Real Estate Legal Update : Global Corporate Real Estate Property and Planning Lawyer & Attorney : Reed Smith Law Firm

The case in question is K/S Victoria Street v House of Fraser and the contract provisions that were being examined in detail were unusual. We are not commenting on those. It is the Court’s remarks about guarantees that are of interest rather than their decision on the very specific facts of the case. We now know that with the right wording a tenant’s guarantor can guarantee the tenant’s obligations given in an authorised guarantee agreement (AGA) when a lease is being assigned.

The practical implications for investors are –

On the grant of a new lease best practice for landlords will be –

• to require the valuable company to be the tenant company and not just a guarantor
• to prohibit assignments intra-group so as to retain control
• to impose a pre-condition to any assignment that any guarantor of the outgoing tenant guarantees their obligations in the AGA

When a tenant wants to assign a lease

• landlords can require that the original guarantor guarantees the outgoing tenant’s obligations being given in the authorised guarantee agreement
• no direct guarantee of the assignee’s liabilities will be enforceable even if given voluntarily by the original guarantor

When an investment acquisition is taking place check early if there are any guarantees with significant covenant strength where the relevant lease has been assigned. Assume any direct guarantee of an assignee will be unenforceable and factor that into any valuation.

Until the Government is able either to dispose of the relevant space or reach agreement with the various landlords for the surrender of the leases, it is clear that ongoing property costs will continue to be borne, ultimately, by the Government. However, where the Government does manage to dispose of its interest Landlords who thought that they owned a building “Let to the Government” as a long term bond may be faced with potentially serious damage to the value of their reversionary interest.

For those ‘new’ leases entered into after 1 January 1996 the newer regime for privity of contract will apply, in that the Government’s liability will continue until assignment – thereafter they will remain on the hook until the next assignment, under an Authorised Guarantee Agreement for the incoming tenant.

For ‘old’ leases entered into before 1996, the Government will have unlimited liability to make good breaches of the lease under the normal privity of contract rules, until the end of the lease.

Many quango leases will have been taken in the name of the Secretary of State and many others contain an automatic right for the Government to assign the leases to a “Crown Body” without consent. Crown Body includes, amongst other things, the quangos which are now in the course of being wound up – landlords may therefore find themselves with a new Government occupier or tenant. On the other hand, where the tenant is the quango and the lease is not assigned, the current tenant may no longer exist.

So where does that leave landlords? It probably leaves them in the same position as if they were dealing with an insolvent tenant because there will be no ongoing guarantee from the outgoing tenant once the lease is assigned. Where landlords gave ‘generous’ terms to a tenant because that tenant was the Government they may regret this. Many leases granted to the Government contain a concession allowing the Government and Crown Body not to pay interest on late rent. Even before the quangos go we may see the exploitation of the quangos' rights and landlords may need to get more pro-active in their management of these assets.

For quangos whose function is being transferred to another body – for example, a local authority, we anticipate that the Statutory Instrument will normally provide that the assets and liabilities of the quango will be transferred to that new body automatically and the property will remain tenanted.

We are advising our clients who own properties let to Government or quango tenants to consider a thorough legal health check to review and formulate a strategy in relation to these issues. We are also looking to the Government to provide some clarity on these issues.

If you require further advice please get in touch with your usual contact at Reed Smith or the authors.

Granting New Leases -

• Some new leases are non-assignable and this is agreed in return for tenants getting a great deal of flexibility in underletting. This preserves covenant strength and value for landlords without the tenants significantly reducing their ability to offload property that they no longer need. A prohibition against assignment does mean that a tenant does not have the opportunity to be released from its obligations as it would be if the lease is assigned twice, but so far that has not been viewed as a significant problem.
• Granting a lease that is non-assignable seems to be a more popular solution than making a proposed guarantor a joint tenant.
•  It is too early to say that we are seeing a tightening of the tests that tenants and assignees have to satisfy before they can assign, but we are seeing some landlords proposing stricter conditions in the first draft of their leases.

Buying and Funding Investments -

• We have been disclosing to potential investors which guarantees would no longer be enforceable.  Banks require this information and are certainly not relying on the fine legal difference between a guarantor giving an authorised guarantee agreement and a guarantor being a sub-guarantor.

Lease Assignments -

• Many existing leases contain wording similar to that considered in the Good Harvest case and requiring a guarantor to give an authorised guarantee on assignment. Some landlords continue to seek such guarantees despite their current unenforceability. Our advice is for landlords to consider investment value based on the covenant strength of the assignee and its guarantor with only the tenant liable under an AGA.

Intra-Group Assignments -

• Where performance by a tenant was guaranteed and the covenant strength rests with the guarantor, group assignments are virtually impossible without a different guarantor of good covenant strength being available.

Sub-letting -

• Tenants are advised to consider subletting as a more realistic and often speedier option if assignments are proving difficult to agree; however, many tenants signed up to leases with tough controls over subletting which are not easy to satisfy in today’s market.  Given the depressed status of the rental market, it is too early to say whether this will have an effect on rental values upon review.

