Legal Briefing

Landlord and undertenant insolvency: the sandwiched tenant

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Real estate | 01 April 2010

The insolvency of a party to a commercial lease, whether it be the landlord, tenant or an undertenant, is going to impose restrictions on, and limit the rights and powers of, the other parties to the lease. Being aware of all the options is therefore imperative to making the best of what is always going to be an undesirable situation.

Here we look specifically at the position tenants can find themselves in if either their landlord’s company or their undertenant falls into financial difficulty.

Insolvency of the landlord

When people think about the insolvency of a party to a lease, invariably people assume it is the tenant that is insolvent. While not as common, landlords can become insolvent and when they do, this can have various adverse consequences for a tenant.

Provision of services

In multi-let buildings the landlord is usually responsible for the maintenance of the common parts, the provision of services, such as cleaning and security, and is in charge of promoting the building or centre as a whole and/or its signage and the provision of adequate insurance cover for the building. Further, in almost every lease, where it is necessary to apply for consent to either alter or assign or underlet the lease, the landlord’s co-operation (approval of plans or the identity of an assignee) is needed.

As and until the lease comes to an end (on expiry or sooner determination), the landlord remains liable to offer these services (provided, if relevant, the service charge continues to be paid), but may genuinely be financially unable to carry them out. While the costs associated with maintenance, cleaning and security are normally recoverable under a service charge, if the landlord is in financial difficulty, it is likely that services will suffer or even cease if the landlord’s contractors are not getting paid. Although the tenant is inevitably responsible for the landlord’s fees on applications for consent, they are normally payable after the event.

Tenant’s options

If the landlord is claiming impecuniosity, the tenants need to consider practical, if not particularly palatable, alternatives, for example, funding maintenance or insurance themselves or paying up front for surveyor and legal fees for licence applications.

Whether the tenant can actually (and legitimately) withhold rent and/or service charges and set off such payments against the landlord’s failure to provide services depends on the wording of the lease – most modern leases expressly exclude the right to do so. However, that is not to say the tenant will not pursue this tactic to at least attract the attention of the landlord.

Formal insolvency

If ultimately the landlord does move into a formal insolvency process, the effect may differ depending on the type of formal insolvency that is engaged (assuming the landlord is a company, the most common possibilities being the appointment of a receiver or administrator, and compulsory liquidation).

To plan the best strategy going forward, it will be important for the tenant to establish the formal insolvency status of the landlord (see box on p70).

For example, with administration, the primary purpose is to rescue the company, with the secondary purpose to achieve a better result for the company as a whole than if the company was wound up. Therefore continued provision of landlord’s services could well fit into one of these purposes. A landlord in administration may decide it is important to continue to engage contractors to maintain the common parts, security and cleaning services, to increase the chances of the future letting of the units within the centre. Such services are potentially essential to avoiding rental voids and are therefore in the best interests of creditors as a whole. Moreover, if the administrator is looking to sell the landlord’s business as a going concern, it is even more likely that the services will continue.

Obviously, in maintaining such services, costs will be incurred (although any advance service charge payments should be used to offset such costs). Costs not covered by service charge payments (whether non-recoverable through the service charge provisions or payable upfront) will need to amount to an expense of the administration, if an administrator is to pay them in preference to other creditor’s debts. There is a strict order of priority for payment as an expense. For example, costs payable in providing services under a lease may fall into the ‘expenses properly incurred by the administrator in performing their functions in the administration of the company’ category and would then rank above the administrator’s own remuneration.

On the other hand, where a landlord has suffered a compulsory liquidation, the role of the liquidator is to realise the landlord’s assets, distribute them to creditors and dissolve the company. There is no primary aim of rescuing the company. That said, liquidators may (and have the power to) carry on the business of the landlord for the purpose of winding up the company, perhaps in an endeavour, as with administrators, to sell the business as a going concern.

In respect of services for which the landlord is liable under a lease, as with administration, any costs associated with the same need to amount to an expense of the liquidation if they are to be paid during the course of the liquidation in preference to other creditors. In terms of liquidation, such costs are most likely to fit into either ‘expenses incurred by the liquidators in preserving and realising the assets of the company’ or ‘any necessary disbursement incurred by the liquidator in the course of the liquidation’ categories.

However, unlike an administrator, a liquidator has the important power to disclaim a lease. The effect of a disclaimer by the landlord of the lease brings to an end the landlord’s obligations under it. This will leave the tenant without any landlord services and it will need to take advice on its options going forward.

If there is no disclaimer of the lease and a landlord is ultimately wound up, all its assets at the time of winding up, including the lease, will vest in the Crown. It is possible for a tenant to make an application to the Crown to acquire the landlord’s interest in respect of its premises. This might not be a realistic option for a shopping centre housed in a single building, but it could be an attractive option for units on an industrial estate.

In the majority of cases, the landlord’s interest will be valuable, so the receiver, administrator or liquidator will seek to comply at least with the bare minimum of the landlord’s obligations. However, the vigilant tenant should check what is being done, especially around services to the building and insurance.

