Legal Briefing

Disclaimer of leases: an essential guide

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Real estate | 01 October 2014

Even within a recovering rental 
market, the impact of insolvency can be severe. In particular, the power to disclaim a lease as onerous property can have significant implications for not only parties to the lease but also group companies (acting as guarantor), sublessees and mortgagees.

As the recent case of Schroder Exempt Property Unit Trust v Birmingham City Council [2014] demonstrates, the impact will be felt not only for contractual liabilities but also in respect of liabilities owed to third parties, such as for non-domestic rates of unoccupied premises. It is essential for all parties to be familiar with the practical realities of a leasehold disclaimer in order that the necessary steps to protect their position can be taken.


THE POWER TO DISCLAIM

A liquidator or trustee in bankruptcy may disclaim onerous property by giving the prescribed notice (Insolvency Act 1986 ss178–182 (companies); ss315–321 (individuals)). A court will not interfere with the decision to disclaim unless there is bad faith or perversity. Leases are readily seen as onerous property given that they include obligations to pay rent and carry out repair works. However, the lease must be wholly disclaimed or not at all; it is not possible to disclaim only part. The position is the same for trustees in bankruptcy, save that the court’s permission is required for any after acquired property or certain personal property of the bankrupt (see Insolvency Act 1986, ss307 and 315).

Upon receipt of a notice of disclaimer it is always advisable to check closely that the mandatory requirements have been complied with, as, if not, the disclaimer will be invalid. In summary the requirements are:

1. The notice of disclaimer must contain such particulars of the property disclaimed as enable it to be easily identified
(Insolvency Rules 1986, Rule 4.187 and Rule 6.178).

2. The notice must be authenticated and dated by the liquidator (Insolvency Rules 1986, Rule 4.187 and Rule 6.178).
3. As soon as reasonably practicable after the date of the notice, the liquidator must send a copy to the registrar of companies (and the trustee in bankruptcy must send the same to the court) and, if the disclaimer is of registered land, a copy must also be sent to the Chief Land Registrar (Insolvency Rules 1986, Rule 4.187 and Rule 6.178).
4. Within seven business days after the date of the notice, the liquidator must give or send copies of the notice to (Insolvency Rules 1986 Rule 4.188 and Rule 6.179):
a) any person who (to their knowledge) claims under the company as mortgagee or underlessee;
b) every person who (to their knowledge);
i) claims an interest in the disclaimed property, or
ii) is under any liability in respect of the property, not being a liability discharged by the disclaimer;
c) if the disclaimer is of an unprofitable contract, to the parties to the contract or who have an interest under it;
d) in the case of bankruptcy, where the disclaimer is of property in a dwelling-house, the trustee must also give a copy to every person who (to their knowledge) is in occupation of, or claims a right to occupy, the house (Insolvency Rules 1986, Rule 6.179(3)).
5. However, a notice of disclaimer may not be given in respect of any property if:
a) a person interested in the property has applied in writing to the liquidator requiring them to decide whether they will disclaim or not, and
b) a period of 28 days beginning with the day on which that application was made, or such longer period as the court may allow, has expired without a notice of disclaimer having been given in respect of that property (Insolvency Act 1986, s178(5)and s316). If a trustee in bankruptcy fails to do so, they will become personally liable under the lease (unlike a liquidator).

In the leasehold context, a disclaimer does not take effect unless the liquidator or trustee has served a copy of the disclaimer (so far as they are aware of their addresses) on every person claiming under the tenant and either (Insolvency Act 1986, s179(1) and s317(1)):

  1. no application for a vesting order is made with respect to the property before the end of the period of 14 days beginning with the day on which the last notice was served; or
  2. where such an application has been made, the court directs that the disclaimer is to take effect.

A disclaimer is presumed valid and effective unless it is proved that the rules about giving notice of disclaimer have been broken (Insolvency Rules 1986, Rule 4.193 and Rule 6.185).

THE EFFECT OF DISCLAIMER ON THE IMMEDIATE PARTIES TO THE LEASE

The effect of a disclaimer is set out in (the almost identical) Insolvency Act 1986 s178(4) and s315(3). The former provides:

‘A disclaimer under this section:

a) operates so as to determine, as from the date of the disclaimer, the rights, interests and liabilities of the company in or in respect of the property disclaimed; but

b) does not, except so far as is necessary for the purpose of releasing the company from any liability, affect the rights or liabilities of any other person’.

Therefore, as between the landlord and tenant, the lease determines (Hindcastle v Barbara Attenborough Associates[1997] at paragraph 87) and, in the absence of any affected third parties, the lease simply ceases to exist. Both of the parties’ rights and liabilities under the lease terminate. Consequently, the landlord is entitled to possession immediately upon the disclaimer and, if the tenant remains in possession, it does so as a trespasser (In the Matter of MK Airlines Ltd[2012] at paragraphs 58-59).

