This is the first case I have seen on this issue in 30 years.  It's a goodie - with lots of food for thought and creates some need to consider language in a variety of documents.  Some will say that I like it just because it shows the predominance of Friedman on Leases as authority.  Well, maybe. . .


Daily Development for Wednesday, October 23, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of
UMKC School
of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City,


MORTGAGES; LEASEHOLD MORTGAGES; ASSIGNMENTS OF RENTS: Where leasehold mortgagee has assignment of rents of sublease rentals, and there is no economic advantage to mortgagor to pay rent on master lease to maintain value of mortgagor's interest in it, leasehold mortgagee (through foreclosure commissioner) may collect sublease rents and keep them with priority over master lessor until master lessor takes action to "activate" its implied priority claim over such rents, which claim is based upon mortgagor/sublessor's involvency.


Hawaii National Bank vs. Brian R. Cook, No. 22225, 2002 WL 31297214 (10/14/02)


The complexity of the caption disguises a really intriguing, though unavoidably complex, little puzzle.  It's worth penetrating.


The problem arose in Hawaii, where there are lots and lots of ground lease estates that form the foundation for the real estate market. Mortgagor had placed several mortgages upon its leasehold interest on certain property used for a "country fair."  (There were two ground leases, running about parallel, and the editor has merged them into one for convenience.)   It had subleased this property to apparently solvent tenants who were paying substantial rents.  Further, it had mortgaged its sublease rights to Bank, which also took an assignment of rents as part of the mortgage.  By time of this dispute, Bank had also obtained the rights of another lender that also had an assignment of rents and leases.  The Master Lessor had consented to these security interests.


The assignments were phrased in the typical "no holds barred way."  The Bank's original assignment, contained in the mortgage, stated that upon default Bank  had the "immediate right to receive and collect all rents . . .

due or accrued or to become due, and said rents . . .  are hereby assigned to the Mortgagee."  The other lender's assignment stated that, upon default lender, "at its option" could sue for a receiver, take possession, or, without taking possession, "demand, sue for or otherwise collect and receive all rents . . . "


With only two years or so to go on the master lease, and with the Master Lessor apparently indicating that it was not planning to renew, the mortgagor became insolvent and stopped paying on both the mortgages and the master lease, but the sublessees apparently paid like clockwork.. The Bank sued to foreclose, and an order of foreclosure issued from the court on Valentine's Day of 1997.  The foreclosure action did not name Master Lessor as a defendant.  Under Hawaii procedure unfamiliar to the Editor, a "commissioner" then commenced collecting the rents in the period prior to the scheduling of a foreclosure sale.


It appears that the primary purpose of the foreclosure action was to formalize the Bank's access to the rents, since the leases, now with only months to go, and subject to the Master Lessor's right to terminate for nonpayment of rent even earlier, had virtually no value at foreclosure auction.  The Bank had not named Master Lessor as a party defendant in the foreclosure action.


In October of 1997, the Master Lessor brought an action to terminate the leases and in November it intervened in the foreclosure action, asking that a receiver be appointed to collect the rents  and that these rents be allocated to it first, as it had an equitable priority in those rents pursuant to the rule that sublease rentals collected by an insolvent sublessor must first be paid to the master lessor.  The Master Lessor's action to terminate the master lease succeeded in January of 1998, three or four months before it would have expired by its terms.  The $363,000 in  rents ultimately  collected prior to the formal termination of the leases exceeded the amount of the master lease arrearages, although they fell far short of the Bank's million dollar claim.  This represents the net collection from July, 1997, until January, 1998.  It is not clear why the court started counting as of July.  The Commissioner had been on the land longer, and had already filed one request for an order of distribution prior to July 1997.  The Master Lessor didn't intervene until November of 1997.


The trial court awarded Master Lessor the rents it needed to make up the arrearages out of the monies collected by the Commissioner.  On appeal, the intermediate appeals court affirmed on the grounds that the Commissioner had an equitable obligation to preserve the estate of the Master Lease for the benefit of the mortgagors (who apparently were not taking a position in this fight - they owed everybody).   A dissenter pointed out that there could be no need to preserve the leases, since they effectively had no value as they were about to expire.  Neither the dissenter or the court points out that the substantial monies that were accruing might have continued to accrue for another three or four months - apparently generating a surplus - had the leases not been terminated for non payment of rent.  Perhaps the sublease rent was cyclical and would not have been payable in the same amounts during the last few months that were lost.


