Friday, 7 October 2011

Lease Guarantees: What Are They Worth Now? How Can They Add Value in Future?

This summer saw the Court of Appeal hand down the most important decision in commercial landlord and tenant law for years in K/S Victoria Street -v- House of Fraser (Stores Management) Limited [2011] EWCA Civ 90.

It would never have made the general headlines, even without a summer dominated by phone hacking and riots, but for property lawyers it is nevertheless a landmark judgement on the workings of the Landlord and Tenant (Covenants) Act 1995 (1995 Act).

I gave a summary of the decision in August in my post Lease Guarantees: Is it the End of the Saga?; but now the dust has settled, and in case it slipped under your summer holiday radar, I’m going to look again at some of the practical implications of this decision.

Why is it so important?

It is often the case that a landlord will be persuaded to grant a lease to a tenant of little value – a “weak covenant” – because the tenant’s obligations will be guaranteed by someone stronger, such as a parent company or a rich individual.

For leases granted since 1996, when the tenant (T) assigns its lease to an assignee (A), it ceases to be responsible for performance of the tenant’s obligations, unless it has given the landlord an authorised guarantee agreement (AGA), which it is nearly always required to do, under which it guarantees the obligations of A. If T by itself is a weak covenant, the AGA is also of little value unless the guarantor (G) can somehow be kept on the hook.

Following the Court of Appeal’s ruling, the law now says:

·         G cannot guarantee the obligations of A

A requirement to do so is void, whether it is contained in a lease, a licence to assign, the assignment itself or a separate guarantee deed. Surprisingly, G cannot even agree to give a direct guarantee of A voluntarily.

·         G can guarantee the obligations of subsequent assignees

So if A assigns the lease to A2, then G can step back into the frame and guarantee the obligations of A2 – even if A2 is the original tenant. But if G guarantees A2, on the next assignment, G could not then guarantee A3 directly, but it could guarantee A4 if there was another assignment. Confused? There’s more on this in the context of group companies below!
·         G can guarantee the obligations of T under an AGA

This is sometimes called a parallel or sub-guarantee, or even a GAGA. Here, G is not guaranteeing A directly, but is instead standing behind T’s guarantee of A in the AGA – which is a subtle difference but one which has some practical consequences.

What should you do now?

Check the leases in your portfolio – where’s the value gone?

Leases which require guarantors to give direct guarantees of assignees will be defective. If any such direct guarantees have been given, even voluntarily, they will not be enforceable and will basically be worthless. On repeated assignments within corporate groups, some guarantees may be effective, whilst others may not be (see below for more on this). What effect will this have on the overall value of your portfolio? This is something you need to discuss with your valuation advisers in tandem with your legal advisers.

Due diligence

When buying investment properties or portfolios; check carefully the position of any guarantors. If any guarantees are defective, take advice on the implications this will have on value and consequently whether an adjustment should be made to the price.

Check your precedents

Make sure that the leases you grant from now on comply with the law, and provide for a guarantor to give a GAGA rather than a direct guarantee of A.

Group companies – intra-group assignments and “leapfrogging”

The rule against guarantors voluntarily providing repeat guarantees will continue to have an impact on intra-group assignments where, for example on successive group reorganisations, the landlord would want the main group company to stand as guarantor for each successive tenant – so in my example, the group company would be G.

The Court has decided that G can validly guarantee the liability of an assignee on a future assignment provided there has been an intervening assignment of the lease during which the guarantor was released from liability as a direct guarantor, but can still have given a GAGA.

So, to keep renewing G’s guarantee (which is where the value lies), G will have to alternate between giving GAGAs and direct guarantees if the lease is assigned several times. I think of this as leapfrogging. On the first assignment to A1, G gives a GAGA. On the next assignment to A2, G gives a direct guarantee of A2. On assignment to A3, G gives a GAGA. On assignment to A4, G gives a direct guarantee of A4. And so on...

So G is giving a GAGA for odd numbered assignees and direct guarantees for even numbered assignees.

If at any time an assignment is back to a former tenant, or even the original tenant, you just need to think of them as another assignee to keep track.

Anyone drafting new leases needs to think carefully about how to provide for the guarantor to give either a GAGA or a direct guarantee on each subsequent assignment at the landlord’s option, and then the landlord needs to think carefully about what it must require on each assignment.

In new leases, landlords should not allow intra-group assignments without consent (which often used to be agreed for big corporate occupiers). This is to ensure an AGA will be given, which can then be backed up by a GAGA.

For existing tenants, the decision may present an opportunity to secure the release of a guarantor which the landlord can do nothing to prevent.

Why is a GAGA less valuable than a direct guarantee?

A GAGA, and indeed the AGA itself, is less valuable than a direct guarantee of an assignee because, if a landlord wants to make a claim under a GAGA or an AGA, it first has to serve notice on the former tenant or guarantor within six months of any rent or other fixed charge falling due and the person paying the arrears may be able to claim an overriding lease. This is not the case with direct guarantors.

But in terms of keeping the valuable group company at least on the hook, this is a lot better than nothing, and should enable multiple group reorganisations to go ahead without the need for further security.

Can a tenant assign a lease to its guarantor?

The Court of Appeal threw out a bit of a curve ball in its judgement when, on looking at the anti-avoidance provisions of the 1995 Act (section 25) it said “it would appear to mean that the lease could not be assigned to the guarantor even where both tenant and guarantor wanted it”.

So an assignment of a lease by a tenant to its guarantor would appear to be void. What does this mean where such assignments have already taken place? Good title will not have been given, even though the transfer might have been registered at the Land Registry. Clearly this would raise a serious defective title issue, the implications of which would need to be thought through on individual cases.

What if the assigning tenant is insolvent?

Where a tenant is insolvent (but has a solvent guarantor), the administrator or liquidator is unlikely to be willing to give an AGA. If that is the case, the solvent guarantor cannot give a GAGA, nor can it give a new direct guarantee of the assignee. In that situation, assignees may be required to provide a fresh guarantor of suitable covenant strength or other security, such as a rent deposit or bank guarantee.

So check your portfolio to determine the validity of existing guarantees; and think carefully from now on about making sure guarantees in future really do add value.

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