by Patrick McLoughlin
Surveyors and lawyers dealing with dispositions of commercial leasehold properties are constantly confronted with the vexed question of whether a landlord can require that an incoming assignee should be supported by sureties. The recent court decision in Vaux Group plc v Lilley [1] 04 EG 136, strengthens the landlord’s hand in this respect, at least where the lease contains a provision that sureties may be required.
Many landlords request a surety as a matter of course, simply to augment the number of persons to whom the landlord can look in the event that the tenant defaults; and it is important that the tenant’s and the assignee’s solicitors and surveyors are able to advise whether the landlord’s request needs to be complied with.
Although both the present tenant and the proposed assignee will sometimes be equally concerned to ensure that the landlord’s consent is obtained, the assignee’s advisers should be alert to the fact that the present tenant will be less concerned than the assignee if the landlord requires a surety, and for this reason the onus will be upon the assignee’s advisers to make the running in resisting a request for a surety.
If the tenant is still in possession and paying the rent, perhaps with its business operating at a loss, it will probably be amenable to objecting to the landlord’s request at the instigation of the assignee. If, however, the assignee has been permitted to take possession, paying a rent, prior to completion of the assignment, the negotiating relationships may change. The present tenant, while being reimbursed for rent may not be so anxious that the landlord’s consent be obtained quickly, while the assignee who has commenced business at the premises and who may be spending money on the property will be under more economic pressure to procure security of tenure by completing the transfer of the lease, particularly if the agreement between tenant and assignee does not impose an obligation upon the tenant to apply to the court for the declaration that the landlord’s request for surety is unreasonable. The prospective assignee does not have an independent right to apply for a declaration unless he actually takes an assignment first (Theodorou v Bloom [4] 1 WLR 1152), thereby risking a forfeiture should it be decided that the landlord’s requirement was reasonable.
Whether the landlord can lawfully require that the assignee provides surety depends upon the precise terms of the lease and in particular whether the lease expressly states that the incoming assignee should provide surety.
No express requirement for sureties in the lease
Where there is no express term in the lease requiring surety, whether the landlord can require surety will depend primarily upon the form of the tenant’s covenant restricting assignment. If the covenant contains an absolute prohibition against assignment the landlord is free to require surety as a condition of waiving the prohibition.
In most commercial leases, however, the restriction against assignment is qualified in that assignment is permitted with the consent of the landlord, in which case the lease will also normally state that the consent is not to be withheld unreasonably. If the lease does not express this, section 19 of the Landlord and Tenant Act 1927 comes into play importing to the lease a proviso to the effect that consent is not to be unreasonably withheld.
The question is then simply whether in the particular circumstances the landlord can reasonably require that surety is provided to guard against the possible non-payment of the rent or non-performance of other terms of the lease by the assignee. Judicial answers to this question are thin on the ground. The usual vague lawyer’s answer to the question is that, yes, as a general principle a surety may be required in appropriate circumstances. The most pertinent court decision in this respect is that in Re Greater London Properties Ltd’s Lease [9] 1 WLR 503. Although Danckwerts J held that the landlord’s requirement of a surety was unreasonable on the facts, he confirmed that the matter should be approached having regard to the circumstances of the case. The overriding question is whether the assignee is of sufficient financial standing. If so, then it is unreasonable to require a surety.
In Re Greater London Properties the proposed assignee was a subsidiary of a large and wealthy trading company. The subsidiary owed £225,000 to the parent and as a condition of giving consent the landlord required the parent to guarantee the subsidiary assignee’s liability on the ground that its financial position would be jeopardised if the parent called in the loan. Danckwerts J held that the landlord’s refusal was unreasonable taking into account the fact that the parent company was unlikely to call in the loan and that the loan had been used to acquire fixed assets. Most important, in Re Greater London Properties the financial position of the assignee was satisfactory and no doubt had been cast upon the sufficiency of the references provided.
So where the prospective assignee can show that it is of sufficient financial strength it can resist the landlord’s request for a surety, but if the assignee’s covenant is weak a surety may make up the deficiency and may be sufficient to persuade the landlord to consent (see Venetian Glass Gallery Ltd v Next Properties Ltd [1] 2 EGLR 42; [1989] 30 EG 92). The financial sufficiency of the proposed assignee and whether it can resist giving a surety may be judged by a number of factors. The primary sources of information in respect of the assignee’s financial standing are references and accounts.
