Landlord and tenant update, 2007
Landlord and tenant update, 2007
Parent company guarantees
The headlines preceding the ruling in Prudential Assurance Company Ltd and others v. PRG Powerhouse Ltd and others [2007] EWHC 1002 Ch were certainly dramatic. A widely quoted press release issued by one leading valuation practice asserted that, “up to £38 billion worth of UK property stock could be devalued if the High Court upholds electrical retailer PowerHouse’s use of Company Voluntary Arrangements to vacate its lossmaking UK stores” (Donaldsons press alert, 9 May 2006). This alarming prospect was raised as several of the UK’s largest landlords challenged Powerhouse’s use of Company Voluntary Arrangements (CVAs) which enabled it both to escape rental obligations and effectively invalidate any guarantee provided by its parent company, Pacific Retail.
In the event, the judge decided that the particular CVA put forward by Powerhouse was unfairly prejudicial to the landlords as it would release the parent company from the guarantees that had been freely negotiated between the parties at the time Powerhouse took the relevant leases, so that the benefit of those guarantees would be lost precisely when it was needed.
The decision has been widely reported as a significant victory and as a relief to landlords. However, it is important to remember that the ruling does not mean that CVAs can never be used to effect the release of a parent company guarantee. It merely states that on the particular facts of the case before the judge, the arrangements embodied in the Powerhouse CVAs amounted to unfair prejudice.
A CVA is a compromise or other arrangement with creditors in satisfaction of a company’s debts, or a scheme or arrangement of its affairs under Part I of the Insolvency Act 1986 (the 1986 Act). The CVA is implemented under the supervision of an insolvency practitioner. A proposal is put to the company’s creditors at a meeting and, if approved by 75 per cent of the creditors by value, it binds every person who was entitled to vote at the meeting or would have been so entitled if he had had notice of it (Section 5(2) 1986 Act).
Under the 1986 Act a CVA, or the manner in which it was ratified, can be challenged. That challenge may be on one or both of the grounds specified in section 6(1):
(a) that a voluntary arrangement...unfairly prejudices the interest of a creditor, member or contributory of the company; or
(b) that there has been some material irregularity at or in relation to either of the meetings.
If the challenge is successful then the court has the power to revoke or suspend the decision approving the CVA.
The facts
In September 2003, Powerhouse acquired assets for its UK electrical business including a large portfolio of high street stores and superstores. On the acquisition a number of landlords, concerned by the limited covenant strength evidenced by Powerhouse, insisted on the provision of guarantees by Powerhouse’s parent company, PRG, in respect of Powerhouse’s obligations under the leases.
Having run into financial difficulties Powerhouse subsequently informed its creditors that it intended to close 35 under-performing stores. It proposed retaining 53 stores from which it hoped to trade successfully. Rent was paid in respect of all the closed stores up until the March 2006 quarter day.
The directors of Powerhouse then proposed the CVA with the following key terms:
The rights of all creditors, save a group defined as the scheme fund creditors, were to be unaffected by the CVA.
The scheme fund creditors (consisting of employees, landlords and local authorities who were creditors in respect of the closed stores) were to be given a capped fund, which in practice would amount to no more than £1.5 million giving them just 28p in every £1 owed (the fund).
All of the scheme fund creditors claims against Powerhouse relating to the closed stores were to be released.
The guarantees given by PRG (the guarantees) to the landlords of the closed stores (the landlords) were also to be released.
The CVA was ratified with the requisite statutory majority on 17 February 2006. Immediately, the landlords challenged the validity of the CVA. The central issue was whether the CVA could be effective to release PRG from any liability in respect of the guarantees provided by it to the landlords.
The following questions were tried as preliminary issues:
Whether, on a correct interpretation of section 5(2) of the 1986 Act, and on the true construction of the CVA and the guarantees given by PRG, any of the guarantees had been released or should be treated as released? (The first preliminary issue.); and
If the guarantees had been released in some way, did the CVA unfairly prejudice the interests of the landlords, as creditors of Powerhouse, within the meaning of section 6(1)(a) of the 1986 Act? (The second preliminary issue.)
