Gordons retail update – retail tenants must be aware of insolvency domino effect

Saturday 16th October 2010

In troubled economic times retail tenants who are struggling to pay their rent may wish to eliminate their rental and rates liability by selling their lease.

This may be difficult if rents have fallen and the lease prevents the tenant selling other than at the rent payable under the lease – a prospective buyer will want to pay a market rent which may be less. To get round this, a tenant may decide to rent their property to a third party by way of an underlease and become a landlord themselves.

In a tenant’s market, an underlease today would generally be on much more attractive terms – with regard to rent free periods or other financial incentives – than the lease would have been when it started.

To get round this a tenant may decide to grant an underlease but enter into a separate side agreement – unknown to their landlord in most cases – which could include further concessions to the undertenant. These could include a lesser repairing obligation, a break clause or a rent reimbursement over a period of time.

On the face of it this would not appear to cause too many problems and may be seen as a sensible way for a tenant to generate the revenue required to pay the landlord’s rent. The problem is that most undertenants are unaware that if the tenant becomes insolvent then its trustee in bankruptcy or liquidator can terminate the tenant’s obligations to its landlord and the undertenant by ‘disclaiming’ the lease. It is now that an insolvency domino effect begins.

The undertenant can remain in the property but must then comply with the obligations the tenant had in the disclaimed lease which may be on much less favorable terms in relation to rent, and repairing liabilities or be for a longer period. If the undertenant fails to do this the landlord can take action to forfeit – in other words, terminate – the lease or instruct bailiffs to recover goods from the property to compensate it for non-payment of rent. This is the second part of the insolvency domino effect in action and it can prove devastating for many businesses.

What can undertenants do to protect themselves in this situation? Some comfort can be obtained from the fact that landlords are unlikely to terminate or forfeit a lease in the current climate, although this may change as the market recovers.

In the meantime, this situation is extremely unsatisfactory for undertenants because of the loss of the more favorable terms in the underlease and the continuing uncertain nature of the basis upon which they will then occupy the property.

Undertenant’s should be aware of this situation and negotiate accordingly when they agree to take an underlease. They must consider the financial strength of the tenant who will be their immediate landlord and consider trying to obtain any inducements as financial inducements payable up front so they can be used to make provision for future liabilities such as rent or repair in the event of the tenant’s insolvency. In this situation, being forewarned is forearmed.

If you wish to discuss the issues raised in this article please contact Joanne Fearnley.