Gemma Kirsch discusses tenants’ options when faced with preconditions to underletting
Where a lease states that a landlord cannot unreasonably withhold consent to an underletting, it is often assumed that the tenant will be afforded the statutory protection of section 1 of the Landlord and Tenant Act 1988 (“LTA 1988”) when it makes a written application for consent. However, if the lease specifies preconditions to any underletting then, provided the preconditions are valid, they may prevent the transaction the tenant wants to complete. If the preconditions are not satisfied, the landlord is not under the statutory duty imposed by the LTA 1988, which requires it to give consent unless it is reasonable not to.
A precondition is valid if it sets out the types of underletting which will be permitted with the landlord’s consent, so the effect of the precondition is to restrict the circumstances in which a tenant can apply for consent to an underletting. If what the preconditions do is to seek to oust the jurisdiction of the court by stating what will be a reasonable refusal of consent, these types of provisions are invalid (see Bocardo SA v S&M Hotels Ltd [1979] 2 EGLR 48 and Crestfort Ltd v Tesco Stores Ltd [2005] EWHC 805 (Ch); [2005] 3 EGLR 25).
Silence
Over the years, tenants have tried various ways to circumvent lease preconditions that conflict with the terms on which they want to underlet. The most obvious is to keep silent, which is especially tempting if the lease provisions do not require the landlord’s approval to the form of underlease and the underlease is not registrable at the Land Registry. Sadly, this will not work. It is a well established principle in law that landlords are entitled to know the terms on which an underletting is taking place (Fuller’s Theatre & Vaudeville Co v Rofe [1923] AC 435).
Collateral agreements
Tenants have also tried to deal with unfavourable preconditions by completing a form of underlease that complies with the terms of the lease while simultaneously entering into a separate collateral agreement to vary the terms. Collateral agreements, even if personal to the parties, have also been held to be invalid.
In Allied Dunbar Assurance plc v Homebase Ltd [2002] EWCA Civ 666; [2002] 2 EGLR 23, Homebase agreed to underlet the property on terms which did not comply with the preconditions in the headlease. In particular, the underlease rent was required to be reviewed on the same dates as the headlease to the full market rent and the underlease had to contain tenant covenants in the same form as in the headlease. Homebase agreed a different rent and review mechanism and limited the undertenant’s repairing obligation by reference to a schedule of condition, contrary to the full repairing covenant in the headlease.
Homebase tried to circumvent the preconditions by completing an underlease which conformed with the headlease while entering into a separate personal deed under which Homebase agreed to pay the undertenant the difference between the rent reserved by the underlease and actual rent agreed, and to reimburse the undertenant for any additional costs of repair and decoration incurred by the undertenant in complying with the full repairing covenant. Both documents were disclosed to the landlord, which refused the application on the basis that the preconditions had not been met.
The court held that the terms of the underlease and the collateral agreement had to be read together in order to consider whether the preconditions had been satisfied and, when read together, the preconditions had not been satisfied. It did not matter that the deed was expressed to be personal. The purpose of the preconditions was to allow the landlord to control the terms on which an undertenant could occupy the premises as it had legitimate interests to protect: the rent payable in the underlease could be used as a comparable and it would want the repairing obligations of the tenant to be observed by the party in actual occupation.
It has been suggested that a collateral agreement may work if a third party provides the indemnity in respect of the unfavourable covenants, but this has not yet been tested by the courts.
Reverse premium
Allied Dunbar was distinguished in NCR Ltd v Riverland Portfolio No 1 Ltd (No 1) [2004] EWHC 921 (Ch); [2004] PLSCS 85. The tenant paid the undertenant a reverse premium to overcome the unfavourable preconditions, in particular the requirement that the underlease rent had to be at the greater of the market rent or the passing rent. At the time of the underletting, the passing rent exceeded the market rent by more than £100,000. The only way for the tenant to find a subtenant was to pay a reverse premium as an inducement. The landlord refused consent, relying on the principles in Allied Dunbar, and stated that the reverse premium, when considered with the rent reserved by the underlease, meant that, in effect, the undertenant was paying less than the passing rent.
The court disagreed and held that the reverse premium was a genuine inducement, the precondition was satisfied and the landlord could only refuse consent where it was reasonable to do so. It is important to note that this decision would not apply where reverse premiums are prohibited by the terms of the headlease. The reverse premium also has to be genuine and not a sham – this rests on questions relating to the parties’ intention and whether the inducement was required to secure an underletting in a falling market.