A landlord will not be entitled to prove in the insolvency for future rents due after the disclaimer, as its entitlement to those rents no longer exists, but can prove for statutory compensation within the insolvency (Insolvency Act 1986, s178(6) and s315(5)).

THE EFFECT OF DISCLAIMER ON 
THIRD PARTIES TO THE LEASE

By contrast, and pursuant to Insolvency Act s178(4) and s315(3), the disclaimer does not relieve a surety or former tenant from liability. While the lease no longer exists, there is a statutory fiction by which the lease is deemed to continue for rights and liabilities other than those of the insolvent party. Lord Nichols stated in Hindcastle, the leading House of Lords decision on disclaimers of leases (at paragraph 88):

‘… the statute takes effect as a deeming provision so far as other persons’ preserved rights and obligations are concerned… Thus when the lease is disclaimed it is determined and the reversion accelerated but the rights and liabilities of others, such as guarantors and original tenants, are to remain as though the lease had continued and not been determined. In this way the determination of the lease is not permitted to affect the rights or liabilities of other persons’.

Therefore, despite a disclaimer of the lease, the following will remain liable for the ongoing obligation to pay rent and observe the tenant’s covenants (Hindcastle):

  1. the original tenant in a pre-1996 tenancy;
  2. a former tenant of a post-1996 tenancy who has provided an authorised guarantee agreement (AGA) (Doleman v Shaw [2009]);
  3. a surety or guarantor.

Such liability will only come to an end if and when the landlord retakes possession; but the landlord is under no duty to do so.

However, a landlord is required to serve a notice pursuant to the Landlord and Tenant (Covenants) Act 1995, s17 in order to recover the rent from such a third party and upon payment that third party is entitled to claim an overriding lease if desired (Landlord and Tenant (Covenants) Act 1995, s19).

The disclaimer (or the insolvency itself) may be a forfeiting event and a landlord may, therefore, be entitled to forfeit the headlease (and terminate any subleases) as a result, independently of the deeming provisions.

THE EFFECT OF DISCLAIMER ON THIRD-PARTY DERIVATIVE INTERESTS

Similarly, derivative interests, such as subleases and mortgages of the disclaimed leasehold, continue, as it is not necessary for their determination in order to free the insolvent tenant from liability. As Lord Nichols reasoned in Hindcastle(at paragragh 89):

‘In order to free the tenant from liability, it is necessary to extinguish the landlord’s rights against the tenant and also the subtenant’s rights against the tenant. The tenant’s interest in the property is determined, but not so as to affect the interest of the subtenant. Determination of the subtenant’s interest in the property is not necessary to free the tenant from liability. Hence the subtenant’s interest continues.’

The landlord is unable to enforce the tenant covenants in the disclaimed lease against the subtenant, until any vesting order is made, as the subtenant is not a party to the lease.

The effect of the Insolvency Act 1986, s178(4) and s315(3) is that, following a disclaimer, the subtenant remains entitled to possession of the premises under their subtenancy but, crucially, only if and so long as the subtenant pays the rent and performs the tenant covenants in the disclaimed lease. A subtenant may, therefore, have to comply with more onerous (or indeed less onerous) covenants in order to remain entitled to possession. If the subtenant merely complies with their own tenant covenants in the subtenancy the landlord will be entitled to forfeit (Re AE Realisations (1985) Ltd [1988]).

Of course, if the landlord does forfeit, the subtenant is entitled to seek relief from forfeiture and a vesting order under the Law of Property Act 1925, s146(4) (Barclays Bank Plc v Prudential Assurance Co Ltd [1998]). It must be noted that the relief will be on terms that the subtenant pay the arrears of rent due under the disclaimed lease and not merely that under the subtenancy.

Similarly, the rights of a mortgagee of the disclaimed lease will continue, including the power of sale (Scmlla Properties Ltd v Gesso Properties (BVI) Ltd [1995]). Again such rights are contingent upon the mortgagee ensuring compliance with the insolvent tenant’s obligations under the disclaimed lease as if the disclaimed lease continued.

THE EFFECT OF DISCLAIMER ON LIABILITY FOR NON-DOMESTIC RATES

Until Schroder it was unclear whether the liability for non-domestic rates of unoccupied premises switched to the landlord immediately upon a disclaimer of the insolvent tenant’s lease or only from when the landlord took possession. In Schroderthe High Court finally held that a landlord becomes entitled to immediate possession upon a disclaimer and, as such, 
is liable for such business rates.