A CVA is binding between the company in question and its creditors. The terms of the Powerhouse CVA meant that, while the guarantor could not be directly protected, Powerhouse could enforce an obligation on the landlords not to claim against PRG under the terms of the guarantees. In effect, therefore,the CVA had successfully disabled the guarantees.
Having reached this decision the judge had to go on to consider whether the result was unfairly prejudicial under section 6(1) of the 1986 Act. He observed that assessing whether a result is prejudicial is not difficult. Any CVA that leaves a creditor in a less advantageous position than that he was in before the CVA will clearly be prejudicial. The key question, though, is whether that prejudice is unfair having regard to the circumstances, to the alternatives available and the consequences of those alternatives. The judge stressed that the fact that a CVA resulted in differential treatment of creditors will not necessarily be sufficient to show unfair prejudice. Indeed, in some circumstances differential treatment may be positively required to achieve fairness.
In this case the judge found that the CVA clearly left the landlords in a worse position. Were it not for the CVA, the landlords would have the benefit of the guarantees. The guarantees were clearly of considerable value to them. By comparing the position of the landlords to the other creditors under the CVA it was clear to the judge that the landlords were unfairly prejudiced. The landlords were to receive nothing extra from the CVA for the loss of the guarantees. All of the creditors, other than the scheme fund creditors, were entitled to be paid in full. The claims of the landlords were to be discharged from the fund at a fraction of their worth in order that other creditors could be paid in full. Consequently, the landlords (the group of creditors likely to suffer least on an insolvent liquidation of Powerhouse) became the category most prejudiced under the CVA. The CVA compromised their position with an inadequate payment from the fund and placed no value on the guarantees which would have improved their position in the event of an insolvent liquidation of Powerhouse. This result was, in the judge’s opinion, “illogical as well as unfair”. In effect, the voting mechanism by which the CVA was approved meant that:
… the votes of those unsecured creditors who stood to lose nothing from the CVA, and everything to gain from it, inevitably swamped those of the landlords.
If different terms had been proposed in the CVA, then deciding the issue of unfair prejudice may not have been so clear. Differential treatment of groups of creditors may well be permissible where the circumstances are different to those in the Powerhouse case. In practice, landlords will be extremely alert to the terms of any tenant CVA to see what arrangements are proposed, particularly in relation to guarantors and co-debtors. If they consider the arrangements to be unfair then they may well decide to challenge them in court – but the Powerhouse ruling will certainly not guarantee that their challenge will succeed.
Rent reviews, former tenants and guarantors
Of less cheer to landlords was the Court of Appeal ruling in Scottish Newcastle v. Raguz [2007] EWCA Civ 150. The decision has surprising implications for – and imposes a significant management burden on –those seeking to recover from former tenants backdated rent following determination of a rent review.
Commercial leases generally provide that if the rent is reviewed upwards and the new rent is agreed or determined after the review date, then the tenant will continue to pay instalments of rent at the “old” rate until the new rent is known. Once the new rent has been agreed or determined (which can be months or even years after the review date) then the tenant must make a single balancing payment equal to the uplift payable on each instalment of rent from the original review date to the date on which the reviewed rent is agreed or determined. This balancing payment will be payable on the quarter day following determination of the reviewed rent.
To the surprise of many property professionals, the High Court decided in 2006 that liability for the balancing payment did not fall due when the balancing payment had been calculated and became payable, but instead accrued as each instalment of the passing rent fell due between the review date and the date the review was completed. To even greater surprise, the Court of Appeal agreed with this analysis.
Under Section 17(2) of the Landlord and Tenant (Covenants) Act 1995, a landlord cannot recover any fixed charge from a former tenant (or guarantor)unless a default notice has been served within six months beginning on the date when the monies became due). Having decided that the balancing payment in respect of reviewed rent falls due (even though its amount is not know) with each instalment of passing rent, the Court of Appeal decision makes clear that:
If a rent review has not been determined by the relevant review date, the landlord should, as a precautionary measure, serve a Section 17 Notice on former tenants (and any guarantors) who will remain liable for the payment of rent.
The Notice must be served within six months of each rent payment date until the rent review has been determined.
However, the landlord will not actually be claiming anything from the former tenant at this stage as a rent review has not been determined. The section 17 notices will, in essence, list the arrears as “nil at the moment – but wait and see”.
