Legal Briefing

Real estate guarantees: a guide to good harvesting

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Real Estate | 04 June 2011

The ongoing House of Fraser sale and leaseback litigation (see box on p61), now due to be heard on 14 June 2011 in the Court of Appeal, brings into sharp focus the issues that can arise from the shifting value of covenant strength between different entities within a corporate group.

This differing and shifting value frequently leads to calls for parent company guarantees (PCG) where operating entities enter into:

  • agreements for lease;
  • leases;
  • development agreements; or
  • joint venture arrangements;

in the real estate context.

Where the commercial context dictates that PCG should be offered, a sound grasp of the technical principles governing guarantees is a necessary pre-requisite to the successful negotiation of an appropriately extensive guarantee. (The validity or enforceability of guarantees can turn on a ‘single word’ – Brooke J in Bank of Scotland v Wright [1991] at p259.)

The essentials of a guarantee are:

  • it is a secondary obligation – the guarantor promises to discharge the principal’s obligation if the principal does not do so;
  • it depends on, and cannot exist independently from, the principal’s primary obligation – this is the co-extensiveness principle – however:
  • it may be limited by express contractual provision; and
  • interest may be payable on amounts due and payable by the guarantor;
  • it must be binding on the guarantor under usual contractual principles;
  • the guarantor must have an adequate power to give it;
  • there must be commercial justification for giving it; and
  • the full extent of the guarantor’s promise (including all material terms) must be in writing and properly signed by it (s4 of the Statute of Frauds 1677).

CO-EXTENSIVENESS PRINCIPLE

Because of the co-extensiveness principle, if any of the principal’s obligations are void, illegal, unenforceable or discharged, then, subject to some statutory exceptions, the guarantor has no liability to the extent of those obligations. Most standard form guarantees try to avoid this and bolster the guarantee’s fragile secondary nature (where applicable) with preservation of guarantee provisions.

POWER TO GUARANTEE

If a company gives a guarantee, there must be an express power enabling it to do so. Most companies’ memoranda of association include some power to give guarantees. (A company registered under the Companies Act 2006 (the 2006 Act), for example, has unrestricted objects unless the articles provide otherwise (s31, 2006 Act.)

COMMERCIAL JUSTIFICATION

When a company gives a guarantee, there must be commercial justification for it (ie in giving it, the directors must be acting in the company’s best interests). If not, the directors will be in breach of trust or breach of duty owned to the company and shareholders can enforce this against the directors. However, the breach can also affect third parties’ rights; for example, a lender who receives assets or benefits from a guarantor who knew, or ought reasonably to have known that the guarantee was given in breach of trust, will be a constructive trustee of them and will have to surrender them back to the guarantor.

There is generally no issue with commercial justification where a parent company guarantees the obligations of its subsidiary; the prosperity of the parent depends on that of the subsidiary (although this should not always be taken for granted).

Equally, usually, there is no issue with commercial justification where a subsidiary guarantees the obligations of its parent or a co-subsidiary, or group facilities are secured by cross-guarantees from all group companies. Often the prosperity of individual group companies depends on the performance of the other companies. However, it is arguable that a financially self-sufficient subsidiary with a positive cash flow and no need to borrow has no reason to burden itself by guaranteeing other group companies’ borrowings. (This is particularly the case if any are in financial difficulties.)

Accordingly, the board resolution approving giving the guarantee should record that the directors have turned their mind to the question of commercial justification and consider there is a good reason to give the guarantee. It is helpful if the resolution records what those good reasons are, but as a minimum the minutes should state that the directors believe there is a commercial justification for giving the guarantee.

As a guarantee is a secondary obligation contingent on default by the principal, the guarantor’s liability can be discharged if the beneficiary of the guarantee deals with the principal in a manner at variance with the contract, the performance of which the guarantor has guaranteed (see box on p62).

In view of these protective rules, increasingly sophisticated provisions have been employed to circumvent them. It is extremely common for the guarantee to include:

  • non waiver of forbearance, time or indulgence to the principal; and
  • preservation of guarantee provisions, whereby any act beyond the powers of the principal and the existence of or failing to perfect or enforce any rights against the principal is not to release the liability of the guarantor.

PRIMARY OBLIGOR STATUS

It is also common practice for the guarantee to prescribe that the liability of the guarantor is to be as principal obligor, thereby negating the secondary nature of the obligation.

However, this then raises the question of whether the language used converts what would otherwise be a guarantee into an indemnity.

In Heald v O’Connor [1971] the High Court decided that the expression ‘as primary obligor and not merely as surety’ was sufficient to avoid the consequences of giving time or indulgence to the principal but did not convert the guarantee into an indemnity.