Conclusions -

• The real estate world has had to adjust to the perhaps surprising unenforceability of authorised guarantee agreements given by guarantors (rather than previous tenants), and at the moment it seems that it is tenants who are paying the price by finding it harder to deal with their leases and to offload surplus properties in a difficult market.

For further advice, do get in touch with your usual contact at Reed Smith or the authors.
 

The case involved a lease granted to Tenant A whose obligations were guaranteed. When Tenant A assigned its lease to Tenant B, the landlord granted consent and relied on the lease clause requiring that both Tenant A and its guarantor enter into an authorised guarantee agreement. The Court decided that, when Tenant B defaulted and the landlord tried to enforce against the guarantor, the landlord was unable to do so as the guarantee was void because of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995.

What are the implications for tenants? Here are some initial thoughts pending the appeal of the case:

Taking a new lease - as landlords’ unease increases over the enforceability of guarantees following assignment, you can expect landlords to examine covenant strengths of tenants and their guarantors separately. It is likely that parent companies, which, in the past, would have stood as guarantors, may find themselves having to enter into leases as sole or joint tenant either instead of or alongside their subsidiaries. This may upset the structure many groups adopt for holding property in one entity or the desire to keep businesses in separate divisions.

Ease of assignments - a landlord is likely to be particularly wary of consenting to an assignment where the existing tenant is of a relatively weak covenant strength and the landlord is relying heavily on the covenant strength of the existing tenant’s guarantor. Existing lease assignment clauses are often heavily weighted in the landlord’s favour. We expect that landlords will refuse consent to assign rather than lose a valuable guarantee. If it is proving difficult to obtain consent to an assignment, it may be worthwhile for tenants to consider subletting as an alternative.

Assigning to a group company - we think it will get harder to do authorised group assignments where a parent company guarantees the performance of one of its subsidiaries as tenant. In order to obtain the landlord’s consent to an intra-group assignment, tenants may have to offer a different company to act as a guarantor for the assignee or be prepared to provide alternative security.

Alternatives to guarantors - you may find more and more landlords seeking rent deposits, letters of credit and other alternative security arrangements in lieu of guarantors. Rent deposits do, of course, bring their own complications, not least the question of how to protect each party from the consequences of the other becoming insolvent. They also tie up a large amount of cash for a long period, but the principle behind them is relatively simple and their certainty has a definite appeal for landlords. Where the tenants can offer them, rent deposits may be the key to unlocking deals.

Existing guarantors - bad news for landlords is potentially good news for guarantors who believe themselves to be guaranteeing obligations under authorised guarantee agreements. If the tenant whose performance a guarantor originally guaranteed has assigned the lease, any authorised guarantee agreement that the guarantor entered into as part of the assignment process may now be unenforceable and the guarantor may be released from its liability.

Conclusion and Warning

This case is being appealed and the outcome will affect many leases and guarantees. For the time being, however, the High Court decision stands, causing concern for landlords granting new leases to tenants with guarantors, for existing investors for whom covenant strength and value depend on such a guarantee, and for potential buyers of investments. Tenants should be prepared for landlords taking an increasingly cautious approach to covenant strength, making their plans for their leases harder to implement.

Please contact your usual Reed Smith attorney for specific advice.

The case involved a lease granted to Tenant A whose obligations were guaranteed. When Tenant A assigned its lease to Tenant B the landlord granted consent and relied on the lease clause requiring that both Tenant A and its guarantor enter into an authorised guarantee agreement. The Court decided that when Tenant B defaulted and the landlord tried to enforce against the guarantor that it could not do so. The guarantee was held to be void because of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995. Leave to appeal has been granted and we expect the appeal to be lodged.

This case has serious implications for landlords granting new leases with guarantors, to investors where covenant strength and value depend on such a guarantee and to potential buyers of those investments. Here are some initial thoughts -

Granting a new lease involving a guarantor - consider now making the guarantor a joint tenant rather than a guarantor. This will avoid the dilution of covenant strength that all too easily happens on assignment. If your tenant is taking separate leases of a number of floors think again about whether this should be a single lease deal. We have a number of options for changing the lease assignments clause and suitability depends on the market place so needs individual advice.

Assignment of a lease involving a guarantor - review any applications for consent being processed to require other security for the assignee to compensate for not being able to call on the original guarantor to guarantee the liabilities of the assignee. These cases often turn on the wording of the lease and we are working with our clients to adopt appropriate solutions to manage individual risk in a situation where tenants have number of statutory rights.

Buying an investment - check that the potential impact of this case is factored into the valuation where an AGA has been given by a guarantor.

Investors suing AGA guarantors - expect some robust defences from guarantors like the one in this case. Consider all your enforcement options.

Please contact your usual Reed Smith attorney for advice.