The situation is most likely to arise in the context of “old leases”(which are leases granted prior to 1 January 1996) or in respect of an assignor of a tenancy granted on or after 1 January 1996 (“new tenancy”) who has entered into an Authorised Guarantee Agreement (AGA).
A further notice must be served once the final rent review has been determined. Such a notice would not be required if the current tenant had actually paid any shortfall that was due following the rent review being finalised.
This decision will impose further property management task on landlords and their agents. Further, at the time of service of such notices no default will have occurred. Accordingly, depending on the terms of the lease, a landlord may not be able to recover the cost of serving the notice on the current tenant.
Where there is more than one former tenant (or guarantor) who is liable for unpaid rent, the service of Section 17 Notices will involve some consideration. When considering whether and on whom to serve a Section 17 Notice the Landlord must bear in mind the potential entitlement of the recipient to an overriding lease. Accordingly, the landlord may not want to serve a notice on a former tenant with lesser covenant strength. Any assignee who gives an indemnity(whether express or implied) to the party assigning the Lease should be aware of the liability that this involves. He should also be aware that unlike the former tenant who receives the Section 17 Notice from the Landlord the assignee is not entitled to claim an overriding lease. Accordingly, the assignee has the burden of the indemnity but no right to claim the benefit of the new Lease of the premises for which it has been asked to pay rent under the indemnity covenant.
Leases as contracts
A lease is a contract. The contractual nature of a lease was strikingly described by Lord Diplock in United Scientific Holdings Limited v. Burnley Borough Council [1978] AC 904:
The mediaeval concept of rent as a service rendered by the tenant to the landlord has been displaced by the modern concept of a payment which a tenant is bound by his contract to pay to the landlord for the use of his land.
Considering the validity of a notice to terminate a contractual periodic tenancy, Lord Bridge said in Hammersmith & Fulham Borough Council v. Monk [1992] 1 AC 478:
As a matter of principle I see no reason why this question should receive any different answer in the context of the contractual relationship of landlord and tenant than that which it would receive in any other contractual context.
There are, however, still some extremely significant points of difference between the treatment of leases and other contracts. The key points of distinction were explored and ruled on by the Court of Appeal in December 2006 in a case that will come as a huge relief to landlords faced with defaulting tenants.
Reichman v. Beveridge [2006] EWCA Civ 1659 concerned the lease of offices occupied by a firm of solicitors. The firm ceased to operate in February 2003 and had no further use for the offices. From that date the tenants did not pay rent or other outgoings. The landlord decided not to forfeit the lease, but instead sued for arrears, seeking only a money judgment. Further, the landlord decided not to accept an offer made by the tenant of their other premises to take an assignment of the lease. The potential assignee would not have stepped into the office lease without surrendering their other premises.
The tenant’s defence to the landlord’s ongoing claim for rent due under the lease was that the landlord had a duty to mitigate its loss. By failing to forfeit or to put a new tenant in place the landlord was in breach of that duty. The main difficulty faced by the tenant was that the landlord’s claim for rent arrears was a claim in debt; the rule relating to mitigation of damages does not apply to debt.
To overcome this difficulty the tenant had to argue that the landlord’s decision to keep the lease alive, and not to put another tenant in place, was“wholly unreasonable” and that damages would be an adequate remedy. To succeed, the tenant would have to show (i) that under English law it is possible for a landlord to recover damages for loss of bargain, equal to the rent that would have been payable had the lease not been forfeited, and (ii)that there ought to be a policy approach which would not leave premises empty after tenants had abandoned them, essentially placing landlords under a duty to find a new tenant. Fortunately for landlords, the tenant failed.
Damages
The tenant argued that damages would be an adequate remedy for the landlord. For that to be the case, the landlord would have to be able to recover “loss of bargain” damages for the period between forfeiture and the end of the contractual term of the lease. This in turn would require the court to overturn the principle that once the landlord has taken possession he cannot recover rent under the lease. The Supreme Court of Canada (Highway Properties Ltd v. Kelly, Douglas & Co Ltd (1971) 17 DLR (3d) 710) and the High Court of Australia (Progressive Mailing House Pty Ltd v. Tabali Pty Ltd(1985) 157 CLR 17) have allowed recovery of loss of bargain damages. However,the Court of Appeal unanimously ruled that there is no English case which decides that landlords can recover damages of this kind, and at least one English decision to the contrary.