Taking action

In respect of both administration and liquidation, the difficulty for tenants is the moratorium on proceedings that is imposed. Ordinarily they would have an automatic right to involve the courts to compel a landlord to provide the services it is obliged to or for a declaration to be made in place of the landlord’s consent to an assignment or underletting. However, the moratorium prevents a tenant involving the court without the permission of the administrator (in administration) or specific leave of the court (in liquidation or administration).

The moratorium will capture not only proceedings issued to resolve disputes over services or applications for consent, but also a tenant’s application for a new lease under Part II of the Landlord and Tenant Act 1954 (Somerfield Stores Ltd v Spring (Sutton Coldfield) Ltd [2009]). As such, a tenant cannot proceed with an application without the permission of the administrator or leave of the court and an administrator cannot hide behind the moratorium if that would amount to an abuse of process.

Insolvency of an undertenant

Often space that is surplus to requirements is underlet to mitigate against the continuing obligations to pay the rent. Where that undertenant becomes insolvent, as the intermediate tenant, you could be left dealing with all the usual issues a landlord faces with an insolvent tenant, together with picking up the shortfall and dealing with the landlord’s concerns.

Common issues

Any undertenant facing financial difficulty may approach the tenant wanting to agree rent concessions and/or a payment plan in respect of arrears. Alternatively, it may want to assign its interest on more lenient terms than the underlease allows, or even agree a permanent variation of the lease to allow monthly rent payments or sharing of occupation.

Intermediate tenants are unlikely to have total freedom to agree such concessions or variations as they are restricted to the terms of the headlease. More than likely is that an intermediate tenant will need its landlord’s consent to agree to any form of rent concession or variation of the underlease. This can hamper the intermediate tenant’s ability to assist the undertenant to manage itself, potentially making formal insolvency more probable.

If the undertenant attempts to sells its business to a third party, that third party is sometimes allowed into occupation by the undertenant, in breach of the terms of the underlease. That third party may then pay the rent owed by the underlease while it opens negotiations with the intermediate tenant for a formal assignment of the underlease.

Intermediate tenants may not consider the change in occupation a problem, providing that they are receiving rental income to offset against their own liability under the headlease. However, landlords will want to protect the value of their assets – concerned that unlawful occupation will detract from its value – and will require the intermediate tenants to enforce the terms of the underlease and/or threaten action against them.

These competing interests may be difficult to reconcile, proving costly and time consuming as the three parties attempt to find some common ground. Unless an amicable way forward can be agreed on, intermediate tenants are in the unenviable position of being caught between the landlord’s threats of formal action and insolvent undertenant’s inability to perform.

Formal insolvency

Where the undertenant does move into, for example, administration or compulsory liquidation, seeking to enforce the terms of the underlease will be even more problematic and costly as the intermediate tenant will need first to obtain the permission of the administrator or leave of the court. This is irrespective of what action the landlord is threatening to pursue.

In terms of payments due to the intermediate tenant from the underlease, if such payments are to be made in preference to other creditors, they need to amount to an expense of the administration or liquidation. The recent Goldacre (Offices) Ltd v Nortel Networks UK Ltd [2009] has given further guidance on when rent should be paid by an administrator (and undoubtedly would apply equally to a liquidator) as an expense of the administration. It appears that as long as the tenant company in administration makes use of or the administrator decides to retain the premises, there is no discretion as to whether rent should be paid or not. All amounts falling due during the period of this use must be paid in accordance with the terms of the lease.

Ultimately, a liquidator of the undertenant can disclaim the underlease or it will pass to the Crown on the dissolution of the undertenant. This will leave the intermediate tenant with no incoming rent, no-one responsible for the premises, its insurance nor payment of utilities or no-one in possession of the premises, and yet being obliged for all such corresponding obligations under the headlease.

An undertenant’s administrator or liquidator will look to dispose the assets of the undertenant as quickly as possible. To ensure payment of rent and continuity, the intermediate tenant must be pro-active in engaging with both the administrator or liquidator and its landlord to ensure the best possible outcome.

Conclusion

Any form of insolvency is never easy. Where it is the landlord who is insolvent, the provision of landlord’s services and co-operation may, although not inevitably, suffer to the detriment of the tenants. Where the intermediate tenant is faced with an insolvent undertenant, its position may be even more difficult as the non-payment of rent or breach of the terms of the underlease could put its lease at risk through no fault of its own, or be faced with a damages claim by its landlord while being restricted on its ability to pass on that liability to the defaulting undertenant. Intermediate tenants therefore need to be particularly wary of accommodating the financial difficulties of their undertenants without a strict regard for the terms of their own lease.

Finding out if a company is formally insolvent

  • The best starting place is to telephone Companies Court (090 6754 0043) who can tell you if there has been a winding up petition lodged against the company or an administration application made (only applies to applications made in London). Subsequently any winding up petition, which is not dismissed by the court, must be advertised in the London Gazette (www.london-gazette.co.uk).
  • These enquires may not prove successful (for example they will not show up administration applications made outside London or creditors’ voluntary arrangement). Try telephoning the company offices, check the company’s correspondence or website, or check on companies house website (www.companies-house.gov.uk).