Commercial rent arrears: third parties, rent deposits and surrender

In the second article in their series, Paul Henson and Amy Wagg conclude their review of the avenues available to landlords of commercial premises when their tenants are in arrears of rent. Last time, we explored some of the legal and court-based options available to commercial landlords when their tenants are in arrears of rent. However, there are options available without the need to seek involvement of the courts, and the added expense and litigation risk that brings. Recovery from third parties A landlord will often require a guarantor to guarantee the performance by a tenant of its obligations under the lease, including payment of rent. This can be a parent company (if the tenant is part of a wider group structure) or even an individual with the required financial means to settle any arrears in the event of the tenant’s failure to do so. In simple terms, the existence of a guarantor allows a landlord to recover arrears from it if the tenant fails to perform. The specific wording of the guarantee is important to check, and legal advice is always recommended before proceeding with such action. A landlord can also seek to recover payments due under a lease from a former tenant which has assigned its leasehold interest. However, the Landlord and Tenant (Covenants) Act 1995 must be considered in such circumstances, as it governs the liability of former tenants post-assignment: If the lease was entered into before 1 January 1996, the landlord can only take action against a former tenant under that lease if it remains liable under the “old” pre-1 January 1996 privity of contract rules. Such an action lies against an original tenant, or a previous tenant (or its guarantor) which, on assigning its lease, has entered into a direct covenant with the landlord and under which it remains liable. If the lease was entered into after 1 January 1996 it is, for the purposes of the 1995 Act, a “new lease” and an action for rent arrears can only be taken against a former tenant or guarantor if it entered into an authorised guarantee agreement on assignment of the lease. The AGA provides for the outgoing tenant to guarantee the performance of an incoming tenant to the landlord. Action can only be taken by the landlord in either “old” or “new” lease scenarios if notice has been served under section 17 of the 1995 Act, and such notice has to be served within six months of the rent, service charge or other liquidated sum payable under the lease falling due. A landlord must bear in mind that, if the former tenant or guarantor pays all sums due under the section 17 notice, it can then call for an “overriding lease” which slots in place above the existing lease. The former tenant or guarantor then becomes the “landlord” of the tenant in default and this allows it to take enforcement action against the defaulting tenant to limit its ongoing liability. A landlord with rent arrears has therefore recovered the debt but now has a new tenant in place which may take some control away from it in how the defaulting tenant is dealt with. If a tenant has sublet the property, a landlord has an opportunity to recover unpaid rent due from the sub-tenant pursuant to section 81 of the Tribunal, Courts and Enforcement Act 2007. This statutory tool allows a landlord to serve notice on the sub-tenant, requiring it to pay the rent due under the sub-lease directly to the landlord rather than to the defaulting tenant. If the sub-tenant fails to pay the landlord, it is able to use the commercial rent arrears recovery procedure against the sub-tenant. As with the CRAR process discussed in our first article, this option is only available for “rent” arrears. A landlord cannot pursue a sub-tenant for other payments due under the lease, such as service charge or insurance rent. The landlord can also serve such a notice on any sub-undertenants, and they will then have to pay rent directly to the landlord. It is not limited to the sub-tenant alone. Rent deposits When available, rent deposits are a cheap and useful tool for landlords where tenants fall into arrears. The rent deposit agreement will usually include a procedure whereby a landlord can draw down the arrears sum from the deposit funds that were provided as a form of security by the tenant at the outset of a lease. To do so, the landlord will usually have to give the tenant prior notice of its intention to draw down from the deposit and detail the arrears that the rent deposit funds are being used to repay. A well-drafted rent deposit agreement will also include provisions for replenishment of the funds drawn down by the landlord. Failure to replenish can often be relied on by a landlord to forfeit the lease. Landlords should be careful to follow the procedure set out in the rent deposit agreement carefully, because failure to follow the process could result in a claim for breach of contract. Surrender of lease If a landlord feels that continuing with a tenant which is in obvious financial difficulties (and which has no third parties or rent deposit to pursue) is simply storing up trouble for the future, it may consider terminating the lease early. This can be done by either entering into an express surrender agreement or surrendering the lease by “operation of law”. The effect of a surrender is that the tenant’s (and its guarantor’s) liability to pay rent and comply with the lease covenants ceases at the date of the surrender and the landlord has the right to possession. An express agreement is usually straightforward and must be completed by deed. It can include terms agreed by the parties, including provision for how rent arrears and any future dilapidations liability might be paid for. Landlords do need to be careful to avoid inadvertent surrenders by operation of law, which require some “unequivocal” act to have occurred, demonstrating that both the landlord and the tenant accept that the lease has come to an end. This is why landlords are often cautious when accepting the return of keys by a tenant, as this can be construed as the landlord accepting a surrender of the lease by operation of law, allowing the landlord to re-enter the premises. In short, if a landlord and a tenant act in a way which is consistent with the lease coming to an end, this can be enough to effect a surrender by operation of law without the need for a deed. It is important for landlords to note that any underleases will remain in place even if the headlease has been surrendered. Any mortgagee rights will also continue. Similarly, any guarantors will need to be a party to a surrender agreement if they are to be released from past breaches of covenant by the tenant. Discussions with tenants Notwithstanding all the options we have considered in these articles, often the most effective and cheapest option to recover arrears under a commercial lease is for landlords to have a full and frank discussion with the tenant and to keep lines of communication open. Ensuring arrears do not escalate without early intervention is also important and close cooperation with a landlord’s internal accounts teams to ensure arrears are monitored is crucial. It might be that a consensual surrender can be agreed by a landlord in communication with its tenant. In any event, a landlord can often glean information from such discussions to help it select the most appropriate enforcement option should the need arise. The routes to recovery are therefore numerous for landlords and there are many strategies that can be pursued to recover arrears of rent, depending on what the ultimate commercial goal might be with the property and the particular tenant in possession. We advise that early intervention and legal advice is sought in all cases to consider the advantages and disadvantages of the options available. Paul Henson is a partner and Amy Wagg is a solicitor at Irwin Mitchell READ MORE Part 1: How to recover commercial rent arrears Photo © Cytonn/Pexels