Landlord and tenant update - underletting

Landlord and tenant update - underletting

Underletting can be an extremely important means of mitigating liability and/or of using surplus space. However, the provisions regulating the tenant’s ability to underlet can often thwart proposals to underlet where they are most needed.

In December 2002, the House of Lords refused leave to appeal in Allied Dunbar Assurance Plc v. Homebase Limited [2002] EWCA Civ 666. That decision dealt a significant blow to the use of side letters or collateral agreements in conjunction with underleases. So is there any room left for side letters? The importance of this debate – and the need to formulate an industry response – has become abundantly clear in recent months.

The problem – Homebase

In Homebase the Court of Appeal upheld the ruling in Bocardo SAv. S&M Hotels [1980] 1 WLR 17 that conditions precedent to the grant of an underlease must be complied with before any question could arise as to whether a landlord was unreasonably withholding consent. Common conditions precedent are:

• 1.

  that any underlease must be granted at not less than the rent passing under the headlease (often moderated to a requirement that an underlease must be granted at not less than the current market rent); and

• 2.

  that the underlease must contain covenants in the same form as those in the headlease.

In a falling market overrented leases are, in effect, unassignable. Underletting represents the only practical means of shifting surplus space or of mitigating liabilities. If underletting at less than the passing rent is prohibited then tenants may well find themselves locked into an unmanageable commitment. To meet this situation, tenants have granted underleases that comply with the requirements of the headlease, and by separate agreement covenanted to indemnify the undertenant against certain obligations (for example, payment of rent over a certain level). These side-arrangements have generally been personal to the parties in order to avoid the suggestion that they might bind successors in title (a concern highlighted by the decision in System Floors v. Ruralpride[1995] 7 EG 125) and/or the superior landlord.

Homebase has confirmed that underleases and side letters are interdependent documents – the test being whether one would be signed without the other. Consequently, tenants will be under a duty to disclose any side letters, and those letters must be read together with the proposed form of underlease to determine whether conditions precedent have been met.

Perhaps more significantly, Homebase has overturned the view that making personal the tenant’s obligations to the undertenant means that the superior landlord cannot be bound and so has no interest in them. Chadwick LJ focused on the effect of the Landlord and Tenant Act 1954 to show that superior landlords might become bound by concessions between tenant and undertenant. When a business lease is renewed under the 1954 Act section 35 directs the court to have regard to the terms of the “current tenancy”. In Chadwick LJ’s view these would include concessions even though expressed to be personal to the parties to the underlease. Consequently, in circumstances where a superior landlord became the “competent landlord” for the purpose of renewal proceedings, the court might conclude that those concessions (for example, a limited repairing obligation) ought to be carried into the renewal lease.

Importantly, Chadwick LJ’s reasoning will be inapplicable where the underlease is “contracted out” from the security of tenure provisions of the 1954 Act. If there is no right to renewal then section 35 cannot operate to foist upon the superior landlord concessions agreed by its former tenant.

Equally, where the only concession relates to rent then section 35 would have no bearing. Rent under a renewal lease is governed by section 34, which requires the court to assess the open market rent. The rent previously payable, and any concessions granted in relation to that rent, may be considered. However, if a concession were granted some time before the renewal proceedings then its evidential weight would be limited (the analogy being a “stale”comparable).

If the underlease were contracted out, therefore, a major obstacle to the use of side letters would be removed. However, contracting out is not in itself sufficient. Chadwick LJ observed that the superior landlord has a commercial interest in the amount of the rent passing pursuant to an underlease. That rent represents an “obvious source” from which the tenant can fund the rent payable under its own lease. This may be so, but if the tenant can show that it has other sources of revenue then the force of this point might be substantially diminished. In any event, where the superior landlord has taken direct covenants from the undertenant, or where the Law of Distress (Amendment)Act 1908 is employed, it would, in the event of non-payment by its own tenant,be able to look to the undertenant for payment, thereby tapping into that“obvious source”.

The rent passing under an underlease is also of commercial concern to the superior landlord to the extent that it represents a valid comparable for the review of the headlease and any other lettings. Indeed, Homebase itself stemmed from the landlord’s concern to avoid prejudicing the review of rents for nearby units by acknowledging that the proposed underlease rent (being considerably lower than that passing under the headlease) represented the open market rent. This concern lies at the root of conditions precedent relating to underlease rents. However, rent review surveyors are adept at spotting such artificial means of avoiding unfavourable comparables and it is open to doubt how far this subterfuge in fact aids intermediate landlords. Moreover, where rent reviews are referred for determination the skilled and experienced practitioners who act as experts or arbitrators will look for fresh comparables,discounting rents and rental concessions arrived at before the relevant review date when market conditions might have been appreciably different. Consequently,where an underlease concession is given far enough (more than 12-18 months) in advance of headlease rent review its effect on that review ought to be nil or negligible.

Indeed, landlords ought to take care when framing conditions precedent to the grant of an underlease to ensure that their efforts to avoid adverse effects at review do not backfire. Clauses requiring underlease rents to be no less than that passing under the headlease have long been regarded as onerous, producing a discount at review. With the additional hurdles placed in the way of side letters by Homebase it is highly likely that tenants’ submissions will seek a discount wherever the alienability of the headlease is restricted. To that extent, Homebase might represent a pyrrhic victory for landlords.

