Simon Bevan and Derek Williams examine how objective conditions can be put into alienation clauses by the use of the “Z-score” approach and how this can help the expert in making subjective judgments.
Readers may be surprised to know that some of our best friends are property litigators! Most of them are now rubbing their hands as they anticipate the work that is going to flow their way as a result of the Landlord and Tenant (Covenants) Act 1995. This became effective from January 1 1996 for all new leases. The cynical might even suggest that some property lawyers are knowingly drafting leases at the moment which they know will lead to litigation.
The Act made certain fundamental changes – well documented in the property and legal press – to the principle of privity of contract.
When agreeing a new lease, section 22 of the Act allows landlords and tenants to agree between themselves the conditions, if any, which will govern assignment. Once agreed, the alienation clause will state the circumstances in which consent will be withheld or the conditions which have to be met before consent will be forthcoming. Landlords will not be acting unreasonably in withholding consent with regard to the non-compliance with factual conditions. However, subjective conditions, such as stating that the assignee be of “equivalent or greater covenant” than the tenant, are valid only if the landlord is required to act reasonably in making the decision or if the matter can be referred to an independent third party. Perhaps because of the state of the current lettings market, most new alienation clauses we have seen are leaving the assessment of covenant to a “reasonable” subjective test, with a simple “rent cover” or “assets test” being the only objective financial tests required.
What is a Z-score?
The Z-score approach is a test of solvency which can objectively quantify the financial standing of a proposed assignee. It is widely used by the banking, investing and accounting professions to measure the financial health of a company. Commercial credit reference firms often provide Z-scores of companies as part of their standard reports. weights are attached to certain financial ratios which are then added to produce a score. A model may be “calibrated” to zero, in which case a positive Z-score would indicate that the company is solvent and should not fail within the foreseeable future. However, if the Z-score is negative, the company has a risk-profile similar to previously failed businesses and is at risk of serious financial problems in the next few years.
One of the main disadvantages of individual financial ratios such as “assets tests”, “rent cover” and “gearing” is that they can often offer conflicting signals as to the financial health of a company and a financial analyst has to use judgment to make a subjective opinion. However, the Z-score approach produces a single figure which can be compared with another company or an industry average.
The Z-score is a result of rigorous statistical regression analysis of financial ratios of companies which are solvent and companies which have failed. This is undertaken from companies in a specific industry sector. The analysis then selects the most relevant financial ratios which, when appropriately weighted and put together, produce statistically significant consistent results in accordance with the sample of companies. A negative Z-score would thus mean that the company in question has a financial profile comparable with the failed businesses in the sample.
An example of a Z-score model is shown below. It was produced by Professor Altman, who devised the original concept in America in 1968.
One should note that the “pass mark” of the Altman model is three and not zero.
During the years since Altman pioneered Z-scores, much development has been done by others, such as Professor Taffler of City University Business School, to make them more country- and industry-specific.
Why are Z-scores relevant to lease assignment?
Landlords are principally concerned with:
- the negative effect on investment value of assignment to a weaker tenant – which is probably best covered by an expert valuer; and
- downside risk of a new occupier being unable to fulfil the lease obligations of the existing tenant – for which the Z-score approach can cater.
The drafting of assignment conditions in alienation clauses would benefit from the use of the Z-score approach to dampen down a debate on the “financial standing” of a proposed assignee. A condition of assignment stating that the proposed assignee has a Z-score equal to, or greater than, the tenant’s Z-score benchmark at each of the last three annual balance sheets (either at granting of lease or time of assignment) would negate the landlord’s reservations in most instances.
Of note is that a firm which has a negative Z-score may recover to prosper as a result of the management overcoming balance sheet and profit-and-loss problems – although the reverse can also occur! The interpretation of Z-scores over time is also important in judging the trend of a company. Indeed, if a financial expert were asked to form a subjective view of the relative covenants of companies, this would, very likely, form a part of the assessment methodology.
Limitations
There are, however, certain caveats with the use of the Z-score approach in conditions of assignment:
- They are sector-specific and thus care must be taken to apply the correct type of model to the companies under investigation.
- Economic circumstances will affect the application of a model if used to compare companies at different points in time.
- Different criteria apply for quoted and private companies, and also for unincorporated businesses, such as partnerships.
There is, therefore, the need for appropriate financial expertise to be used in the drafting of alienation clauses. It may also be appropriate to call on that financial expertise when making a subjective assessment of covenant.
Use of Z-scores
Some pundits have noted that strict consent conditions in alienation clauses may affect rental growth in the longer term, which may in turn influence capital values. In this regard, landlords of certain properties may prefer to have more open alienation clauses to allow tenants to move freely: for example, landlords of shopping centres, in seeking good tenant mix, might prefer young retail businesses which have little trading history. Conversely it may be very difficult for a “blue-chip” retailer, in a High Street location, to find an assignee with a Z-score equal to theirs.
Nevertheless, in those cases where a landlord is determined to seek protection from assignment to a weaker tenant, using comparative Z-scores as the objective test should give the landlord the protection sought in a far more scientific way than traditional “assets” or “profits” tests.
On the other hand, if the landlord’s preference is to rely on subjective “covenant” assessments, then the Z-score approach should be part of the armoury used by the professional who is conducting the assessment. Simon Bevan is a member of BDO Stoy Hayward’s Property Group, and Derek Williams is an MSc student at City University Business School.
