here, the ground lease was not a junior encumbrance, and foreclosure neither terminated the ground lease nor otherwise adversely impacted the ground lessor’s rights.

SIGNIFICANCE
The existence of an additional party (i.e., the ground lessor) in leasehold loans creates additional complexities and risks. As BACC discovered, the common workout tactic of taking a deed in lieu with respect to a fee interest may be perilous in the context of an ‘assignment in lieu’ of a leasehold. By not assuming, BACC would have been in default; and by assuming, BACC had ongoing liability. Query whether BACC would have been protected by using a single purpose entity to be the assignee and assume the lease. Perhaps the lender here could have attempted to sidestep the pitfalls of assumption altogether by seeking a receiver pending foreclosure.

Vallely further underscores the importance of analyzing the “mortgagee protection” provisions of a ground lease before funding the loan. The lease stated that if a leasehold mortgagee acquired the lease by foreclosure, its liability would be limited to the obligations arising during its period of ownership. Had the lease gone on to provide the same protections for a lender affiliate who acquired the leasehold estate by assignment in lieu of foreclosure, this case could have been avoided. Many leasehold mortgagee protections also include a provision requiring the landlord to provide a “new lease” to the lender in the event the lease is terminated under certain circumstances (e.g., bankruptcy). Query whether and how often such provisions provide that the new lease contain a release of the lender for obligations arising after its period of ownership.


For more information or to arrange an interview, please contact Leeza Hoyt, APR or Vanessa Amin, The Hoyt Organization, 310-373-0103 or the following attorney at Pircher, Nichols & Meeks: John H. Irons 310-201-8937.

Founded in 1983, Pircher, Nichols & Meeks is a national real estate law firm with a diversified real estate practice that includes litigation, bankruptcy, corporate, tax and public finance matters. Based in Los Angeles, the 45-attorney firm also maintains a full-service office in Chicago. The Los Angeles office is located at 1999 Avenue of the Stars, Los Angeles, CA 90067; phone: (310) 201-8900.