Important landlord and tenant decision

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

Summary

The High Court in EMI Group Limited v O & H Q1 Limited [16 March 2016] has decided that a tenant cannot assign a “new tenancy” (under the Landlord and Tenant (Covenants) Act 1995) to its guarantor. Such an assignment is void for breaching the anti-avoidance provisions of the Act and is ignored. The consequence is that the assignor remains the tenant and the guarantor continues to guarantee the tenant’s obligations. Complexities arise in terms of Land Registry registrations of the assignee which do not reflect that the assignment was void and the party in occupation will not necessarily be the legal tenant. This uncertainty of occupation and obligation will cause concerns for landlords in investment terms.

This is a point to be watched on due diligence (checking whether tenants of “new tenancies” have assigned to their guarantors) and it should also be borne in mind that the effect of this decision is retrospective. While it is understandable that the Act would look to protect former tenants or former guarantors who are no longer involved with the property, it is strange that the Court has decided that the guarantor is unable to become the tenant and use the premises, even if all the parties desired it. The ultimate solution seemingly is for legislative change to clarify this and other points in the Act. This decision only affects “new tenancies” under the Act i.e. essentially those entered into on or after 1 January 1996.

Further thoughts

House of Fraser context

The context for this decision was the Court of Appeal’s famous decision in K/S Victoria Street v House of Fraser (Stores Management) Limited [2011] and its obiter (non-binding) comments on the question of whether a tenant can assign to its guarantor, or to the guarantor and itself. The general tenor of that judgment suggests that the court considered such an assignment did not work, because it would be the equivalent of asking the outgoing tenant's guarantor to directly guarantee the assignee (which the Court of Appeal had held did not work). However, they did not have to decide the issue. Their comments were regarded as somewhat disconcerting, because prior to the decision, the general view seemed to be that, provided there was no sham, assignments to guarantors did not fall foul of the anti-avoidance provision in the Act. That was because the guarantor was becoming the tenant, a different capacity from its previous one as direct guarantor for the tenant. The major purpose behind the Act was to protect tenants after they had assigned - however, in this situation, the guarantor was becoming the tenant, and with the ability to occupy and use the premises, it should be liable under the tenant's covenants in the lease.

Issues

The High Court in the EMI case has now addressed the specific questions of whether:

• a tenant is precluded under the Act from assigning the tenancy to its guarantor; and
• any agreement which seeks to give effect to such an arrangement is void, because it frustrates the purpose of the Act.

Decision

It has decided that the tenant is so precluded and the agreement is void. The consequence is that the assignment did not take effect to vest the lease in the (former) guarantor as an assignee. However, the guarantor retains its liability as guarantor. (An unfortunate possible consequence for the landlord of the decision is that if he had assumed the assignment was fine and subsequently the tenant (assignor) went bust and its liquidator disclaimed the tenant’s interest in the lease, the landlord (because he wasn’t focusing on the guarantee provisions, because he assumed they were no longer relevant) may have lost the opportunity under the guarantee provisions to require the guarantor to take a new lease and also possibly thereby lost the right to claim further rent from the guarantor depending on the drafting.)

Reasoning

As background, on assigning a “new tenancy” under the Act (other than an “excluded assignment”), the assignor is released from its lease liabilities (as tenant) and a guarantor for the tenant is likewise released. The exception to the release is that the assignor may be required to enter into an authorised guarantee agreement (“AGA”) in respect of its immediate assignee, which AGA obligations may be guaranteed by the guarantor.

The Court’s reasoning for its decision included the following factors:

• The Law Commission in its report recommended that, whenever the liability of a tenant would be wholly cancelled by their recommendations, then liabilities which had been undertaken "in parallel and are essentially to the same effect" should also be terminated. In the case, the guarantor was not simply a guarantor, but was also a principal debtor with primary liability in respect of the lease obligations (this primary liability is commonly encountered).
• The "whole thrust of the Act" is that there should be no re-assumption or renewal of liabilities, whether on the tenant or the guarantor (see sections 5(2)(a) and 24(2)(a)). This means that, if a tenant and the tenant's guarantor are each liable for the same or essentially the same liabilities as a result of the tenant's covenants of the tenancy, the guarantor cannot as a result of assignment by the tenant to it of the tenancy re-assume those very same, or essentially the same, liabilities as the tenant. Or the guarantor cannot, on an assignment by the tenant whom it guarantees, become the assignee. This is because on the assignment by the tenant to the guarantor: The tenant is released from the tenant covenants of the tenancy, as from the assignment. The guarantor is released from the tenant covenants of the tenancy, as from the release of the tenant.It is the effect and intention of the Act that as from the tenant’s release, the guarantor should be released from its liabilities as guarantor under the lease. However, as from the assignment to the guarantor (in its new capacity as tenant), that same party becomes bound by the tenant covenants.
• The assignment, therefore, releases the guarantor from the tenant covenants of the tenancy but, at the very same moment in time, binds the same party (but now in its capacity as tenant) with the tenant covenants of the tenancy. In practical terms, therefore, there is no release at all for the guarantor in respect of its liabilities under tenant covenants. This is because the liabilities under the tenant covenants are simply re-assumed by the guarantor, but this time as an assignee (and not as a guarantor). Also the liability re-assumed by the guarantor as the new tenant is the very same, where the guarantor is also primarily liable in respect of the tenant covenants. The objective effect of the assignment is that the guarantor re-assumes precisely the same liability in respect of the tenant covenants as a result of becoming the tenant. It is that consequence which "frustrates" the Act and the assignment is rendered void by the “generous” anti-avoidance provision in section 25 of the Act. The guarantor is, therefore, absolutely precluded from becoming the assignee, on an assignment by the tenant whose tenant covenants he is guaranteeing.
• There is nothing in the Act, which provides for there to be sequential steps in relation to the release of the guarantor from his liabilities under the tenant covenants, and the re-assumption of those very same liabilities on him as the assignee. Rather, the Act provides that these events should all happen at the very same moment in time, which is "as from" the assignment. There is, therefore, no moment in time when a person who is the guarantor, and then becomes the assignee, is actually released from, or otherwise freed from, his liabilities in respect of the tenant covenants. This means that, whether as guarantor or as assignee, the liabilities in respect of the tenant covenants have continued unchanged. In House of Fraser, the court made it clear that there is a need for an actual period of release.
• The fact such a conclusion is unattractively limiting and commercially unrealistic is neither here nor there – this is a disconcerting comment on the part of the Court.
• The Court made its decision despite contrary comments by the preeminent property expert and judge Morgan J in a talk delivered by him to the Property Bar Association. He said “On the assignment, section 24(2) operates to release the guarantor from its earlier guarantee and section 3(2)(a) operates to impose the burden of the tenant covenants on the former guarantor as assignee. The release under section 24(2) does not frustrate the operation of section 3(2)(a). The imposition of the burden of the covenants under section 3(2)(a) does not frustrate the release under section 24(2). There is no conceivable policy reason not to give effect to this logic."

Consequences of decision

A number of uncertainties are created as a result of the assignment being void. They include:

• What is the impact on registration of the assignment at the Land Registry?
• Or, on any derivative underlease or mortgage of the assigned lease?
• What is the position of the party in occupation who now is no longer the legal tenant under the assigned lease?
• If a tenant cannot assign to its guarantor, can a tenant assign to itself and another party? By the same logic, it appears not, and this could have serious implications for partnerships and trustees, although trustee legislation may assist in allowing for changes in trustees in a way that does not fall foul of the anti-avoidance provision in the Act.
• These concerns may lead to tighter controls on intra-group assignments, but landlords will need to consider the rent review and other valuation impacts of a more onerous level of control.

This decision will impact on due diligence in terms of there being the need to check whether tenants have assigned “new tenancies” to their guarantors. The 7th edition of the CLLS Land Law committee’s Certificate of title has a standard statement in relation to “Letting Documents” that are new tenancies as follows “ 8.4.3 the Letting Document is not now and has not been previously vested in any guarantor of a previous tenant”. So the checking of this issue has already been going on in a certificate of title context.

EMI Group Limited v O & H Q1 Limited [16 March 2016] High Court