REAL INSIGHT - Property Update - March 2011

Good Harvest, Bad News?

The High Court held in Good Harvest Partnership LLP v Centaur Services Ltd that a tenant’s guarantor is released on a permitted assignment of a lease and cannot be required to guarantee the assignee’s obligations under the lease. An appeal to a higher court was settled out of Court, but the decision was followed in K/S Victoria Street v House of Fraser (Stores Management) Ltd, so it looks likely to stand unless and until the point is considered on appeal in May 2011. 

Background

In 1996, the Landlord & Tenant (Covenants) Act 1995 ("the Act") swept away the concept of privity of contract in leases. It provided for tenants to be released automatically on a permitted assignment, subject only to them guaranteeing the assignee under an Authorised Guarantee Agreement (AGA). Any existing guarantor is automatically released at the same time and the Act does not say that an existing guarantor can be required to join in the AGA or give a fresh guarantee. It is not possible to contract out of the Act.

Landlords have frequently employed two common methods of attempting to keep a tenant’s guarantor on the hook following an assignment by the tenant:

1. requiring the guarantor to guarantee the obligation of the assignee by a new direct guarantee (in the same way as the tenant guarantees the assignee's obligations under its AGA); and
2. requiring the guarantor to guarantee the tenant’s obligations under the AGA it gives to the landlord (a sub-guarantee)

Decision

It was option 1 that was considered in Good Harvest and which the court considered was void under the Act. The offending condition on assignment provided that "the Tenant... and its Guarantor .... shall enter into an AGA.” The court held that only a former tenant could give an AGA and the contractual guarantor of a former tenant could not be obliged to give a direct guarantee for an assignee. As the Act expressly releases both tenants and contractual guarantors on lawful assignment of the lease, extending their liability frustrated the operation of the Act and fell foul of its anti-avoidance provisions. Furthermore, it was held that a guarantor could not give a guarantee voluntarily in these circumstances either.

The judge, Newey J, also commented that a sub-guarantee of a tenant’s obligations under an AGA would not work either . This comment, although not relevant to the facts in this case, may be treated as persuasive.

No surprise

This decision was not a huge surprise as these lease mechanisms had been treated with caution for a number of years. The case was due to be appealed on 29 June 2010 but it settled on the eve of the hearing which is an unsatisfactory conclusion. It had been hoped that the appeal would overturn the decision or at least clarify the position in relation to sub-guarantees. The House of Fraser case concerned a clause in an agreement for lease requiring the tenant to assign the lease to a group company with the tenant's guarantor also acting as guarantor of the assignee’s liabilities. In that case, the Deputy Judge had difficulties with the reasoning in Good Harvest but the decision was reluctantly followed. This case is due to be appealed in May 2011.

Unfortunately, we are now left with uncertainty in relation to the position of the guarantor for existing leases and it is also difficult to structure new leases where the landlord wants a guarantor to have continuing liability.

Any guarantee covenants following the method set out in option 1 may now be void and it is also uncertain whether guarantee covenants following option 2 will be valid. This undermines the investment value of commercial reversions if they can no longer rely on guarantors' covenants following assignment.

Group re-organisations may also be problematic if the strongest company in the group has been the assignor’s guarantor, as that company cannot even voluntarily guarantee its assignee, leading to a dilution of the financial strength of the covenant.

Solutions

Landlords can still refuse to consent to assign in circumstances in which it is reasonable to do so, and they can lawfully impose conditions.

In relation to leases to group companies where the main financial covenant is the original guarantor (such as a parent company), there is a need to balance the tenant’s requirement for operational flexibility and to preserve the investment value.

There are the following possible lease mechanisms:

1. The proposed tenant and the parent company become joint tenants, with an absolute prohibition on intra group assignment of the lease, but group sharing is permitted. Other assignments are permitted with the landlord’s consent and an AGA from the tenants.
2. The proposed tenant and the parent company become joint tenants, with an absolute prohibition on intra group assignment of the lease, but group sharing is permitted and the tenant is permitted to hold the lease on trust for group companies (i.e. a virtual assignment, not a legal assignment). For accounting purposes, the tenant may prefer this to the first mechanism.
3. The proposed tenant becomes the sole tenant under the lease and cannot assign the lease other than to the parent company. Further intra group assignment by the parent company is prohibited, but group sharing is permitted. Other assignment of the lease is permitted with the landlord's consent and an AGA from the tenant. The effect of this is that the lease must be assigned to the parent company before being assigned out of the group so that on such assignment the main financial covenant gives an AGA. However, an extreme interpretation of Good Harvest may result in the view that this particular mechanism falls foul of the anti-avoidance provision of the Act.
4. The proposed tenant becomes the sole tenant and the parent company is guarantor. Group sharing is permitted. The tenants are also permitted to assign the lease with the landlord's consent and an AGA from the tenants, subject to stringent financial tests e.g. the assignee (whether or not a group company) being of no less financial strength than the combined covenant strength of the tenant and the guarantor by reference to their latest audited accounts. There are of course, many other financial tests which could be substituted for this, such as assets and profits tests, a test by reference to a particular rating agency, or any combination of these.

In all the above, the more restrictive the lease, the more likely it is that the assignment provisions could be viewed as onerous and impact on rent review. Therefore, landlords should consider an assumption or disregard in the rent review clause to counter this, and it may also be advisable to seek advice from a rent review specialist. 

Bribery Act guidance is released

Yesterday, the Ministry of Justice published the guidance on the Bribery Act 2010 (”the Act”). Please click here for more information.

The Act introduces a strict liability offence for organisations that fail to prevent bribery. The guidance clarifies the Government’s intentions with regard to areas such as hospitality, facilitation payments and a company’s liability for the actions of joint venture partners.

The primary defence under the Act is to demonstrate that your organisation has in place “adequate” procedures designed to prevent bribery. Some organisations will be more at risk than others and small companies may not need to create costly procedures. Most organisations should, however, at the very least, undertake a review of the bribery risks it faces and act fast to minimise any risks found.

We have developed Mishcon ASSURE®, a unique Bribery Act risk assessment product, and Mishcon Enable™ , bespoke Bribery Act training, to help our clients prepare for the Act. 

My tenant has gone into administration...

Should I serve a section 17 notice on the previous tenant to recover fixed charges?

Landlords should be wary that service of a section 17 notice under the Landlord & Tenant (Covenants) Act 1995, will entitle a former tenant to apply for an overriding lease and become the landlord’s direct tenant.

Balanced against this the administrator will aim to dispose of or reduce the existing tenant's liabilities possibly by an assignment - an application which, if made, will require the landlord to act within a reasonable time frame.

Landlords may be tempted to quickly complete an overriding lease placing the onus on the overriding tenant to deal with any application to assign. If this option is pursued, the landlord should consider whether to disclose any application made by the administrator to the proposed overriding tenant.

In some situations, non-disclosure of such an application may be used against the landlord in a claim for misrepresentation which, if successful, could entitle the overriding tenant to rescind the overriding lease and/or a claim damages against the landlord.

It may be preferable, in such circumstances, to open up the channels of communication between all parties to reach a solution acceptable to all.

Please get in touch if you need more information. 

Head off the Competition

From 6 April 2011 competition law will apply to previously exempt land agreements.

The OFT has now published final guidance which makes it clear that there is no presumption that a land agreement will infringe competition law and the OFT expects that only a small minority will do so. Also, the OFT is unlikely to take further action in cases where none of the parties to an agreement has more than a 30 per cent share of the market in which the land is being used.

For details of the guidance click here.