References and accounts
In the case of an assignee which is a newly incorporated company references are taken up on those persons who have incorporated the company. References in standard form describing the subjects as responsible and respectable, but excepting the referees from liability do not carry much weight and “no landlord in his senses” would rely upon them, according to Warner J in Ponderosa International Development Inc v Pengap Securities (Bristol) Ltd [6] 1 EGLR 66; (1985) 277 EG 1252. References of a similar “qualified and not at all enthusiastic character” were regarded as inadequate by His Honour Judge Finlay QC in Warren v Marketing Exchange for Africa Ltd [1988] 2 EGLR 247.
The trading accounts of the proposed assignee are likely to be a better guide than references to the sufficiency of the assignee. The accounts will show the capital adequacy of the assignee and the general level of profitability. The best indicator of whether the assignee will be able to pay the rent is the profit-and-loss account. In British Bakeries (Midlands) Ltd v Michael Testler & Co Ltd [6] 1 EGLR 64; (1985) 277 EG 1245 evidence was given that “a generally accepted test of the financial standing of any proposed assignee is that his accounts should show a pre-tax profit of not less than three-times the amount payable under the lease”. The pre-tax profit is the relevant figure since it is that profit against which the rent will be charged. In the British Bakeries case the proposed assignee could not show that its existing business produced profits at the level of three times the rent. In addition, the assignee was to start up a new business from the premises; so evidence of the profitability of the old business was of limited assistance. Taking into account also the relatively weak references it was held that the landlord’s refusal was reasonable.
Although the “three-times profits” test has been generally adopted it must be appreciated that it is only a rule of thumb and not a rule of law. A court will examine the whole picture and may decide that the assignee is suitable notwithstanding a recent low profit margin. In Venetian Glass Gallery Ltd v Next Properties Ltd the proposed assignee was a company whose recent trading figures were poor, but it was improving its trade, and other factors, such as the availability of a strong guarantee, showed that the assignee was suitable despite its low profitability.
The other aspect of the accounts which may be considered is the balance sheet. The net asset value of the assignee is a relevant consideration since if the landlord has to sue for rent or damages for breach of obligation the asset base may be important. In considering the value of the business the goodwill may also be valued (see the British Bakeries case) although often it will not appear in the accounts. The balance sheet should, however, be regarded as a secondary indicator only since “a reasonable landlord is concerned with the tenant’s ability to meet the obligations under the lease as those obligations fall due” (see Peter Gibson J in the British Bakeries case) and it will be the pre-tax profit figure rather than the asset base which will show whether the assignee will be able to meet the obligations.
Rent deposit instead of surety?
An option which might be considered by both landlord and assignee as an alternative to a surety contract is a “rental deposit”. A capital sum is “put up” by the assignee and in the case of default the landlord draws upon the deposit instead of having sureties to look to.
Such an arrangement has advantages and disadvantages for both parties. The advantage from the tenant’s point of view is that it is not necessary to find a third party to guarantee the performance of the obligations under the lease. This will be of particular significance where the assignee is a private limited company and its directors would not wish to expose themselves to unlimited personal liability as sureties for the company. The advantage from the landlord’s vantage point is that there is a ready sum of money which can be drawn upon and, depending upon the terms agreed, without the necessity of pursuing litigation.
The disadvantages for the tenant are that it has to be able to fund the deposit and, if the deposit is under the landlord’s complete control, the landlord will be in a position to withdraw sums where it claims that there is a breach even if the tenant disputes the point, leaving the tenant to try to recover the sum from the landlord. Problems may also arise if the landlord becomes insolvent. Unless the deposit has been organised in such a way as to remain an asset outside of the landlord’s ownership, it will be available to the landlord’s general creditors.
If the landlord chooses to request a deposit by way of security upon assignment care needs to be taken in framing the terms of the request, since a sum of money requested as payment for consent is a “fine” prohibited by section 144 of the Law of Property Act 1925. It was held, in a different context, that a large sum paid at the commencement of a lease and purporting to represent rent paid in advance was a fine for the purpose of deciding whether a lease was at a rent or a premium in Hughes v Waite [7] 1 All ER 603. That decision is distinguishable on the basis that the word “fine” in Hughes v Waite was being used to describe a single capital payment as opposed to recurrent income payments by way of rent, whereas in section 144 the word is used to denote a sum in the nature of a penalty.