Drawing those points together it is arguable – even after Homebase– that side letters remain as part of the commercial property toolbox. When used in connection with a contracted-out underlease or where the only concession relates to rent, and where that concession will have little or no effect on a subsequent rent review, then the objections raised by Chadwick LJ will have been met.

When market conditions are poor, and where the effect of restrictions on underletting would be to render a headlease inalienable, it is surely in the interests of all parties for there to be a mechanism allowing for the grant of underleases. That being so, it is unlikely that side letters and collateral agreements will be relinquished without a struggle.

Reverse premiums

In NCR Limited v. Riverland Portfolio No 1 Limited [2004] EWHC 921 Ch, the court considered as a preliminary issue whether a landlord was entitled to refuse consent to an underletting, where the proposed undertenant would receive a significant premium for taking a lease from the tenant.

The tenant occupied premises under a 25 year lease commencing in 1984 and with rent reviews every five years, the final review taking place in December 2004. Following a rent review in 1999, the rent was £710,000 per annum.

The premises became surplus to the tenant’s requirements and terms were agreed with a prospective undertenant for an underlease at a rent of £710,000,but with the tenant paying a premium to the undertenant of £3 million. The passing rent exceeded the open market rent for the premises. Under the terms of the head lease the tenant could grant an underlease subject to obtaining the landlord’s consent and provided it was at “the best rent obtainable in the open market was achieved without payment of a premium or other capital consideration”.

The landlord refused consent to the underletting on the grounds that the tenant had not secured the best rent obtainable in the open market. It argued that the effect of the premium was to reduce the rent to a level below that of the open market rent.

The court ruled that the terms of the proposed underlease met the condition laid down in the head lease and the payment of the premium did not affect the amount actually paid as rent. The premium was not a sham of any kind. Unlike in Homebase where the courts found for the landlord, there was no perception of a fictional calculation in either the rent or the premium. The court felt that, in the absence of such an argument, there could be no justification for treating the arrangement as anything other than legitimate.

It is clear following this decision that the courts will not re-write the terms of a lease so as to turn a genuine reverse premium into a figure constituting rent. However, the success of such arrangements will depend upon the wording of a particular lease.

A further note of caution arises from the recent Court of Appeal ruling in NCRv. Riverland [2005] EWCA Civ 312. The court held that the judge had been wrong to hold that the decision to refuse consent was not made within a reasonable time. This was “not an uncomplicated transaction capable of summary treatment”. Whatever earlier discussions there had been, the landlord was entitled to adequate time following receipt of the completed application to consider the serious financial and legal implications of a refusal with its advisers, and if necessary to report to the relevant board. In the absence of special exceptional circumstances, the period of three weeks actually taken could not be categorised as inherently unreasonable for that process.

The judge was entitled to hold that the unusual terms of the lease were not on the evidence a reasonable ground of refusal. The landlord was unable to show at trial that there was any foundation for its concerns about the unusual characteristics of the arrangement. The arrangement would not adversely affect the forthcoming rent review, since the market rent was likely to remain well below the current lease rent. Similarly, although the landlord’s bankers’consent would have needed to be obtained, the landlord failed to adduce any evidence to show that that would have been a practical obstacle.

The judge was not entitled to regard the strength of the prospective tenant’s covenant as wholly irrelevant because of the continuing liability of NCR as head lessee. He was entitled to give great weight to the security provided by NCR’s covenant during the remainder of the lease, but a reasonable lessor could be expected also to take account of the position at the end of the lease when the sub-tenant, if still in occupation, would have a right to seek a new tenancy under the Landlord and Tenant Act 1954. The expert evidence was that there was a material difference in the value attributable to the prospect of a single new letting, albeit at the market value, and the possibility of smaller leases of a vacant building. Therefore the landlord’s concern about the weakness of the sub-tenant’s covenant had been reasonable and it was not suggested that it had not been genuine. The landlord’s refusal to consent to the underletting was therefore reasonable.

A reminder of the remedies

The High Court judgment on 25 May 2005 in Crestfort v. Tesco[2005] EWHC 805 (Ch) alerts tenants, under-tenants and their advisers to the dangers of granting an underlease in breach of the terms of a superior lease.

It was held that the grant of an underlease by Tesco Stores Limited to Magspeed Limited was in breach of the terms of Tesco’s headlease. The court concluded that by granting the underlease, Tesco committed a breach of contract and Magspeed, by accepting the underlease, intended to induce or procure such a breach.

It was held too that Magspeed knew that the landlord might view the breach of covenant seriously and take legal action. Magspeed was prepared to go ahead and take the underlease in “flagrant disregard” of the rights of the landlord if Tesco was prepared to take the risk of proceeding with the grant of the underlease without the landlord’s consent. Magspeed was held to have committed the tort against the superior landlord of wrongful interference with contract by agreeing to accept and accepting the grant of the underlease. As a consequence, not merely was Magspeed liable in damages, but in the absence of any equitable defence or plea that its grant would be oppressive, the court granted a mandatory order against Tesco and Magspeed for the surrender of the lease. The superior landlord was not required to accept damages in place of such an order as such lesser relief would be inadequate in the circumstances.