On appeal to the Hawaii Supreme Court, held, reversed in part and affirmed in part.  The Master Lessor gets the net sublease rents accruing from time of its intervention in November of 1997 until the termination of the lease.


The court relied heavily on Friedman on Leases for an analysis of the rights of the Master Lessor to the sublease rents.  It noted that Friedman cites extensive authority for the proposition that "if the prime tenant is insolvent the head landlord may resort to the subrents and has a preference therein ahead of other creditors of the prime tenant - to the extent necessary to satisfy the prime tenant's liability under the head lease."    This seems to be something akin to the priority of the purchase money mortgagee.


The court went on to follow Friedman's analysis that the rights of the Master Lessor are not automatic, but must be "activated."  Friedman basically analyzes this issue only in the context of a formal provision for a lien right on the sublease revenues created by the master tenant in favor of the master lessor.  But the court applies the same analysis here, where there was no such formal lien or assignment.  It concludes that the issue should be treated analogously to the question of the validity of a claim of a rents assignee in a mortgage.  Typically, even notwithstanding language for "automatic" attachment of the claim to the rents upon default, courts have held that the mortgagee/assignee must take some action to activate (the court uses the somewhat discredited term "perfect") the assigment before its priority claim actually takes effect.


The Hawaii court acknowledges that a few American courts have given effect to language in a rents assignment that purports to "automatically" vest the mortgagee with the accruing rents upon the execution of the mortgage, subject only to the conditional collection by the mortgagor until default, but it indicates that Hawaii has never ruled on the question, and the lien theory of mortgages in Hawaii would appear to support in general the recognition of the rights of the mortgagor's interests in the rents for as long as possible.  "Absolute assignments are generally disfavored in lien theory jurisdictions."  (Quoting from Thompson on Real Property (Thomas Edition).


The court concluded that it agreed that "public policy weighs against construing assignment of rents clauses as absolute assignments absent a clear indication that the parties intended to create one."  Consequently, where, as here, there is no language expressing the rights of the Master Lessor at all in the master lease, and the Master Lessor's rights are based purely on equity, the Master Lessor had to have taken some action to activate its interest.  It did so, the court held, when it intervened in the foreclosure action in November of 1997, and therefore the pro rata share of the net rents that covers the period from November 1997 until January

1998 should be paid over to it.


The court apparently agreed with the dissenting judge below that the Master Lessor had no claim to rents based upon the argument that the Commissioner had a duty to preserve the master lease.  The court acknowledged that this was an unusual case in this regard, since without a potential extension of the ground lease, it had no marketable value. (Again, the court does not mention rents that might have accrued from January to April, 1998 when the lease term would have expired).


As a final argument, the court notes that the Master Lessor got the benefit of restoration of possession of the property through its action to terminate, and thus got "full benefit" of the lease rights when it also collected the rent.  It stated that "this can hardly be called fair, just and equitable," where the Bank got only around $100,000 to be applied to its million dollar deficiency.


Comment 1: Taking the last first, the court's closing comments are mysterious to those of us who aren't aware of the rents situation for the last three or four months of the lease.  Perhaps the sublease revenues terminated on January, 1998, regardless of whether the master lease had continued.  We just don't know.


In any event, surely this case cannot be about what is "fair just and equitable."  These parties were all "players," and they were entitled to get exactly what their documents and their legal positions gave them, no more and no less.


Comment 2: The Editor has weighed in quite a bit in past law review articles about the appropriate characterization of the mortgagee's interest in an assignment of rents.  In virtually every case, the parties, in fact, intend an arrangement that is a collateral assignment, not a present assignment.  The Editor not only agrees with the Hawaii court's tipping in that direction here, but hopes that it will continue to "tip" when it gets the issue in a battle of rents assignees.


Comment 3: Because landlords under master leases are not in privity of estate with subtenants, in general they have no claim for the rents.  But they do have the right to reach the rents, under established authority, when they have been collected for period in which the master tenant/sublandlord is not paying the rent on the master lease.   It does seem equitable that if the possession conferred by the master lease is creating these revenues, that the master lessor (and its creditors) should not enjoy the benefit of these revenues without paying the cost.  Of course, these rights can be disclaimed, and perhaps tough minded mortgagees will see that they are so disclaimed in the future, but the result seems appropriate as a "default construction" of the parties' relationships.



Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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