In the February 2009 edition of property update, we considered the case of Clarence House Ltd v National Westminster Bank plc. The High Court's decision that a virtual assignment constituted a breach of a typical covenant against alienation has now been overturned by the Court of Appeal.

A "virtual assignment" is an arrangement under which all the economic benefits and burdens of a lease are transferred to a third party, but without any actual assignment of the leasehold interest. In this case, the tenant entered into a virtual assignment with a company called New Liberty. At the time of the virtual assignment, the property was let to an undertenant, who was in occupation. Under the terms of the virtual assignment, New Liberty was obliged to manage all dealings with the landlord and the undertenant as if the property had been assigned to it, and was appointed as the tenant's agent in all dealings connected with the property. To enable New Liberty to do this, the tenant granted a power of attorney to New Liberty enabling it to act in the name of the tenant in relation to the property. The document stated that all monies receivable from the undertenant belonged to New Liberty.

The High Court had ruled that the virtual assignment breached the tenant's covenant not to share or part with possession of the property. The Court of Appeal disagreed.

The Court of Appeal noted the definition of "possession" in the Law of Property Act 1925, which includes (unless the context otherwise requires) the receipt of rent, or the right to receive rent. However, it ruled that, as between New Liberty and the undertenant, New Liberty collected the rent as agent for the tenant. Its right to keep the rent, once collected, derived from the contractual arrangement it had with the tenant. This did not amount to a transfer to New Liberty of the right to receive rent in the sense envisaged by the Law of Property Act. This was demonstrated by the fact that an action against the undertenant for arrears would have to be brought in the tenant's name, not New Liberty's (albeit that the tenant was unlikely to be able to refuse consent for its name to be used). Even if the effect of the virtual assignment was to transfer to New Liberty the right to receive the rent, the consequence was not to put New Liberty in possession of the premises, but to pass to it a personal right to the debt. New Liberty could in those circumstances recover the rent from the undertenant as a debt, but could not forfeit the underlease or distrain for non-payment; those rights being attached to the tenant as holder of the reversion.

The court held that "possession" must be given its normal meaning. The hallmark of the right to possession was the right to exclude all others from the property. At all times since the virtual assignment was entered into, the tenant had not been in possession of the property at all, since it was let to the undertenant. Therefore, the tenant could not be said to have parted with possession to New Liberty, or be sharing possession, as a result of the virtual assignment. In the court's view, a covenant against sharing or parting with possession was concerned with the question of whether the tenant had allowed another into physical occupation, with the intention of relinquishing its own exclusive possession.

The Court of Appeal also agreed with the conclusions of the High Court that the virtual assignment did not constitute a breach of the covenant against assigning the property, underletting it or holding it on trust. The result was that there had been no breach of the lease by the tenant.

Things to consider

In giving the judgment of the Court of Appeal, Ward LJ stated that "I recognise that virtual assignments are strange new beasts in the forest; that one must circle around them suspiciously and cautiously; but the moment one gets close and has a good sniff, the overwhelming smell is of contract, not trust".

There can be powerful commercial drivers to put a virtual assignment in place. It is therefore unfortunate that, in this case, since New Liberty's involvement, the rent payable under the lease fell into arrears. However, despite that, the basis of the landlord's concerns is not entirely clear. The landlord had - and always did have - a cause of action against the tenant for non-payment of rent, whether as a debt claim or as a ground for forfeiture. It was also open to the landlord to serve a notice on the undertenant requiring it to pay the rent under the underlease directly to the superior landlord in order to cover those arrears.

Some draftsmen have amended their precedent leases to prohibit virtual assignments in the light of this case. The argument in favour of this is that a landlord may be concerned about underlease rent being diverted to a virtual assignee and the effect that this might have on the tenant's covenant strength. However, against this is the fact that landlords do not - and arguably should not - seek to regulate how tenants run their business, including what they do with income from underleases. After all, if the premises have not been underlet, having carried out its initial assessment of covenant strength, the landlord has no ongoing control over the income from which the tenant pays its rent.