How can a tenant protect its lease if a landlord company is wound up? - Insolvency/Bankruptcy

Following a High Court of Australia decision the liquidator of a landlord company has a statutory right to disclaim a tenant's lease of premises.

Following the decision of the High Court of Australia in Willmott Growers Group Inc v Willmott Forests Limited (Receivers and Managers appointed) (In Liquidation) [2013] HCA 51 (Willmott), the liquidator of a landlord company has a statutory right to disclaim a tenant's lease of premises. If this statutory right is exercised, and not successfully challenged by the tenant, the disclaimer brings to an end the lease.

Subject to the tenant's rights to challenge the disclaimer under Section 568B of the Corporations Act 2001 (Act), the tenant can only do one thing – lodge a proof of debt in the winding up of the landlord company.

S568B OF THE ACT

The tenant has rights under s 568B of the Act to challenge a disclaimer of lease by a liquidator before it takes effect.

Under s 568B the tenant (or any person with an interest in the disclaimed property) may apply to the Court for an order setting aside a disclaimer where the Court is satisfied that the disclaimer would cause prejudice to the tenant (or other person) that is grossly out of proportion to the prejudice that setting aside the disclaimer would cause to the landlord company's creditors.

Given there are no legislative criteria to control or guide the exercise of the Court's discretion under this section and the limited case law on the operation of these provisions, the current position is very unsatisfactory from a tenant's perspective.

The High Court provided no guidance on what "grossly out of proportion" means in this context. However the following points are likely to be relevant:

the liquidator will ordinarily measure the prejudice to be suffered by the landlord company's creditors in terms of direct financial disadvantage. It may be difficult for a tenant to measure the potential prejudice that the tenant may suffer in terms of direct financial loss. However, it will be necessary to do so in order that a proper comparison can be drawn. Section 568B(3) requires a comparison of the direct consequences of a disclaimer or setting aside of the disclaimer.
one consequence of the disclaimer is that the tenant will become a creditor of the landlord company. It is possible that damage to the tenant will be so significant with result that it would lodge a proof of debt claiming a very large sum with a consequence that the creditors of the landlord company as a whole are no better off (even if the liquidator is able to realise a greater sum for the asset).
if the landlord company has no creditors, the potential prejudice to the tenant (or other interested party) need not be great in order to set aside the disclaimer. As a practical matter, this means that placing a solvent landlord into members voluntary liquidation and using the disclaimer power as a commercial strategy to negotiate a better deal or to exit a lease is unlikely to be successful.

If a party applies to set aside a disclaimer, the test will have to be applied on a case by case basis.

A tenant has additional rights to apply to set aside the disclaimer after it has taken effect – see s 568E of the Act.

THE COMMERCIAL IMPACT ON LEASES GENERALLY

The Willmott decision is a game changer but only in relation to certain types of leases.

It is rare that a liquidator of a landlord will disclaim a lease if it has commercial benefit for a subsequent purchaser of the freehold property. If a lease is on commercial terms at a market rent, a disclaimer is unlikely.

However the circumstances where the liquidator of a landlord may be encouraged to seek to disclaim a lease would include leases where:

the current rent payable is not at market rates and the rent is not subject to review. This situation may arise if the tenant has paid a substantial upfront payment of rent by a premium or otherwise. This would include most long term ground leases which are discussed below.
the existence of the lease impedes a potential redevelopment of the land which would enhance the value of the freehold land; or
in the case of prime retail premises, a competitor of a sitting retail tenant may be prepared to pay a significantly higher rent.

From a financing perspective, as a consequence of Willmott, the value of a leasehold for security purposes has been made uncertain.

GROUND LEASES - HOW TO MAKE THEM BANKABLE?

A leasehold which has a significant value is a long term ground lease.

For example:

there is a 99 year ground lease which is granted by Government;
under the ground lease, the tenant pays a lump sum premium for the grant of the 99 year lease with only limited obligations to pay outgoings or other money to the owner of the freehold reversion over the term;
the tenant erects a building on the land;
the 99 year lease allows the tenant to derive income from the land as if it was the freehold owner for the term of the 99 year lease.

Whilst this is not a problem if the Government remains landlord throughout the 99 year term, there is nothing to stop the Government selling the freehold reversion. Even if the tenant obtains a contractual promise from the Government not to sell the freehold reversion, for public policy reasons, the law does not recognise promises which act to restrict an owner's right to sell the land it owns.

From a security perspective, prior to the Willmott decision, banks had no problem financing construction of buildings by tenants on land held under long term ground leases. Similarly, the banks were comfortable with funding acquisition of long term ground leases of developed properties having regard to the income streams being generated.

But Wilmott has changed this.

A SOLUTION? TENANT TAKES A REGISTERED CHARGE OVER THE LAND

Logically the more value that a lease has to a tenant the greater the likelihood that a liquidator of the landlord may derive an uplift of the value of freehold reversion by disclaiming the lease.

Given the statutory right of the liquidator of the landlord to disclaim the tenant's lease, the best strategy to protect the tenant requires the tenant to negotiate as a condition of the lease that the landlord company grants a registered charge over the freehold reversion to secure payment of damages if the lease is disclaimed.

In short, while this strategy does not protect the disclaimed lease, it does give the tenant a right to recover 100 cents in the dollar for the tenant's loss.

In a practical context this may discourage a liquidator of a landlord from disclaiming the lease.

If there is a third party financier with a registered mortgage over the freehold reversion, the tenant's charge must rank in priority to the third party financier's interest.

In practice the existence of the tenant's charge will not impact on the value of the bank's mortgage security recognising that the bank's mortgage will give the bank the ability to maintain the tenant's lease and the bank would have assumed that the lease would continue when the bank valued the land for security purposes.

In the case of a long term ground lease granted by the Government, the strategy for the tenant would be to obtain a promise by the Government that if it wishes to transfer the freehold reversion, the transfer would be conditional on the transferee granting a registered charge. In this way, the tenant's interests are protected against the insolvency of any future private sector landlord.

IS THIS SOLUTION WORKABLE?

The arrangements using a registered charge on the land to protect the tenant should a liquidator of the landlord disclaim the lease go some way to overcoming the Willmott decision and would leave both the landlord and its financiers in a similar financial/secured position to that which applied pre Willmott.

That said, there is a pressing need for legislation to resolve the uncertainty created by Willmott.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.


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