Nevertheless, in General Produce Co v United Bank [1979] the High Court held that similar primary obligor wording would enable the guarantor’s liability to continue even where the principal had been released. While it is, as always, a matter of construction in each case, the general view of a ‘principal obligor’ clause is that it does not convert what would otherwise be a contract of guarantee into a contract of indemnity as acknowledged in Jaya Sumpiles Indonesia PT & anor v Kristle Trading Ltd & anor [2010] in the Singapore Court of Appeal.

Naturally, if the guarantee includes a separate indemnity in favour of the beneficiary, then there is no doubt that if the underlying transaction is set aside for any reason, or the principal is discharged from liability, that the guarantor remains liable, and again separate indemnity provisions have become common.

In the light of these principles, where formulating a group protocol for obtaining a PCG in the real estate context, consideration should be given to whether:

  • a transaction value threshold should be imposed only above which a PCG may be sought;
  • with the current uncertainty as to the scope and extent of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995, in so far as they relate to guarantors under leases, whether a ‘revolving free pass’ provision is fully effective;
  • specific and express consent by the guarantor should be obtained to variations to the underlying principle agreement;
  • rights of set off and counterclaim should be negated;
  • rights of subrogation against the principal should be negated or limited;
  • principal obligor status should be accepted;
  • the liability of the guarantor should be expressly expressed to be co-extensive with that of the principal under the underlying agreement;
  • the provision of express indemnities should require additional special clearance;
  • an express release of the guarantor contemporaneous with the release of the principal should be included;
  • in the joint venture context, the amount of the cap on several liability by each joint venturer and, where offered, the amount of the cap on a claim-by-claim basis; and
  • the provision of and extent of cross indemnities from each joint venture partner is adequate.

By Elizabeth Thompson, associate director, Berwin Leighton Paisner LLP.

E-mail: elizabeth.thompson@blplaw.com.

House of Fraser sale and leaseback litigation

The dispute in K/S Victoria Street v House of Fraser (Stores Management) Ltd & ors [2010] concerns an external sale and leaseback of the James Beattie Ltd store in Wolverhampton, which was preceded by an asset purchase from James Beattie Ltd into the House of Fraser group via a previously dormant (and consequently assetless) subsidiary.

Unsurprisingly, the buyer and landlord (K/S Victoria Street) was not prepared to allow the new leaseback to remain vested in a group subsidiary of derisory covenant strength (albeit guaranteed by the group holding company). The terms of the transaction accordingly required onward assignment of the leaseback to a group subsidiary of ‘good’ covenant but, if not so identified within a three-month period, to be assigned to the main operating company in any event.

Litigation has ensued following the failure by the House of Fraser group to comply with these terms exacerbated by a group restructuring, which has rendered the previous group holding company (and existing guarantor to the leaseback) also a worthless covenant.

The dispute has centred on the correct interpretation and validity of the terms of the alienation clause governing the onward assignment of the leaseback.

These terms included a requirement for the existing guarantor to enter into a new guarantee of the incoming assignee. The High Court agreed that this requirement did fall foul of the anti-avoidance provisions of the Landlord and Tenant (Covenants) Act 1995, following the Good Harvest Partnership LLP v Centaur Services Ltd [2010] ruling albeit that that specific requirement could be severed from the remainder of the legitimate alienation provisions.

The other aspect of the dispute that has also been heard separately by the High Court relates to the correct construction of a ‘revolving free pass’ provision authorising assignments of the leaseback within the House of Fraser group subject to the group holding company always acting as guarantor to any group assignee. On this issue, the High Court ruled that the provision in question did not give House of Fraser an automatic free pass. Both rulings have been referred to the Court of Appeal.

Protective rules for guarantors

If the beneficiary gives the principal more time to perform the underlying obligation, the guarantor’s liability will fall away (the basis of the rule being that the guarantor has a right against the principal to compel it to perform its underlying obligations; if the beneficiary has given time to the principal then the guarantor can no longer compel the principal to perform its original obligation).

Equally, if the beneficiary agrees to a variation with the principal but fails to obtain the guarantor’s consent to the variation that failure discharges the guarantor from liability (unless the variation is unsubstantial or non prejudicial to the guarantor) (Holmes v Brunskill (1878)).

In the context of lease guarantees it should be noted that under s18 of the Landlord and Tenant (Covenants) Act 1995 (the 1995 Act) former guarantors, (whether the lease is a new lease or an old lease for the purposes of the 1995 Act) are freed from liability to the extent that liability is referable to a variation of the tenant covenants (being one that the landlord has absolute right to refuse or allow) but the former guarantor remains liable for the original obligation given.