Is the law on former tenant and guarantor liability getting in the way of legitimate commercial transactions? Mathew Ditchburn makes the case for reform.

For some time now, the property industry has struggled with a lack of certainty about what is and is not permitted under the Landlord and Tenant (Covenants) Act 1995 (the Act) on the assignment of leases, particularly in the way of repeat guarantees.

Two years ago, the Court of Appeal tackled the issue in K/S Victoria Street v House of Fraser (Stores Management) Ltd [2011]1 and provided some welcome clarity. However, the decision hasn’t exactly been good for business, particularly in relation to the assignment of leases between group companies, and has ultimately raised more questions than it answered.

In July, the Law Commission began consulting on its 12th Programme of law reform. One of its suggestions is to address the property sector’s concerns over the state of the law following K/S Victoria. This coincides with an initiative by the Property Litigation Association (PLA) to draft a proposed amendment to the Act designed to rectify its perceived shortcomings and invite comments from the industry.

The Law Commission’s proposals are due to be submitted to the Lord Chancellor for approval in summer 2014. Has the time finally come to reform this troubled area of the law?

Inequitable results

That the Act was intended to avoid a particular mischief seems clear and well understandable. Prior to it coming into force in 1996, the original tenant and any guarantor signing up to a lease would remain liable for the performance of covenants for the whole of the term, even if the lease was assigned. In practice, landlords also required assignees of leases and their guarantors to accept liability for the whole of the term as well.

This resulted in some fairly inequitable examples of retired former shop keepers and the like being required to pay arrears long after they had assigned their lease as a result of the insolvency or default of the current tenant. The Act brought about a sea change in the treatment of lease covenants on assignment: tenants and guarantors of “new tenancies” (broadly, leases granted on or after 1 January 1996) are automatically released from liability when the lease is lawfully assigned. Section 25 of the Act contains some wide–ranging anti-avoidance provisions, making void any agreement to the extent that it would “exclude, modify or otherwise frustrate” the operation of the Act.

Post-assignment liability was not completely abolished by the Act. Section 16 permits a tenant assigning a lease (T1) to guarantee the performance of covenants by the assignee (T2) under an authorised guarantee agreement (AGA).

Uncertainties remained about whether T1’s guarantor (G1) could guarantee T2’s performance, including by G1 guaranteeing T1’s obligations under an AGA – a so-called sub-guarantee or GAGA.

The case of Good Harvest Partnership LLP v Centaur Services Ltd [2010]2 spread consternation throughout the industry when it was decided that any provision in a lease or other document requiring G1 to guarantee T2 as a condition of assignment was unenforceable. Moreover, the court suggested that such a guarantee would be void even if it was volunteered by G1. The decision was largely upheld by  K/S Victoria but with an important qualification: G1’s release on an assignment of the lease could be limited by way of a sub‑guarantee of T1’s obligations in an AGA.

Rather than providing a complete cure, however, K/S Victoria has in many respects caused a serious headache for the property sector.

The central ruling of the case was that repeat guarantees are void under section 25 of the Act and any provision in the lease or other document requiring such a guarantee is unenforceable. This means that G1 is unable to stand as guarantor of T2, whether the guarantee is required by the landlord or freely offered by G1. While the court recognised the commercial inconvenience that this might cause, concerns were expressed that it may be impossible in retrospect to ascertain the motives of G1; it was preferable to have a clear rule that all repeat guarantees were void.

No guarantees

This inflexible and commercially harsh rule is particularly problematic in the case of intra-group assignments. In that situation, it is not uncommon for G1 to be the parent company (and the only entity in the group with sufficient covenant to provide the guarantee) and for T1 and T2 to be shell companies with no function other than to hold the property interest. As a result of K/S Victoria, landlords are reluctant to agree assignments between group companies because they are not prepared to lose G1’s guarantee (which may have been a fundamental part of the commercial bargain for accepting the tenant in the first place). Whilst it is true that, following K/S Victoria, G1 can enter into a GAGA, this will be limited to the period up to the next lawful assignment and will not cover T2’s obligations under any subsequent AGA. Further limitations arise from the strict notice requirements under section 17 of the Act before a landlord can recover a fixed charge under an AGA (or GAGA).

The result is that the Act, as applied in Good Harvest and K/S Victoria, does not assist but hinders group reorganisations because it prevents a landlord being given the repeat guarantee it needs even when the tenant is happy to provide it. It can also call into question alienation provisions in leases specifically designed to preserve covenant strength on intra-group assignments. The resulting potential loss of investment value has, according to The Times (17 August 2012), led to insurance having to be put in place for at least one high profile building in the City of London.

It may be possible for landlords to engineer a form of repeat guarantee by insisting upon G1 alternating between sub- and direct guarantees on each assignment, i.e. a direct guarantee for T1, a GAGA on assignment to T2, a direct guarantee for T3 and so on. Whilst K/S Victoria suggests that this is possible, it is rather convoluted and may be difficult to achieve in practice. It also begs the question: if this is acceptable, why not just allow repeat guarantees?

The implications of K/S Victoria go even further. Comments made in the judgment that a lease could not be assigned by T1 to G1 even where both parties wanted it caused alarm as assignments to group company guarantors were not, until then, untypical.

Joint ownership

The Act also creates difficulties for transactions involving partnerships and other joint ownership situations. In professional partnerships, leases are commonly held in the name of four of the partners (ABCD). If one of the partners, D, retires, is it possible under the Act to assign the lease from ABCD to ABCE, despite the fact that A, B and C will not be released on the assignment?

Arguably, where T1 comprises two or more persons (including bodies corporate), one or more (but not all) of them can take an assignment. This is because section 28(4) of the Act suggests that T1 is treated as being ABCD collectively, not A, B, C and D individually. However, the point is not beyond doubt.

Furthermore, section 28(4) is not expressed to apply to guarantors. Where G1 comprises more than one person, there is nothing in the Act to suggest that one or more (but not all) of those persons may do what G1 collectively would be prohibited from doing, such as guaranteeing T2 or, perhaps, taking an assignment from T1.

PLA’s proposal

The PLA has drafted a proposed amendment to sections 24 and 28 of the Act which is intended to deal with these issues, particularly those concerning repeat guarantees in intra-group assignments. The draft can be viewed on the PLA’s website (http://bit.ly/19WWXMO)) and the main provisions are summarised in the table overleaf.

As can be seen, the proposal does not go as far as allowing all repeat guarantees, which would not safeguard against the mischief that the Act was supposed to prevent. Instead, the suggestion is that repeat guarantees ought to be permitted in the context of intra-group assignments, be that between companies, LLPs, partners or some combination of these.

The proposal also seeks to avoid potential issues with duediligence: it may be all but impossible, perhaps several years down the line, for the buyer of property subject to a lease with a repeat guarantee to verify that T1 and T2 were indeed in the same group when the lease was assigned. Therefore, a certification given by G1, T1 and T2 to this effect in the document containing the repeat guarantee will be deemed to be conclusive.

While the intentions behind the Act are laudable, arguably its remit goes further than it was ever intended or needed to go. In the process, it seems that some ordinary commercial transactions necessary for the operation of many businesses have unwittingly been prohibited. Any hope that the courts would adopt a more flexible interpretation has been dashed by recent case law.Reforming the Act now seems the only way to rectify the situation.

Click here to view table.

Anyone wishing to provide feedback to the Law Commission on their suggestions for reform can find details and instructions on how to do so on their website (http://lawcommission.justice.gov.uk/consultations/our-ideas.htm). The closing date is 31 October. Any comments on the PLA’s proposed draft amendment should be sent to [email protected] Responses from across the property industry are welcomed.