Daily Development for
By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of
Of Counsel: Blackwell Sanders Peper Martin
Kansas City,
prandolph@cctr.umkc.edu
MORTGAGES; DEFICIENCY; NON RECOURSE CARVE-OUTS Expenditures
to pay obligations that are subordinate to a mortgage must be characterized as
made for the purpose of preserving the borrower's interest in the property and
not as related to the cost of "keeping the property." Therefore they do not fall within the
exception to the carveout exception for operating
expenses.
Variable Annuity Life Insurance Company v.
The case involves a mortgage on a subordinated ground lease
interest. The mortgage
agreement contained non-recourse
carve-out provisions of the loan documents against the borrower and the
borrower's general partner. The relevant
provisions provided for personal liability upon failure to turn over tenant
security deposits, monies collected for unpaid real estate taxes, and unpaid
rent collected after occurrence of a default, if not applied to the property's
operating expenses.
Apparently, there was no question that the security deposits
had not been turned over, and the lender claimed these amounts as a carve-out
from the nonrecourse provisions. In response to the claims made by the
lender, the borrower and its general partner responded that under the terms of
the carve-out they were entitled to a credit against such payment obligations
for any money paid to operate and maintain the security.
These expenses, in the borrowers' view, included rent on the ground lease, money paid for a
premium on a bond required to secure the ground lease, repayment of monies lent
by a related entity, management fees, the salary of an on-site building
superintendent, and monies extended to "fit up" office space for a
new tenant.
The lender objected for the following reasons. First, the ground lease was subordinate to
the mortgage. Therefore, the lender
argued that ground lease payments were not normal operating expenses because
they were "made to preserve [the borrower's] interest, not ... the
property." Similarly, the lender argued that the payments associated with
the letter of credit and bond used to secure the ground lease were not costs
related to "keep[ing] the property." The lender argued that there was no
management agent on site at any time and therefore "refuted the claim for
on-site superintendent services."
The lender also argued that the "fit up"
expenses were capital in nature,
and not normal operating expenses.
Essentially, the lower court agreed with the lender and
rejected most of the property owner's claims.
It viewed the obligations under the ground lease as similar to "a
subsequent lien," like "a second mortgage," in light of the fee
owner's subordination of its lease to the mortgage. It reasoned that recognizing the ground lease
expenses as "operating expenses" had the potential for 'eliminating
[the borrower's] obligation under the terms of the note to be personally
responsible for the rents that were due to the [lender].'"
The lower court also rejected the borrower's claim for a
credit for the building superintendent's salary and the management fee, finding
that the borrower was never actually billed for those charges. As a result, it found it difficult "to
believe that this management fee ... was ever really legitimately claimed ...
as something that it normally charges... ." Because
there was no proof of any specific services rendered by an on-site building
superintendent, that claim was also rejected.
As to the "fit up" expenses, the lower court found
insufficient proof as to the amount of the claimed credit. It did not reach the issue as to whether it
was a capital expense. As to delinquent
taxes, the lower court only held the borrower and the general partner
personally liable for the interest and penalties on the delinquent taxes
because during the course of the proceedings, the receiver paid the delinquent
taxes, resulting in no loss to the lender.
The Appellate Division, upon review of the record, agreed
entirely with the lower court and affirmed the lower court's decision.
Comment 1: DIRTer Ira Meislik submitted this case as a commentary on Wednesday's
DD, in which a
The critical difference is that in this case the ground
lease had subordinated to the mortgage. In the editor's view, that makes all
the difference in the world. Both cases
are correct.
Comment 2: As DIRT has commented before the very phrase
"subordinated ground lease" is a misnomer. What actually has happened is that the ground
lessor has agreed to be a co-mortgagor with respect
to its interest in the property. Looked
at from that perspective, it is easy to see that when the co-mortgagors pass
the property proceeds around among themselves, it can hardly be described as
"preserving the property interest" and the mortgagors should not
claim such transfers have priority over the mortgagee's
claims to pledged monies.
Comment 3: There apparently is a mortgage market for unsubordinated ground leases, but such arrangements are very tetchy and only the most sophisticated mortgagees should participate.
Readers are urged to respond, comment, and
argue with the daily development or the editor's comments about it.
Items in the Daily Development section
generally are extracted from the Quarterly Report on Developments in Real
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