Estoppel
The landlord’s conduct may be relevant and used to the tenant’s advantage if it can raise an estoppel argument. In Crestfort, until commencement of proceedings, the parties had acted on the basis that the tenant was entitled to apply for consent and that the landlord could only refuse on reasonable grounds. On that basis the landlord demanded, and the tenant gave, an undertaking for costs.
In the judgment, it was said that the tenant may have had grounds to raise an argument for estoppel on the basis that the provision of the undertaking in compliance with the landlord’s request may constitute or evidence a contract, to the effect that the landlord would consider the application in consideration of the undertaking. The question of the reasonableness of the landlord’s refusal would then arise.
Remedies
If a tenant grants an underlease without having complied with the preconditions then forfeiture of the headlease is an obvious remedy. However, a landlord can also seek an injunction requiring the surrender of the unauthorised underlease if it can establish that, by accepting the underlease, the undertenant had unlawfully interfered with the contractual relations between the landlord and tenant and had therefore committed the tort of interference with contract.
In Crestfort, Tesco proceeded to grant an underlease even though the landlord had withheld consent on the basis that the underlease did not comply with the preconditions in the headlease, in particular that any underlease had to be granted on the same terms except as to the amount of rent and the term. The repairing obligation in the underlease granted by Tesco was limited by reference to a schedule of condition. The landlord sought an injunction to force the surrender of the underlease and Tesco counterclaimed that the landlord had unreasonably withheld consent.
The court found for the landlord as, on the proper construction of the alienation clause, Tesco had not complied with the preconditions. There was no duty on the landlord to consider the application as the proposed underletting was prohibited by the terms of the lease. Furthermore, the undertenant was liable to the landlord under the tort of wrongful interference with contract. The undertenant’s managing director knew that by completing the underlease Tesco would be in breach of contract and therefore, by accepting the underlease, induced or procured that breach. The landlord was also entitled to additional compensatory damages against both the tenant and undertenant in a sum which the landlord might reasonably have demanded for relaxing the covenant against underletting for the period prior to the injunction.
Why this matters
While, on an underletting, the tenant remains directly responsible to the landlord for the observance and performance of the tenant’s covenants in the headlease, leases will still often restrict the tenant’s ability to sublet as the landlord has a legitimate right to control the terms on which premises are occupied. The headlease may cease to exist, resulting in the undertenant becoming the direct tenant of the landlord, or the rent payable in the underlease may be used as a comparable on a rent review of the headlease. However, the interests of the landlord must be balanced with the interests of the tenant, who will want freedom to sublet the property if it becomes surplus to requirements.
Restrictions on subletting may actually prohibit the transaction, known as an absolute covenant (subletting of part is often prohibited due to estate management and marketability concerns), or only allow the transaction with the landlord’s consent, known as a qualified covenant. Where the covenant is qualified, the provisions of section 1 of the LTA 1988 apply so that the landlord is obliged to give consent unless it is reasonable not to do so. It is also obliged to give its written decision within a reasonable time, stating its reasons for refusing or, if the consent is subject to conditions, specifying the conditions in the decision.
Where restrictions on assignment are qualified, the provisions of section 19(1A) of the Landlord and Tenant Act 1927 apply, allowing the parties to specify in writing circumstances which must exist before a landlord is obliged to act reasonably in reaching its determination. This provision does not apply to sublettings, but the parties are still free to specify preconditions which must be satisfied, commonly relating to the form of the underlease or the underlease rent. If the proposed underletting does not comply with the preconditions, then the tenant is seeking consent for a prohibited transaction and the statutory duties imposed by the LTA 1988 relating to consent do not apply.
Underletting provisions may not be uppermost in a tenant’s mind when negotiating lease terms, but tenants and their advisers need to be mindful of changing market conditions as well as business and operational needs that might occur during the lease term. If a tenant subsequently wants to underlet the premises on more favourable terms, it may be prevented from doing so due to the preconditions that must be satisfied and it will then find it has limited options available to avoid them.
Further reading
Hill & Redman’s Law of Landlord and Tenant, volume 1
Woodfall: Landlord and Tenant, volume 1
Gemma Kirsch is an associate solicitor at Bristows
