In the final part of our series on alienation, Tom Merrick and Annabel Lindsay focus on underletting, a flexible solution for corporate occupiers.
Underletting (also known as subletting) is the legal process whereby a tenant grants a third party a lease (being an underlease) out of its own leasehold interest (in whole or part). The underlease would sit beneath the tenant’s lease. While the tenant remains the tenant under its lease and continues to be liable to its landlord, it becomes the undertenant’s landlord under the underlease.
A tenant is free to underlet unless the lease prohibits or restricts it, so it is necessary to analyse the lease to establish if, and to what extent, underletting is permitted.
Why might a tenant wish to underlet?
Underletting is one option to consider when a tenant wishes to temporarily leave the premises or wants to downsize but does not want to let go of its interest completely. Unlike assignments, underletting is often a temporary solution in a long-term plan and can also allow a tenant to vacate part only if the lease permits.
Why should a landlord be concerned?
A landlord will want to keep control over the identity of the undertenant and the terms of the underlease. Though, at first glance, the tenant appears to act as a buffer between the landlord and undertenant, the landlord may come into a direct relationship with the undertenant if, for example, the tenant’s lease is surrendered, forfeited or disclaimed. Unrestricted underlettings of part could also impact on the future marketability of the landlord’s property if subdivided in a detrimental manner.
What is the underletting process?
The initial steps are very similar to that of an assignment (see our previous article, Lease assignments under the microscope).
It is likely to be a requirement under the lease that landlord’s consent is obtained. As such, section 19(1) of the Landlord and Tenant Act 1927 stipulates that consent is not to be unreasonably withheld.
Section 1 of the Landlord and Tenant Act 1988 imposes further statutory duties on the landlord:
- To provide consent, except where it is reasonable not to do so;
- To provide consent within a reasonable time;
- To provide the tenant with written notice of the decision;
- Where consent is given, subject to conditions, to specify the conditions. If consent is refused, to provide the reasons for the refusal; and
- To pass on the application to anyone else whose consent is needed under the lease.
The tenant will need to submit a formal written application for consent in accordance with the lease and failure to do so could mean that the statutory duties above (including the duty on the landlord to respond within a reasonable time) are not triggered.
It is therefore important to review the notices provision in the lease to establish how the application needs to be submitted or, if the lease is silent, to submit it in accordance with section 23 of the 1927 Act (section 5 of the 1988 Act).
The landlord will require sufficient information to assess the identity and covenant strength of the proposed undertenant.
The landlord is also entitled to know the true nature of the underletting, so any side letter or deed which alters the headline rent terms should be disclosed to the landlord at the outset (Allied Dunbar Assurance plc v Homebase Ltd and another [2002] EWCA Civ 666; [2002] PLSCS 123).
A copy of the proposed underlease is not required at the application stage as long as sufficient details are provided. It may, however, still be reasonable for the landlord to require as a condition to its consent that the form of underlease is approved by it.
The underlease is likely to either be in substantially the same form as the lease or it will be drafted by reference to the lease and incorporate its terms (subject to any agreed variations). Consent to the underletting is normally documented in a licence to underlet and a copy of the agreed form underlease is usually annexed to it.
For further details on the landlord’s statutory duties and what is considered to be reasonable circumstances for refusal and a reasonable time for providing consent, see our previous article.
Common preconditions
The landlord is likely to impose certain preconditions on the tenant in the lease to retain some level of control over any potential underletting. These preconditions must be true preconditions and not an attempt to stipulate what is a reasonable refusal and frustrate the discretion of the court.
As there is no privity of contract between the landlord and the proposed undertenant, the landlord will usually require a direct covenant from the undertenant that it will comply with the tenant’s covenants in the lease (except in relation to rent) and its covenants in the underlease. This then enables the landlord to enforce against the undertenant directly in the case of a breach.
It is not uncommon for the parties to negotiate an underlease on slightly different terms than the lease.
For example, undertenants may not wish to take on onerous obligations and existing dilapidations. A schedule of condition may therefore be more appropriate for a short-term underletting (if approved by the landlord).
Other common examples of preconditions include:
- The undertenant providing a guarantor (to be approved by the landlord) if required;
- No premium is to be received by the tenant;
- The underlease must reserve at least the market rent for the underlet premises;
- The underlease must contain a covenant not to deal with the premises, surrender, or vary the underlease without the landlord’s prior consent;
- Any rent review provisions must be on the same terms as the lease and any reviewed rent must be approved by the landlord;
- If the lease is contracted out of the Landlord and Tenant Act 1954, the underlease must also be contracted out from the 1954 Act. Even the lease is not contracted out, the landlord may still want underleases to be contracted out.
It is also often a condition that the term of the underlease is less than the lease, otherwise the underlease will take effect as an assignment of the lease to the undertenant (Milmo v Carreras [1946] KB 306). There are numerous methods of dealing with gaps between renewal leases, such as granting intermediary tenancies at will or licences, and the commercial consequences should be evaluated on a case-by-case basis and any issues raised with the landlord as early as possible.
Underletting the premises without satisfying the preconditions will be a breach of the lease and the issue of whether the landlord is reasonably or unreasonably withholding consent does not arise. The landlord may have a claim for damages or rely on its other remedies under the lease (such as forfeiture).
It is therefore important for the tenant to review the underletting provisions in the lease as early as possible to ensure any requirements can be met.
Permitted parts
If the lease permits underletting of part, a landlord will likely want to restrict the part which may be underlet to prevent the division of a building into incoherent and unusable spaces (which could have a detrimental impact on estate management and/or future marketability).
The landlord may define the “permitted part” very narrowly.
Typical examples include:
- Permission to underlet a particular square footage of one floor;
- Permission to underlet one whole floor; or
- Permission to underlet two or more adjoining floors.
Each example could be subject to the proviso that the proposed premises has an independent means of access, functions as a separate unit in relation to services and benefits from separate access to, and enjoyment of, the common parts of the building.
A landlord may require that any proposed permitted part be approved by it.
Group sharing
One other option which is often available to a tenant is to share occupation of its premises with a group company without needing to obtain landlord’s consent.
The lease usually provides that such
an arrangement must not create a landlord and tenant relationship, that the group company must vacate if it is no longer a group company, and that the landlord is notified of such an arrangement.
We are seeing some variation to this, with some leases permitting sharing with business associates and/or service providers as tenants seek to secure added flexibility.
Final thoughts
Landlords, be conscious of your statutory duties, but at the same time protect your interests. Tenants, negotiate the alienation clause when taking a lease to try to obtain the maximum flexibility and avoid onerous preconditions which could prevent you from underletting if circumstances require it.
Typical legal documents on an underletting
By the end of an underletting transaction, parties will likely have entered into:
- A licence to underlet (documenting consent) between the landlord (and possibly a superior landlord), tenant and undertenant (as well as any applicable guarantor)
- An underlease between the tenant and the undertenant (as well as any applicable guarantor)
- A rent deposit deed between the tenant and undertenant (if required as a condition to landlord’s consent)
There may be further documents, depending on the terms of the transaction.
Tom Merrick is a managing associate and Annabel Lindsay is an associate in the real estate team at Lewis Silkin
Read part 1: Flexible lease solutions – alienation and beyond
Read part 2: Lease assignments under the microscope
