Shona Ferguson and Andrew Wade provide an overview of rent deposit structures and outline the implications for deposits on an assignment of a lease or a sale of a reversion
Rent deposits are deceptively simple: a tenant pays a sum of money to a landlord as security for the performance of the tenant’s obligations under a lease. Yet the commercial rent deposit is riddled with such legal complexity that even the deputy judge of the High Court in a key case, Re Greenport Ltd (in liquidation); Obaray v Gateway (London) Ltd [2004] 1 BCLC 555, found the issues difficult. Despite this, when a tenant assigns a lease or a landlord sells its reversion, a rent deposit may too often be an afterthought in the heat of a high-value transaction.
Deposit structure: charge
Commonly, the landlord holds the deposit in a separate account and the tenant (who owns it) charges it in favour of the landlord. If the funds are identified as the tenant’s, the bank cannot set-off the landlord’s other liabilities against them and the landlord’s insolvency practitioner knows to investigate before using them. The landlord normally controls the account and would be a secured creditor on the tenant’s insolvency.
Prior to 6 April 2013, normal practice (for corporate tenants) was to register the charge at Companies House, although the Financial Collateral Arrangements (No 2) Regulations 2003 cast doubt on whether this was required. Amendments to the Companies Act 2006 mean charges over rent deposits from that date need not be registered.
Deposit structure: trust
A trust is often considered a fair balance: the landlord holds the deposit on trust for the tenant according to the terms of the deposit deed. The landlord usually controls the account, but it also has fiduciary duties. Provided there is a separate account (the tenant needs evidence of this) and the bank knows the money does not beneficially belong to the landlord, the deposit is safe from the landlord’s insolvency and set-off by the bank.
Other deposit structures
Other structures exist, but are rarely used because they create difficulties for one of the parties. If the landlord holds the deposit with only a contractual obligation to return it, the deposit is vulnerable to the landlord’s insolvency or set-off. If the tenant holds the deposit, even if the landlord takes a charge over it, the landlord may fear a loss of control and losing access to the money on the tenant’s insolvency. There are difficulties also with the “neutral” stakeholder structure, where an independent third party holds the deposit as agent (usually) for the landlord and tenant: the burden of administering the funds and the risk of disputes over releasing them.
If the landlord sells the reversion
On a sale by the landlord, a buyer usually wants to inherit any existing deposits, but due to the Landlord and Tenant (Covenants) Act 1995 (“the 1995 Act”) the implications depend on when the lease was granted. “Old leases” were granted before 1 January 1996 and “new leases” were granted on or after that date (except pursuant to an earlier contract or court order).
Rent deposits relating to old leases are considered in Hua Chiao Commercial Bank Ltd v Chiaphua Industries Ltd [1987] AC 99. The Privy Council held that rent deposit obligations did not run with the reversion: the landlord’s obligation to repay the deposit did not “touch and concern” the land, so the buyer was not bound by it. However, normal practice for old leases is to transfer the deposit to the new landlord, provided it covenants with the tenant to perform the landlord’s obligations, and the tenant releases the outgoing landlord.
Rent deposit deeds associated with new leases are “collateral agreements” under section 28 of the 1995 Act, so the obligations are treated as lease covenants. A new landlord and new tenant will therefore both take on the benefit and the burden of the provisions (unless the obligations are personal to the outgoing landlord or tenant, respectively).
An outgoing tenant would automatically be released on assignment, but an outgoing landlord can only be released using the procedure in sections 6, 7 and 8 of the 1995 Act. Unsurprisingly, there have been attempts to get around this. In Avonridge Property Co Ltd v Mashru [2005] UKHL 70; [2006] 1 EGLR 15, a lease provision was upheld which limited the original landlord’s liability to the period it held the reversion. Some lawyers doubt how widely this authority applies, suggesting that the only reliable way to limit a landlord’s liability is through an express release under the 1995 Act.
Alternatively, if the landlord’s covenants are personal, they are outside the 1995 Act entirely (BHP Petroleum Great Britain Ltd v Chesterfield Properties Ltd [2001] EWCA Civ 1797; [2002] 2 EGLR 121). This means the landlord could legitimately be released from its obligations on a sale – but if the deposit will be passed to the new landlord (not returned to the tenant) the tenant will want a direct covenant from the new landlord to comply with those obligations from completion.
In practice, a tripartite deed is usually made between the outgoing landlord, the new landlord and (ideally) the tenant, which assigns (or novates) the benefit of the deposit deed. The new landlord covenants to comply with the landlord’s obligations, indemnifies the outgoing landlord and acknowledges payment of the deposit. Normally the tenant releases the outgoing landlord, although this might not be legally effective (unless its covenants are personal). A covenant from the new landlord to perform the landlord’s obligations should not be necessary for new leases.