Another decision points to the conclusion that for the purpose of section 144 a deposit by way of security is not a fine. In Re Cosh’s Contract [7] 1 Ch 9, a tenant under a building lease wanted to assign. The landlord refused consent unless the tenant deposited money by way of security for the performance of the building obligations. Under section 3 of the Conveyancing and Law of Property Act 1892 (the predecessor of section 144) the lease was subject to an implied proviso that no “fine or sum of money in the nature of a fine” should be demanded. The Court of Appeal held that a deposit of this type was not a fine because the Act pointed “at a sum of money which is to go irrevocably into the pocket of the lessor. Here there was only a deposit, not a payment which transfers the title to the money and enables the payee to hold it as his own”.
Although a deposit may not be a fine prohibited by section 144 it should not be thought that a deposit may be demanded by landlords as a matter of course. The demand will still, in the case of a qualified covenant, have to satisfy the requirement of “reasonableness” and whether the landlord is acting reasonably will again depend upon the financial strength of the assignee. If the assignee is of relatively low financial standing it may gain an advantage by offering a rent deposit instead of a guarantee, and the landlord may be acting unreasonably if it refuses the offer.
Express requirement for sureties in the lease
Many commercial leases contain express terms stating that sureties can be required on assignment. There has been much speculation as to whether such a requirement would be enforceable where section 19(1)(a) imports to the lease a proviso that consent should not be withheld unreasonably. The recent court decision of Vaux Group plc v Lilley indicates that the express requirement will be enforceable, but the judgment of Knox J, being at first instance, and relating to such an important issue, is unlikely to be the last word on the subject.
At the outset it should be noted that Vaux Group plc was concerned not with the construction of section 19(1)(a) but with the construction of section 19(1)(b), which provides that in a building lease exceeding 40 years containing a qualified prohibition on assignment there is an implied term that the landlord’s consent is not needed to any assignment or other dealing made more than seven years before the lease ends. The lease in question in Vaux Group plc fell within section 19(1)(b). In addition, clause 3(17) prohibiting assignment included a proviso that upon any assignment to a private limited company the tenant was to obtain, if the landlord so required, a guarantor. The tenant company sought a declaration that the effect of section 19(1)(b) was to relieve the tenant from the requirement of providing a guarantor. Counsel for the tenant submitted that the overall policy of section 19(1) was to enable tenants to assign freely despite any restrictions in the lease and without complying with any conditions. Counsel for the landlord argued that the only effect of section 19 was to imply words into the lease. The lease then stood to be construed in the same way as if the parties had introduced the word themselves. On this basis, although the landlord’s consent was not needed prior to assignment, the landlord could rely upon the express requirement for a guarantee.
Knox J rejected the policy argument, relying upon Bocardo v S & M Hotels Ltd [0] 1 WLR 17, as authority for the principle that the effect of the statute is simply to imply words into the lease, but does not prevent the parties from otherwise agreeing words which might restrict the tenant’s freedom to assign the lease on such conditions as it might wish (even though the section applies notwithstanding any express provision to the contrary). In any case, according to Knox J, the obtaining of a guarantor was not a condition precedent to assignment, it was something that had to be effected after assignment.
Vaux Group plc and section 19(1)(a)
The decision in Vaux Group plc was based upon section 19(1)(b), but much of the reasoning of Knox J would appear to be equally applicable to section 19(1)(a). Where there is a qualified restriction on alienation section 19(1)(a) implies a proviso “to the effect that … consent is not to be unreasonably withheld”. Where the lease contains conditions to be satisfied upon assignment, the effect of Vaux Group plc may be that such conditions are to be construed as tenant’s or assignee’s obligations independent of the landlord’s obligation not to unreasonably refuse consent.
So an obligation upon the incoming assignee to give a guarantee might be enforceable no matter how unreasonable it is in the circumstances, because (arguably) it does not have the effect of allowing the landlord to withhold consent unreasonably. The tenant is free to assign but the landlord may upon assignment require the assignee to provide a guarantee. Attractively simple though such “literal” interpretation may be, it is submitted that this is not without its difficulties and the better view may be that a guarantee cannot be required unless it is reasonable.
It is suggested that the construction of section 19(1)(a) rests upon the fact that the proviso implied is one “to the effect that such consent is not to be unreasonably withheld”, but the section does not actually state that specific words should be incorporated (although Knox J said that the section requires the writing into the relevant clause of the words that the section contains). The section is to have this effect (that consent is not to be unreasonably withheld) “notwithstanding any express provision to the contrary”. For this reason it has been held that the effect of the section cannot be reduced by the addition of other words in the lease.
