Find out what you can expect to face in a commercial foreclosure.
Commercial foreclosures are, for the most part, similar to residential foreclosures. The foreclosure may be nonjudicial or judicial depending on the state where the property is located and what the loan documents say.
When Does a Commercial Foreclosure Start?
With both nonjudicial and judicial commercial foreclosures, the process starts when the borrower defaults on the mortgage. A "default" happens when the borrower falls behind in payments or fails to do something that the loan documents require, such as maintaining hazard insurance on the property.
The Lender Accelerates the Loan
After the default, the lender may "accelerate," or call due, the outstanding balance on the loan.
Typically, the lender must first send a breach letter to the borrower that outlines the reason for default and gives a time frame during which the borrower may cure the default and avoid acceleration. Usually, the amount of time given to cure a default is 30 days, but this time frame can vary depending on the terms of the mortgage.
Once the time period given in the breach letter expires and if the borrower hasn't cured the default, then the lender may start foreclosure proceedings.
How Nonjudicial Commercial Foreclosures Work
A nonjudicial foreclosure, or "power of sale" foreclosure, is an out-of-court process.
With a commercial foreclosure, just like a residential foreclosure, the lender may proceed nonjudicially if the loan documents contain a power of sale clause and if allowed by state foreclosure law.
What Is a Power of Sale Clause?
The power of sale clause is located in the deed of trust or mortgage and empowers a trustee to sell the property without court supervision.
Nonjudicial Foreclosure Procedures
This process typically involves:
- recording a notice of default (or similar document) in the county records
- mailing a copy of that notice to the borrower and other interested parties, and
- publishing the notice of default or notice of sale.
Once all requirements under state law are met, a foreclosure sale is held. Nonjudicial procedures vary from state to state.
How Judicial Commercial Foreclosures Work
Judicial foreclosures are processed through the court system and begin when the lender files a lawsuit, usually in the form of a "complaint for foreclosure" or "petition for foreclosure," against the borrower seeking a judgment of foreclosure and order for sale.
Title Report
First, the lender will order a title report so that its attorney can determine all interested parties that must be named as defendants in the lawsuit.
Defendants in a Commercial Foreclosure
The defendants might include lienholders (like junior mortgage holders) or the U.S. Internal Revenue Service if a federal tax lien is on the property.
The attorney will also receive copies of all underlying commercial mortgage documents, including the mortgage, the security agreement, the assignment of leases (if any), the assignment of rents (if any), any UCC filings, and any guaranties. Because commercial loans are often taken out in the name of the business, in many cases the business owner will have provided a personal guaranty pledging payment of the loan. The business owner as guarantor will also be included as a defendant in the foreclosure suit, along with the business itself.
Answering the Lawsuit
Each defendant must be served with a copy of the complaint for foreclosure, either personally or by publication if a particular defendant can't be found. Defendants get a certain amount of time, often 20 or 30 days, to file an answer to the complaint.
Contested vs. Uncontested Commercial Foreclosures
In an uncontested foreclosure, the lender's attorney will file a motion to get a judgment. In a contested case, the matter will typically proceed to trial.
Foreclosure Sale
If the lender wins the suit and after a judgment and order of sale have been entered, a notice of the sale date is given to the defendants. The notice might also be published, depending on state requirements.
The foreclosure sale will be held, and the property will be deeded to the new owner after any applicable redemption period has expired.
The Role of a Receiver in a Commercial Foreclosure
Once a commercial property goes into foreclosure, the lender will want to ensure that:
- the borrower isn't damaging the property's value in any way, and
- the income from the property is going toward paying off the loan and maintaining the property and not being used for any other purpose.
To ensure that these objectives are met, a lender might seek the appointment of a "receiver" as soon as a commercial mortgage loan goes into default.
What Is a Receiver?
A "receiver" is an unbiased third party that the court appoints to protect the property from damage or lost rental income. Typically, the receiver is an individual person, though it could be a company.
What Is Receivership?
The receivership process ordinarily begins when a commercial property owner goes into default. The lender submits a petition to the court to appoint a receiver either before an action to foreclose or concurrently with the foreclosure.
The court-appointed receiver is then responsible for managing the property until the foreclosure is complete. Once appointed, the receiver is generally able to:
- manage existing leases or enter into new leases
- collect all rental income
- maintain the property by arranging for repairs and maintenance
- secure the property to protect it from vandalism or damage by tenants
- obtain insurance and pay taxes
- take control of the bank account associated with the commercial property, and
- sell the property, with the court's permission, and if the lender, borrower, and any junior lienholders consent.
Furthermore, the duties of the receiver include:
- honoring the rights of tenants in the commercial property
- safeguarding the welfare of the tenants, as well as guests
- managing continued operations and expenses while maximizing profitability, and
- submitting financial and property reports to all parties, including the property owner, the lender, and the court. (In a report, the receiver must describe precisely what actions were taken, how much income was received, and how any money was spent.)
Why Would the Lender Want a Receiver?
The main reason a lender might want a receiver is because, once appointed, the receiver (rather than the borrower) manages the income-producing commercial property. Having a receiver reduces the risks of "rent skimming" and "waste."
Downsides to Using a Receiver
Hiring a receiver can be costly for the lender. Generally, receivers are paid on an hourly basis, with rates typically being several hundred dollars per hour. Though, rates vary quite a bit based on the geographic location of the property. The lender has to cover the cost of a court-appointed receiver.
Moreover, a court-appointed receiver answers to the court, not the lender. So, the lender must give up some control. This lack of control is of particular concern to lenders when it comes to selling the commercial property, setting a minimum sale price, and distributing the proceeds.
Potential Defenses in a Commercial Foreclosure
In a commercial foreclosure, just like with residential foreclosures, many potential defenses are available to a property owner to fight the action. Possible defenses include:
- failure to comply with state foreclosure procedural requirements
- inaccurate affidavit
- failure to comply with notice provisions
- mistakes or errors
- failure to prove who owns the mortgage and note
- equitable estoppel
- laches, and
- unclean hands.
Tenants' Rights Following a Commercial Foreclosure
The rights of any tenants in a foreclosed commercial property will depend on the terms of the lease and the date on which the lease was signed. The tenant's interest could potentially be terminated by a foreclosure due to the legal concept referred to as "first in time, first in right." This general rule allows the purchaser of a foreclosed property to void a lease if the mortgage was executed before the execution of the lease.
Subordination, Non-Disturbance, and Attornment Agreements
Many commercial leases contain a subordination, non-disturbance, and attornment agreement (SNDA). Under the terms of an SNDA, the tenant agrees to subordinate, or make junior, its interest in the lease to any lender making a loan secured by the commercial property. The tenant agrees to attorn to, or recognize, any new owner of the commercial property as its landlord. And any new owner of the commercial property agrees not to disturb the tenant's possession of the property as long as the tenant pays rent and complies with the terms of the lease.
For tenants, an SNDA provides some assurance that their rights to their premises will be preserved even if the property is foreclosed.
When to Seek Counsel
If you're a commercial property owner facing foreclosure, or a commercial tenant with a landlord in foreclosure, it's important to keep in mind that many legal intricacies are involved with foreclosures. It might be beneficial to employ the services of a qualified attorney to help you through the process and ensure that you fully understand your rights under the law.