Is a new charge needed?
If the deposit is secured by a charge, many believe a new charge may be needed, depending on the exact asset charged according to the deposit deed. For example, the asset might be “the deposit”, “the balance standing to the credit of account X from time to time” or “the right of the tenant to receive payment of the deposit from the landlord/bank”. Due to the vagaries of the law of money (which are not considered here) none of these is entirely watertight, but the parties should note the effects of the chosen wording. For example, a new bank account could change the asset and necessitate a new charge (perhaps in the tripartite deed). Others argue that the money is the same (however complex) wherever it is held.
Notably, if a lesser known structure is used – the tenant retaining the deposit and charging it to the landlord – no new charge is needed. This may not be enough to persuade a landlord to adopt this structure, however.
A trust might be considered a safe alternative, but as a personal arrangement by its nature, to “assign” a landlord’s interest, the new landlord must be appointed as a new trustee.
If the tenant assigns the lease
Rent deposit covenants relating to old leases are personal to the landlord and tenant, so the new tenant would not take on the tenant’s covenants, but the outgoing tenant must be expressly released once the deposit is repaid.
For new leases, a new tenant automatically takes on the rights and obligations in the deposit deed. The outgoing tenant is released automatically (unless it signs an authorised guarantee agreement which covers a new deposit from the assignee), but the landlord is not. To avoid these issues, many rent deposit deeds provide for repayment on assignment – though from that moment, the tenant loses the right to sue the landlord for the balance, under section 5 of the 1995 Act. A safer option (for a tenant) might be for the tenant’s obligations (and the benefit of the landlord’s covenants) to be personal to the tenant, ensuring the outgoing tenant has the right to be repaid and the new tenant does not take on the liability. Either way, the aim of all parties is normally to ensure the old deposit is repaid and a new one created.
Proceed with caution
Care is needed when drafting a rent deposit deed and dealing with a change of landlord or tenant. The 1995 Act creates difficulties, but in essence: on a sale of the reversion, a new deed should be made between all parties, and on assignment, it is best to repay the deposit and create a new arrangement with the assignee.
Why this matters
The relative lack of judicial authority on rent deposits does not necessarily mean disputes are rare. It is more an indication of how complex and expensive they are to litigate. Careful consideration should be given to the rent deposit structure, how the deposit deed is drafted and how a sale or assignment will be dealt with.
Lack of clarity as to a deposit’s structure is a recipe for a dispute about who owns the deposit, how it is secured, when it can be repaid or even the tax implications. The position on the insolvency of the landlord or the tenant would be even more unclear, the different regimes adding a further layer of complexity.
On a sale of the reversion, without an express release, an outgoing landlord retains liability to repay the deposit to the tenant even if it has already paid it to the buyer. The buyer should covenant to comply with the landlord’s obligations, and indemnify the seller – but even so, using the 1995 Act is the only way for the outgoing landlord to secure a true release, unless the landlord’s covenants are personal to it or there is a release clause complying with Avonridge. It is also possible for a buyer to take on liability to repay a rent deposit of which it had no knowledge (one would hope due diligence would solve this problem).
On a lease assignment, because the tenant’s covenants in the rent deposit automatically pass to the new tenant, if an existing deposit is not repaid, a new tenant risks having to provide “top-up” payments even if the withdrawal they relate to results from the outgoing tenant’s breach. If a landlord tries to make such withdrawals, it risks a dispute with the new tenant. From an outgoing tenant’s point of view, if the landlord fails to repay the deposit, that tenant risks being unable to recover its money because it can no longer sue the landlord.
Perhaps the most basic issue is the effect of the 1995 Act itself: an agreement which purports to “contract out” of the 1995 Act is void. Automatic release clauses should be drafted to allow severance from the rest of the agreement, so that if they do not comply with Avonridge and are void, the other provisions remain intact.
Further reading
Landlord and Tenant (Covenants) Act 1995, especially sections 2, 3, 5, 6, 7, 8, 25 and 28
BHP Petroleum Great Britain Ltd v Chesterfield Properties Ltd [2001] EWCA Civ 1797; [2002] 2 EGLR 121
Re Greenport Ltd (in liquidation); Obaray v Gateway (London) Ltd [2004] 1 BCLC 555
Hua Chiao Commercial Bank Ltd v Chiaphua Industries Ltd [1987] AC 99
Avonridge Property Co Ltd v Mashru [2005] UKHL 70; [2006] 1 EGLR 15
Shona Ferguson is a professional support lawyer and Andrew Wade is a consultant at Farrer & Co LLP