Briefly, liability for unoccupied non-domestic rates attaches to the ‘owner’ of the property (Local Government Finance Act 1988, s45(1)) which is defined by s65(1) as being the person ‘entitled to possession of it’. In Sobam BV and Satelscoop BV, Brown v City of London Corporation [1996], this was interpreted as being only the person ‘immediately’ entitled to possession.

In Schroder Hickinbottom J held that:

  1. a disclaimer determined a lease for all purposes. All the insolvent tenant’s rights under the lease ceased upon the disclaimer.
  2. prior to the disclaimer the tenant had the right to immediate possession; after the disclaimer, the former tenant had no such right.
  3. The Insolvency Act 1986, s178(4) and s315(3) only preserved the contractual rights and liabilities of guarantors, but not any property rights under the lease.
  4. Therefore, the landlord had an immediate right to possession upon disclaimer.

As a consequence of this recent decision, it is now clear that a landlord will become liable for non-domestic rates of unoccupied property immediately upon the disclaimer. Of course, in many situations the landlord will be able to pass this liability on to a surety, but nonetheless it is a potentially significant liability of which all landlords and institutional investors ought to be aware.

VESTING ORDERS

An application for a vesting order of the remainder of the term of the disclaimed lease may be made by (Insolvency Act 1986, s181(2) and s320):

  1. any person who claims an interest in the disclaimed property; or
  2. any person who is under any liability in respect of the disclaimed property, not being a liability discharged by the disclaimer.

Therefore, the following parties may apply for a vesting order within three months of becoming aware of the disclaimer (Insolvency Rules 1986, Rule 4.194 and Rule 6.186):

  1. an original tenant under a pre-1996 lease;
  2. a guarantor;
  3. a former tenant having provided an AGA under a post-1996 lease;
  4. a subtenant; and/or
  5. a mortgagee.

A party without a proprietary interest, such as a mere licensee, has no right to apply for a vesting order.

Further, a landlord may apply to the 
court requiring a subtenant or mortgagee 
to take a vesting order of the disclaimed lease (Insolvency Act 1986, s182 and 
s321). This has the effect of putting 
that party to election whether to take 
a vesting order. If the party declines 
to accept a vesting order it is excluded 
from all interest in the property and, therefore, a subtenant may lose its right to possession of the premises as its subtenancy will terminate (Re AE Realisations Ltd).

The court has a broad discretion to make 
a vesting order on such terms as it thinks fit (Insolvency Act 1986 s181(3) and s320(3)). However, the court must not 
make an order vesting a leasehold in any person claiming under the insolvent tenant as sublessee or mortgagee except upon terms making that person (Insolvency Act 1986, s182(1) and s321(1)):

  1. subject to the same liabilities and obligations as the insolvent tenant was subject to under the lease at the commencement of the winding up; or
  2. if the court thinks fit, subject to the same liabilities and obligations as that person would be subject to if the lease had been assigned to them at the commencement of the winding up.

Where there are a number of applicants for a vesting order, the court will hear all the applications before the disclaimer takes effect (Insolvency Rules 1986 Rule 4.194(7) and Rule 6.186(7)).

LANDLORD’S INSOLVENCY

Where a landlord’s leasehold is disclaimed, identical principles apply as above. Where there is a disclaimer of the landlord’s freehold, the freehold escheats to the Crown (see Scmlla). In short:

  1. the statutory deeming provisions have the same effect and, for the purposes of third-party liabilities, it is as if the disclaimed freehold continued in existence.
  2. Sublessees and mortgagees interests continue.
  3. Sublessees and mortgagees are entitled to apply for a vesting order (also potentially under Law of Property Act 1925, s181).
  4. Unless and until a vesting order is made (or the Crown sells a freehold to the premises) the freehold vests in the Crown as escheat property. The Crown will not be liable for the property unless and until it takes any active steps of management or possession; which is as rare as hen’s teeth.

OVERVIEW AND PRACTICAL TIPS

Where an insolvent tenant disclaims the lease, a landlord ought to give consideration to:

  1. if there is a guarantor or AGA, whether to sit back and demand the ongoing rents from that third party, ensuring that no acts of possession are taken 
by it;
  2. how re-lettable the premises are and whether it would be better to wait and see if either a sublessee or mortgagee pay the head rent or to force the issue by putting either to an election for a vesting order;
  3. whether the disclaimed lease contained a right to forfeit upon disclaimer;
  4. whether to prove for compensation in the insolvency if there are no third parties from which to recover.

Alternatively, if an insolvent landlord disclaims its interest, a tenant or subtenant ought to consider:

  1. whether to pay any rents due under the headlease or to use the opportunity to leave the premises earlier than permitted under the sublease.
  2. Whether to apply for a vesting order of the headlease or even the freehold.
  3. Whether to seek to purchase the freehold from the Crown.