A recent case Aviel vs. Ng, (2008 Cal. App. LEXIS 475) was first deemed by the Appellate Court to be one that didn't need to be published. On second thought, they decided to publish it. It essentially delves into mortgages versus deeds of trusts in California and whether a commercial lease is extinguished by a foreclosure sale pursuant to a subordination clause in the lease. The case originated out of San Mateo County and the facts in the underlying matter led to the former lessees of the foreclosed property, asserting that their lease was not forfeited because the subordination clause encompassed only mortgages, not deeds of trust. The trial court entered judgment in favor of the foreclosed property's purchaser. The trial court concluded that the deed of trust was senior to the lease by virtue of a clause in the lease subordinating it to future mortgages. The Court of Appeal affirmed the judgment reasoning that under long-settled legal precedent the two instruments were functionally and legally the same.

The facts were that the Ngs entered into a commercial lease with Don Junkin for the basement suite of 415 Grand Avenue, South San Francisco, for the purpose of operating a restaurant called the Grand Palace Restaurant. It was a six-year lease with three five-year renewal options. Monthly rent began at $4,780.

The lease included a subordination clause, as follows: "This lease shall be subject and subordinate to all underlying leases and to mortgages which may now or hereafter affect such leases or the real property of which the premises form a part, and also all renewals, modifications, consolidations, and replacements of the underlying leases and mortgages. Lessee agrees to execute such estoppel letters or other documents required to confirm the same."

In December 2000, Howard Sylvester borrowed $300,000 from Simon David Aviel to purchase the property from Junkin, securing the loan with a deed of trust in favor of Aviel. Two years later, Aviel acquires the property through a trustee sale. Thereafter, he successfully negotiates a new lease with each of the 415 Grand Avenue tenants except the Ngs. At times Aviel and the Ngs are close to getting the deal done but they never actually sign a new lease.

In June 2003, Aviel files an unlawful detainer action against the Ngs. The Ngs remain in possession of the property until November 17, 2003, at which time they move down the street to 359 Grand Avenue. In November 2003, Aviel sells the property to Khalil Abusharkh and Dalal Metwally, trustee of a living trust. Thereafter he converts the unlawful detainer into an action for reimbursement of reasonable rental value. The Ngs cross-complain against Aviel and his wife, as well as Abusharkh and Metwally, alleging numerous causes of action. The Aviels move for summary adjudication of certain causes of action arguing that these causes depended on a valid lease but the lease was extinguished by the subordination clause at the time of the trustee sale. Opposing the motion, the Ngs maintained that the lease was not forfeited by the subordination clause because that clause applied only to mortgages, not deeds of trust. The trial court concluded that the lease was subordinated to Aviel's deed of trust under the subordination clause, and thus was extinguished by the trustee's sale.

The Ngs appeal and the Court looks at mortgages and deeds of trust in California. The Court cites that a mortgage is a contract by which specific property is hypothecated for the performance of an act, without the necessity of a change of possession (Civ. Code, § 2920, subd. (a)). For purposes of the procedures governing exercise of a power of sale in a security device, the term "mortgage" also means any security device or instrument, other than a deed of trust, that confers a power of sale affecting real property or an estate for years therein, to be exercised after breach of the obligation so secured (§ 2920, subd. (b)). A mortgage may confer a power of sale upon the mortgagee or any other person, to be exercised after breach of the obligation for which the mortgage is given as security (Civ. Code, § 2932).

Looking at deeds of trusts the Court cites that the forms of deeds of trust generally in use provide that the trustor of the deed of trust grants, transfers and assigns the property to the trustee, who holds the title as security for the performance of the obligation. There are three parties to a deed of trust: (1) the trustor, who owns the property that is conveyed to (2) the trustee as security for the obligation owed to (3) the beneficiary.

Nevertheless, many years ago, our Supreme Court held that the function and purpose of deeds of trust and mortgages are identical, and "except for the passage of title for the purpose of the trust, deeds of trust are practically and substantially only mortgages with a power of sale ... ." (Bank of Italy etc. Assn. v. Bentley (1933) 217 Cal. 644, 657 [20 P.2d 940] (Bank of Italy).) Both are subject to (1) the same procedures and limitations on judicial and nonjudicial foreclosure; (2) the same redemption provisions prior to and after the foreclosure sale; and (3) the same antideficiency limitations. (4 Miller & Starr, Cal. Real Estate, supra, [*8] § 10:1, pp. 13-14.) Although technically under a deed of trust legal title passes to the trustee, this conveyance of title is "solely for the purpose of security, leaving in the trustor ... a legal estate in the property, as against all persons except the trustees and those lawfully claiming under them. [Citations.]" (Bank of Italy, supra, 217 Cal. at p. 656.) As summed up by our State Supreme Court, a deed of trust is essentially a lien on the property. The deed of trust conveys "title" to the trustee only so far as may be necessary to the execution of the trust.

As far as subordination is concerned, a lease otherwise senior to a deed of trust may be subordinated to that instrument by way of a subordination agreement (Dover Mobile Estates v. Fiber Form Products, Inc. (1990) 220 Cal. App. 3d 1494, 1498 [270 Cal. Rptr. 183] (Dover)). A subordination agreement is a contract by which a party holding a senior lien or other real property interest agrees to lower its priority in relation to that of another holding an interest in the same property. (Miscione v. Barton Development Co. (1997) 52 Cal.App.4th 1320, 1327 [61 Cal. Rptr. 2d 280]). The foreclosure of a senior encumbrance will wipe out all subordinate liens, including leases. (Id. at p. 1326.) Thus, if the sale of the landlord's interest is forced by one having a superior title to that of the tenant, the tenant's interest will be defeated by the sale under the deed of trust. (Dover, supra, 220 Cal. App. 3d at p. 1499.)

The purpose of a subordination clause is to rearrange lien priorities so that the priority of a future lender's lien will overtake that of a lessee whose interest in the property otherwise is first in time and thus ahead of the deed of trust. A future lender's ability to rely on a subordination clause should not depend on whether the security instrument is called a mortgage or a deed of trust. While there is a difference between the limitation period for enforcing a debt secured by a deed of trust and the limitation period applicable to a mortgage, case law has nonetheless consistently held that the two security instruments serve identical functions and purposes and that the same rules should apply to both.

The Ngs, argued that a deed of trust conveys legal title, and, citing Anglo-California T. Co. v. Oakland Rys. (1924) 193 Cal. 451, 452 [225 P. 452], urged the Court that the interest in the property vested as an estate and not as a lien. That theory has been discredited and the law recognizes that a deed of trust, for all practical purposes, is a lien on the property. The Ngs also stressed that a "straight mortgage" requires a judicial foreclosure, as compared with a deed of trust which also allows a trustee sale in the event of a default. In a judicial action, they argue, a tenant would be named as an interested party and have the opportunity to defend its leasehold interest during the proceeding. They were adamant that their bargain with the owner of the building was limited to subordinating to mortgages. But of course their subordination clause did not exclude a mortgage with a power of sale, which is the functional equivalent of a deed of trust. The Ngs further argued that the limitation period for enforcing a debt secured by a deed of trust is longer than the period applicable to a mortgage. Even though that is true, case law has consistently held that the two security instruments serve identical functions and purposes and the same rules should apply to both. (Bank of Italy, supra, 217 Cal. at p. 655.)

What can we learn from this? Well, drafters can expand the terminology in a subordination clause to include deeds of trust though this case says that's not necessary. But more important is a commonly found provision that apparently wasn't in this lease. Namely, nondisturbance provisions which grant tenants a right to stay in possession following a foreclosure.

Peter A. Kleinbrodt