The first article in this two-part series (EG, 8 March 2014, p102) looked at the risks for subtenants, particularly of part, following forfeiture of the headlease. Subleases are more vulnerable than headleases because they can be terminated for issues relating to the headlease as well as for issues affecting the sublease. While some protections exist for subtenants in such circumstances, these are not as strong as often assumed. Another area of vulnerability for subleases relates to the disclaimer of the headlease following the liquidation of the head tenant.
Overview of disclaimer
A liquidator of a tenant is entitled under section 178 of the Insolvency Act 1986 to disclaim onerous property, which has the effect of ending all the tenant’s liabilities under a lease.
Usually disclaimer occurs in insolvencies, but a solvent company can also put itself into liquidation in order to divest itself of unwanted leases.
Disclaimer operates to terminate the rights and liabilities of the tenant under the headlease, but leaves third parties’ rights unaffected, save so far as necessary to effect the release of the tenant (Hindcastle Ltd v Barbara Attenborough Associates Ltd [1996] UKHL 19; [1996] 1 EGLR 94).
Any person interested in the disclaimed lease can either apply for this to be vested in them or apply for the lease to be vested in someone else. The time limit for such an application is three months from the disclaimer (unless extended by the court). The effect of the order is to vest the same rights and obligations as under the disclaimed lease.
There is a pecking order, with subtenants and mortgagees having a right of first refusal. If they decline to take a vesting order, they are excluded from all further interest in the property and their subtenancy or mortgage is at an end. This means that the superior landlord cannot apply to have the intermediate leasehold interest vested in him with the benefit of subtenancies, as it can only apply once any subtenants have refused a vesting order.
Any person suffering loss due to the disclaimer can make a claim for compensation in the liquidation which, in the case of an insolvency, will be considered alongside any other creditors’ claims. The effect of any vesting order is taken into account in assessing the extent of any loss.
What disclaimer means for the subtenant
On disclaimer of a headlease, a subtenant’s obligations to its immediate landlord are brought to an end. The subtenant is entitled to remain in occupation for the duration of the sublease provided that it performs the tenant’s obligations in the headlease. However, the disclaimer itself does not result in the superior landlord acquiring direct rights against the subtenant.
It may seem therefore that a disclaimer of the headlease could be a good way for a subtenant to stop paying rent and walk away when it wishes. However, that opportunity is limited by two factors:
? a subtenant often enters into a direct covenant with the superior landlord in the licence to underlet, giving the latter the right to enforce the sublease covenants; and
? a landlord can enforce the subtenant’s obligation to pay the sublease rent by serving a notice under section 6 of the Law of Distress Amendment Act 1908 (section 6).
For a subtenant that wishes to stay in the premises, it can remain in occupation provided it performs the headlease covenants including payment of rent. If it fails to pay the full head rent, it is open to the superior landlord to forfeit, so that the subtenant’s rights fall away (subject to a right to apply for relief).
There is no ability for a subtenant to remain on the terms of the sublease (save by negotiation with the landlord). The most obvious solution for a subtenant of whole who wishes to stay is to apply for a vesting order, albeit this will require the subtenant to take on the liabilities under the headlease.
For a subtenant of part, disclaimer creates particular problems. First, pending any decisions about vesting orders, the subtenant may find itself having to pay the head rent for the whole of the premises in order to avoid forfeiture. Secondly, in a multilet building the obligations to repair, insure and provide services are likely to have rested with the intermediate landlord, and the subtenant cannot force the head landlord to take on those obligations, nor enforce any landlord obligations in the headlease. Subtenants of part also face particular difficulties in relation to vesting orders. The court can grant a vesting order in respect of part of the premises, as if the headlease had originally related only to that part. However, there is no authority on how this would work in practice.
It will be easier to apportion the headlease liabilities where the superior landlord was responsible for repairs and services under the headlease, with the head tenant simply paying a service charge. However, where the headlease was of the whole building and the head tenant had repair and insurance liabilities, it will be unsatisfactory to create a situation where multiple former subtenants of part each assume a repairing or insuring obligation in relation to just their part. The superior landlord may use this to argue against the granting of a vesting order.
One solution is for the subtenants to club together and apply jointly for a vesting order in favour of a management company set up by themselves, as was done in Re Ginwell Ltd [2002] All ER (D) 92. The only other option is to negotiate directly with the landlord for the grant of new leases on the same terms as the former subleases.
