Security for Tenant’s Covenants in Business Leases 3 Comments

Security for Tenant’s Covenants in Business Leases

Proposition: It is never completely safe for landlords to grant leases of business premises to limited companies without additional security.

In what circumstances should a landlord, on a new letting of business premises to a limited company, look for security for the performance of the tenant’s covenants, and what form should the security take?

The traditional institutional landlord test was to look at the tenant company’s audited accounts for the immediately preceding three years and to accept the tenant’s covenant without security if the tenant’s gross or net profit on average or in each year (practice varied) exceeded a multiple (usually three) of the initial annual rent. This was always a backward looking test – as investment advisors are constantly telling us, past performance is no guide to the future. As we know to our cost, economic circumstances can change drastically.

Closing Down Sale/To LetThis is particularly true in the retail sector – for example, GAME, Blacks Leisure Group and, now, Clinton Cards are examples. However, professional firms are not immune – the best known cases recently have been Colliers and DTZ but one might also mention Halliwells and Donns. In the industrial sector, there was the pre-pack (see below) sale of Cobra Beers to Molson Coors in 2009. Even banks are not exempt – Lehman Brothers proved that. No doubt all of these companies would, at the time the leases of their operational premises were granted, have met the kind of institutional landlord test to which I have referred.

Since the Enterprise Act 2002 promoted administration as the principal insolvency procedure, the appointment of an administrator is the most likely outcome where a tenant gets into financial difficulties. Once an administrator is appointed, there is a moratorium on any legal action against the insolvent tenant; the landlord cannot distrain or forfeit the lease or sue for arrears without the administrator’s consent or the leave of the court.

Very often, administrations arPheonixe pre-packaged. A basic pre-pack administration involves a sale of the tenant’s business which is negotiated prior to administration and completed by the administrator after he is appointed. In the retail sector, the usual practice is to agree a pre-pack sale of the tenant’s most profitable shops, with the tenant at a later stage entering into liquidation so as to enable the liquidator to disclaim leases of the remaining unprofitable premises. Quite often (particularly in the case of professional practices) in a pre-pack the business is sold to a new company controlled by the same individuals as the insolvent company – in effect, the phoenix arising from the ashes.

The Licensed Insolvency Practitioners Statement of Insolvency Practice 16 recommended that the government introduce a requirement for prior notice of pre-packs to creditors, including landlords. The proposed reforms were initially looked on with favour by the government but were shelved in January this year; it remains the case, therefore, that landlords receive no prior notice of pre-pack proposals.

Going back to the questions posed at the beginning of this post, when advising landlords granting leases to limited companies (especially, but not exclusively – see below – private limited companies) I have always recommended clients to require security in the form of a rent deposit or (when bonds were available) bond, for reasons which precede the growth of the pre-pack industry.

In a lease, a landlord can only control the actions of the tenant company in relation to the premises demised by the lease; so far as I am aware, there has never been anything to prevent a private company from distributing its other assets to its members by way of dividend and then going into liquidation.

The Ark HammersmithI mentioned above that these considerations primarily apply to private limited companies but it is worth mentioning the saga of the Ark building in Hammersmith. My understanding is that in the mid-1990’s, Canadian drinks conglomerate Seagram occupied most of the 141,000 ft² 1980’s – built Ark from 1995 onwards, on a 25 year lease with a break clause in 2010. The rent was considerable – £4.5m per annum. In 2000 Seagram agreed a £19billion merger with French media group Vivendi. Vivendi did not want to occupy the Ark but could not find a sub-tenant or convince the landlords ( Deka and Legal & General) to renegotiate the lease or take a surrender. Vivendi initiated a complex restructuring, as part of which the name of Seagram Distillers was changed to Centenary Holdings III and the company was sold to a New Zealand based private investor, Murray Richards.

Richards’ plan was to use the cash which came with the shell company as collateral for a loan of up to £185m and to let the Ark so Centenary Holdings III could meet the lease liabilities. There were many proposals but as I understand it they all foundered on the fact that a tenant could not be found for the entire building and the lease restricted the number of occupiers to two.

My understanding of this saga is based on articles in Property Week and Financial News but whether or not I have got the story entirely right, the facts I have gleaned do suggest that even in the case of a letting to a publicly quoted company the landlord is not without risk, even though the circumstances in the Ark case meant that the landlords ended up receiving a substantial settlement. Prior to that, however, the case caused UK institutional investors some degree of anxiety and concern about the safety of UK property investment.

It is also worth bearing in mind the threats of large quoted companies to move their assets overseas (whether one believes them or not).

Stack of £20s

The second part of the question posed at the beginning of this post was; what form should security take? I doubt whether bonds are readily available at any rate at any reasonable cost, and asking directors to give personal guarantees would of course defeat the object of limited liability. The only real alternative is a rent deposit, but in current market conditions it would need to be a substantial one as rent free periods of 12 or even 18 months are not unusual on the grant of new business leases. Allowing say 6 months for marketing and 18 months’ rent free would indicate a rent deposit of 24 months’ rent, and I have not myself been involved in a case where a deposit has been so high.

Where there is to be a deposit, it is highly desirable:-

-  that the deposit is the absolute property of the landlord (though held in a separate account), so that the landlord can draw down on it at all times (rather than it remaining the tenant’s money subject to a trust or charge, although that is now the more usual practice); and

-  that the rent deposit document does not include provision for the deposit to be returned when the tenant’s profits reach a particular level – for all the reasons given above.

Although not directly material to the questions posed at the beginning of this post, I have referred to pre-packs and for completeness I ought to mention another case which has been much commented on; Leisure (Norwich) II Limited v Luminar Lava Ignite Limited [2012] EWHC 951(Ch). In that case, the court decided that if rents payable in advance have fallen due but have not been paid before the appointment of an administrator who then uses the premises during the course of the administration, the administrator is not liable to pay such rents at an expense of the administration.

This appears to mean that a tenant company could appoint an administrator immediately after a rent payment date, and since rents for business premises are normally payable quarterly in advance, even if the administrator were then to occupy the premises the landlord will have lost the best part of 3 months’ rent. The solution which has been suggested in other places (though not a complete one) is that it would be sensible on the grant of new leases for landlords to make the rent payable monthly in advance so as to limit the amount of the loss which the landlord would incur in this situation.

In summary, a landlord letting business premises should, in theory, always seek a substantial rent deposit, though in the case of more robustly healthy private companies, and even more quoted companies, there is likely to be considerable resistance – much depends on market conditions at the time.

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This Post Has 3 Comments

  1. W Killick says:

    As an ” add on” at a time when rent free periods extend to many months and quite often years, the tenants perceived financial situation may deteriorate very quickly. Any form of security must be accessible and ” ring fenced” from day 1. In the event of tenant insolvency the landlord must be able to accesss that immediately, so that the sum involved can at least be used to offset the dilapidations which, inevitably have been incurred.

    • oliver bates says:

      I believe your comments to be accurate but as an agent who is currently active in the Central London marketplace I can say that in practice it is increasingly difficult to to get private limited companies, who can pass the usual institutional profits test, and certainly public companies, to provide rent deposits or other security.

      • raymond cooper says:

        I agree entirely with Oliver Bates’ comment – he may even be slightly understating the case! What really interests me though is something on which I would welcome a comment by an investment agent; If the kind of security I have referred to is not available, what is the effect on safety of the investment and how does that impact on the expected yield?

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