The point is important. Lawyers who do not specialise in property law –and even more specifically in the law relating to landlord and tenant –frequently assert that such damages can be recovered in England. This can lead to some extremely ill-advised decisions, such as forfeiting a lease at a time when the letting market is poor. The Reichman case should serve as a salutary reminder to landlords to be wary of forfeiture in those conditions.
The Court of Appeal also decided that the landlord cannot be required to bring the lease to an end or to seek a fresh tenant. The Court cited with approval the comments of Romer LJ in Boyer v. Warbey [1953] 1 QB 234:
A tenant who goes out of possession without giving due notice has no right to dictate to his landlord how he shall deal with his property; and why the landlords here should have disposed of the flat in a manner disadvantageous to themselves in order to save the tenant from the full consequences of his wrongful act I am at a loss to conceive.
And also the comments of Sir John Vinelott in Bhogal v. Cheema[1999] L&TR 59:
However, the landlord cannot be compelled to take possession and, of course,it will not be in his interest to do so if the market rent of the premises is less than the rent payable under the lease, unless possibly he takes the view that his remedy against the surety is unlikely to yield the full amount of the rent
Finally, in Reichman itself, Lloyd LJ rejected the tenant’s position, which seemed to be that any landlord, knowing that the tenants have abandoned the premises, ought to take steps to re-let, and therefore to terminate the tenancy, and look to the tenant for damages to cover any resulting loss. The problem is, at root, the tenant’s. If the landlord chooses to regard it as up to the tenant to propose an assignee or sub-tenant or a substitute tenant under a new tenancy rather than taking the initiative (and incurring the expense) himself, then that is not unreasonable – still less wholly unreasonable.
deciding whether to forfeit
The Court of Appeal ruling in Reichman serves as a useful reminder that the landlord has a range of potential remedies against a defaulting tenant,and that forfeiture is often not the best choice. When a lease is forfeited the tenancy – and with it, entitlement to rent and other payments under the lease – comes to an end. Also, any sublease carved out of the forfeited lease will end at the same time. It would be for the subtenant to seek relief from forfeiture, and if the sublease is of part only of the premises or if it is on diluted terms, then the landlord cannot be sure that the court, in granting relief, would require the subtenant to take on the whole premises or the more onerous terms of the forfeited headlease. If the subtenant decided not to seek relief, then the landlord would be left without a tenant, and so without an income stream.
In some cases, tenants have calculated that the landlord would not forfeit for unauthorised assignment or subletting. Indeed, tenants have pressed ahead with unlawful alienation in the misplaced belief that the landlord’s only real remedy would be forfeiture. Hemingway v. Dunraven [1995] 1 EGLR 61 showed that the courts can award a mandatory injunction requiring the unauthorised transaction to be undone (for example, by surrendering a sublease or re-assigning a lease). More recently, in Crestfort v. Tesco[2005] EWHC 805 (Ch) the court made it clear that damages could be awarded as well as – and not just instead of – an injunction, and that the unauthorised subtenant or assignee would be on the hook (for the tort of inducing a breach of contract) as well as the tenant (for breach of covenant). In each of those cases, market conditions and the disparity between headlease and sublease covenants meant that the landlord had good reasons for rejecting forfeiture as a sensible commercial option.
Where the breach is non-payment of rent, the landlord may have equally strong reasons to reject forfeiture. Forfeiting the lease ends not only the obligations of the tenant, but also those of any guarantor, sub-tenant or former tenant still liable to perform the tenant covenants of the tenancy. To preserve those covenants, the landlord must keep the lease alive. An ongoing relationship of landlord and tenant is also necessary if the landlord wishes to levy distress or to serve notice on a sub-tenant under section 6 of the Law of Distress Amendment Act 1908. Where a 1908 Act notice is served, the subtenant is required to pay rents direct to the landlord until the tenant’s rent arrears have been satisfied.
The Court of Appeal ruling in Reichman recognises and accommodates the range of remedies open to the landlord. While there is often a strong argument in favour of the consistent development of the common law across the Commonwealth jurisdictions, this is one area in which English landlords and their lawyers will not be clamouring for change.
Malcolm Dowden