Practical tips for subtenants
Before entering into a sublease, a subtenant should:
? consider whether it would be willing to take on the headlease terms if necessary as a condition of relief from forfeiture or as the terms of a vesting order; and
? carry out due diligence on the tenant’s solvency (while remembering that disclaimer can also occur in solvent liquidations).
The subtenant may have a claim in the tenant’s liquidation for any extra costs it has to incur as a result of disclaimer, including due to a vesting order. However, there may be no money to meet such claims and a damages claim is less satisfactory than continued business occupation.
The landlord’s position
The landlord’s position is also problematic.
On a short-term basis, the landlord may be able to rely on a direct covenant to enforce the sublease covenants and claim the sublease rent by serving section 6 notices. It is advisable that the head landlord does serve such notices to clarify that rent is being received under the subleases and it is not creating new periodic tenancies. However, this is unlikely to be satisfactory in the long-term, when for example a rent review of the subrent needs to be activated. It is particularly problematic in a multilet building with no-one obliged to provide (or pay for) services or upkeep.
Recovery of possession
The landlord may wish to recover possession. If so, it may be able to forfeit, based either on the insolvency of the tenant (if the right to forfeit has not been waived) or on unpaid head rent. Alternatively, it may apply for an order vesting the headlease in itself but this will only be granted once subtenants and mortgagees have declined to accept a vesting order.
If it is a solvent liquidation or there is likely to be a reasonable distribution to creditors, the landlord needs to bear in mind what effect its actions may have on its financial claim. The landlord will have a claim in the tenant’s liquidation for the difference between the rent and other sums which it would have received if the disclaimed lease had continued to the end of its term and the sums that it will actually receive following the disclaimer, assuming it takes reasonable steps to re-let the premises, and discounted to reflect early receipt (Christopher Moran Holdings Ltd v Bairstow [1999] UKHL 2; [1999] 1 EGLR 1). Any evidence of mitigation is therefore relevant.
Dealing with subtenants
The landlord cannot directly obtain the benefit of the subleases, but is unlikely to want the subtenants of part to obtain vesting orders either. The landlord will not want a multiplicity of tenants each with responsibility for only part of the repairs or services. In addition, if the headlease has security of tenure, the subtenants may potentially acquire such security.
If the landlord wishes to retain the subtenants, the best course of action is to agree with the subtenants that they will allow the landlord to obtain a vesting order, in return for the landlord granting the subtenants new leases (on the same terms as their old ones) once the headlease has been vested in it. This is a win-win scenario. It allows the landlord to obtain the benefit of the subtenancies, while allowing the subtenants to receive leases on similar terms to their subleases (which would not be available via a vesting order).
However, a forward-thinking landlord that wants to retain the subleases would do better to avoid a disclaimer situation entirely, and try to agree a surrender of the headlease with the tenant’s liquidator before any disclaimer occurs. In the case of a solvent liquidation, the price paid for a surrender should reflect the financial claim the landlord could have made in the liquidation in the event of disclaimer.
Why this matters
It is not just liquidators of insolvent companies that can disclaim leases. A solvent company can also put itself into liquidation and use disclaimer to get rid of over-rented or unwanted property: see Christopher Moran. This makes the risk of disclaimer of a headlease more difficult to predict at the outset.
Disclaimer puts the subtenant in a tricky position in that it can remain in occupation of the premises provided it performs the covenants in the headlease, but cannot enforce any of the landlord covenants in the headlease. This presents particular problems for subtenants of part, who are dependent on their landlord for repair, insurance and services.
Disclaimer also creates problems for the head landlord, which is put in a “limbo” situation, unable directly to obtain the benefit of the subtenancies.
Although both the head landlord and any subtenants can apply for a vesting order and/or claim damages for any loss suffered as a result of the disclaimer, both options carry with them pitfalls. Damages are unlikely to be an adequate remedy in many circumstances. It is therefore essential that landlords, tenants and their advisers consider their actions very carefully when faced with the disclaimer of an intermediate lease.
Further reading
• Hindcastle Ltd v Barbara Attenborough Associates Ltd [1996] UKHL 19
• Christopher Moran Holdings Ltd v Bairstow [1999] UKHL 2; [1999] 1 EGLR 1
• Insolvency Act 1986 Sections 178-182
• Law of Distress Amendment Act 1908 Section 6
Jane Fox-Edwards is a consultant and head of real estate litigation and Sophie Schultz is a senior associate at Allen & Overy LLP