In Creery v Summersell & Flowerdew Co [9] Ch 751, for example, there was a qualified restriction with the additional words that “the lessor reserves the right not to give his consent if in his opinion the proposed … sublessee is for any reason in his discretion undesirable as an occupant … or underlessee”. Harman J took the view that the additional words were ineffective in so far as they went beyond section 19(1)(a). Similarly in Re Smith’s Lease [1951] 1 TLR 254, a proviso to a qualified restriction which stated that the landlord might refuse consent while offering to accept a surrender from the tenant was held void.
The same principle should apply if the lease, instead of reserving to the landlord the right to refuse for a bad reason, provides that the landlord may consent but subject to an unreasonable condition; so that if the lease provides that as a condition of giving consent the landlord may require a surety, the proviso will be ineffective in a case where it would not be reasonable for the assignee to give surety.
Does it make any difference if, as a drafting technique, the lease (instead of providing that the giving of surety is a condition precedent to the landlord consenting to an assignment) provides, independently of the landlord’s duty not to refuse consent unreasonably, that as a condition precedent or subsequent to assignment the landlord may (whether reasonably or not) require a surety? The question is admittedly a difficult one, but it is submitted that the answer is the same and that in so far as any clause in the lease reserves to the landlord the right, irrespective of reasonableness, to require a surety as a condition precedent or subsequent to assignment it will fall foul of section 19.
Although a clause requiring surety may be drafted in form as an obligation independent of the landlord’s obligation not to withhold consent unreasonably, in substance the two provisions are interlinked in the following way. The effect of a reservation of the Vaux Group plc genus is to reserve to the landlord the right to require a surety upon an assignment. If the incoming assignee makes it clear that it will not provide surety the landlord would be able to refuse consent because of the proposed breach (see Jenkins v Price [8] 1 Ch 10, and FW Woolworth plc v Charlwood Alliance Properties Ltd [1987] 1 EGLR 53; (1986) 282 EG 585). In substance therefore the landlord is by a clause in the lease attempting to reserve a right to refuse consent except upon the imposition of a condition which may in the circumstances be unreasonable. The attempted condition should be ineffective as a “provision to the contrary” to the proviso “to the effect that consent is not to be unreasonably withheld”. It is clear that since the section is to apply “notwithstanding any express provision to the contrary”, the parties should not by drafting device be permitted to contract out. If the decision in Vaux Group plc is applied in relation to section 19(1)(a) there will be contracting out wherever the bargaining power of the tenant is such that the incorporation in the lease of unreasonable conditions cannot be resisted. It is suggested that the operation of section 19(1) should not be reduced in this way.
Extent of surety
Even assuming that surety has to be provided assignees’ advisers should consider carefully the extent of the guarantees to be given by their clients. The form of guarantee document proffered by a landlord is likely to state that the surety for the assignee guarantees payment of the rent and performance of the other obligations in the lease for the remaining duration of the lease and not simply for the period of the assignee’s ownership. Thus, in the case of an assignee which is a private limited company, a company director acting as surety will be asked to guarantee compliance with the lease both by his own company and also by any later assignees, even though he has no connection with such assignees.
In Evans v Levy [0] 1 Ch 452, Eve J held that a landlord could not require a surety to guarantee compliance with the lease by later assignees. Eve J said: “…it was altogether unreasonable to ask him to enter into a covenant … during the whole residue of the term for the rent and in respect of all the covenants in the lease as a condition precedent to the licence to assign being granted”. So the basic rule is that if a surety can reasonably be required, the guarantee should be limited to the period of ownership of the assignee.
Of course, each case must turn upon its facts and it may be that Evans v Levy could be distinguished where, for example, the assignee is itself entering into a direct covenant for the duration of the lease, or where the lease itself prescribes the form of the surety covenant.
Summary
Where a lease contains a qualified restriction or assignment but is silent on the question of guarantees the landlord will be able to require a guarantee only where it is reasonable to do so. In an appropriate case an assignee may be able to resist providing a surety by offering to the landlord as an alternative a deposit as security for non-payment of rent and nonperformance of the other obligations in the lease. In the case of a lease expressly reserving to the landlord the right to require a guarantee upon assignment the decision in Vaux Group plc v Lilley suggests that the requirement, if drafted independently of the question of the landlord consenting, is valid. Although the decision can be criticised, unless and until it is distinguished or overruled it will make life very difficult for tenants and intending assignees of commercial leases.