Furthermore, the court held (referring to Jaggard v. Sawyer[1995] 1 WLR 269 and Experience Hendrix LLC v. PPX Enterprises Inc[2003] FSR 46), that in circumstances such as in this case, the court may award as additional compensatory damages such sum as the superior landlords might reasonably have demanded at the date of the breach of contract or tort for relaxing the covenant against underletting for the period that no injunction is in force. The court rejected Magspeed’s argument that the award of damages should be made against Tesco alone because Tesco alone was subject to the covenant requiring relaxation. As both Magspeed and Tesco required the covenant to be relaxed if the underlease was lawfully to be granted, the court ordered an enquiry into an award of compensatory damages to be paid by both.

Tenants and under-tenants therefore must now be very wary of pressing on with an underletting on the assumption that the superior landlord can do nothing effective short of forfeiting the head lease. A robust approach to such a grant will now apparently be met with an equally robust approach by the court, which stated in this case that the tenant and under-tenant “took a calculated gamble that the landlords would be unable to obtain any effective remedy for the breach of covenant: the gamble rightly has not paid off”.

These remedies are not new (see, for example, Hemingway Securities Limitedv. Dunraven Limited [1995] 1 EGLR 61) but this case adds to the recent authorities strengthening the effectiveness of a superior landlord’s remedies short of forfeiture and highlighting the possibility that substantial damages could be awarded as well as (and not instead of) an injunction.

Many landlords have persistent difficulties with unlawful subletting, often organised by agents who are well aware of the unauthorised nature of the occupation they are arranging. Whilst this situation is different from the facts of this case, landlords may now have more confidence in seeking a remedy in damages as well as forfeiture, not only for breach of contract but in tort.

It may well be the case that unlawful occupiers are innocent of the legal basis of their occupation, particularly if they are relatively short-term occupiers for whom the accommodation has been arranged as “holiday”accommodation. However, the agent who organises such accommodation would arguably be liable to the landlord in damages on the tortuous ground of unlawful interference with contractual relations between the landlord and the tenant. The landlord would no doubt also seek an injunction against an agent who persisted in organising unlawful sub-letting in breach of appropriate warnings. The agent would probably be in receipt of sums by way of “rent” from the unlawful occupiers far in excess of the rent being received by the landlord from the lawful tenant which, in the residential context, may be limited by statute. The question of how to calculate damages in such circumstances is one that would no doubt give rise to further questions.

4 BPF announcement April 2005

The British Property Federation (BPF) has recently published a press release on a declaration made by certain BPF members.

The declaration states that:

• 1.

  All new occupational leases entered into pursuant to negotiations that started after 30 April 2005, that are granted by a party to the declaration and which permit subletting, whether of whole or part, will not contain any restriction requiring a subletting to be at the higher of the passing or reserved rent and the market rent.

• 2.

  As from 30 April 2005, each of the parties to the declaration will agree to a tenant’s request that a provision requiring sublettings to be at the higher of the passing or reserved rent and the market rent will be waived to permit sub-lettings at the market rent, save in the following exceptional circumstances:

  • where the landlord is prevented by an existing contractual arrangement such as with a provider of finance;

  • where the landlord is prevented by a superior lease;

  • where it can be shown in the original lease negotiation or renegotiation that some value was given in exchange for the tenant agreeing not to sublet at below the passing or reserved rent (for example, for sale and leasebacks);

  • where the rent at the last rent review was agreed at a lower level because of the existence of this provision;

  • where the tenant has refused the landlord’s request to enter a variation to the lease removing the restriction on sub-letting below the passing rent.

The parties to the declaration hope that this initiative will become a standard policy for the commercial property industry and are calling on other owners and investors to follow suit.

List of BPF members making the declaration

• British Land.

• Capital and Regional.

• Crown Estate.

• Derwent Valley.

• Dorrington.

• F&C Property Asset Management.

• Frogmore.

• Great Portland Estates Plc.

• Grosvenor.

• Hammerson.

• Land Securities.

• Legal & General Assurance Society Limited.

• MEPC.

• Morley.

• Prudential Property Investment Managers Ltd.

• Romar Investments.

• Secondsite Property Holdings Ltd.

• Slough Estates.

• Taylor Woodrow.

• Threadneedle.

The following professional firms have signed up to promote the declaration, although are not signatories to the declaration:

• AON.

• CB Richard Ellis.

• CMS Cameron McKenna.

• Drivers Jonas.

• Freshfields.

• Jones Lang Lasalle.

• Lovells.

• Savills.

Government review of law on subletting and assignment

On 16 March 2005, the Office of the Deputy Prime Minister announced that the government will be conducting a review of the law on subletting and assignment.

The BPF stressed in its press release that the declaration “significantly predates” the government announcement and is not intended to pre-empt the government’s review. It is clear, though, that there is a great deal to be taken into account in that review.

Malcolm Dowden and Robert Highmore