Property Law – Side-letters sidelined!

By : Alexander Bastin

It has been common practice for tenants with over-rented, surplus commercial premises to enter into collateral agreement or side-letters with prospective sub-tenants, giving a reduction in rent and/or an indemnity against specified claims by the superior landlord. The Court of Appeal’s decision in Allied Dunbar Assurance plc v Homebase Ltd (2002) EG 134 puts an end to this practice and may have far reaching consequences for the commercial property market, particularly where leases contain upwards-only rent review clauses and market rents have fallen. In January 2003, the Lords refused Homebase permission to appeal.

The Allied Dunbar case

In 1986, Homebase took a 25 year lease from Allied Dunbar. By 1998, Homebase had no further use for the premises and only Lairdale was interested in taking the premises, albeit at substantially less rent than Homebase was paying under the head-lease. The lease permitted subletting with consent, but only at or above the market rent and on the same repairing covenants. Homebase and Lairdale agreed upon a sub-lease that satisfied this requirement and a collateral deed, expressed as personal to the parties, that Homebase would refund part of the rent and indemnify Lairdale against the cost of specified repairs. Allied Dunbar refused Homebase’s application for consent and sought an injunction to prevent the sublet. Homebase counterclaimed, alleging that consent had been unreasonably withheld.

The Court of Appeal found for Allied Dunbar, ruling that the proposed sub-lease and collateral deed were interdependent and to be read as one document. As there was an anticipated breach of the headlease, Allied Dunbar had not unreasonably withheld consent and clearly had a legitimate interest in controlling the terms of any sub-tenant’s occupation.

The implications of the decision

Collateral agreements were a popular and common mechanism by which tenants in Homebase’s predicament could minimise their losses. Such agreements are likely, given the terms of most leases, to be in breach of covenant and best avoided, unless landlords are prepared to waive strict compliance. Prospective tenants should be wary of entering such unlawful agreements, as they may have little security of occupation.

The decision, therefore, has wide future implications for tenants in Homebase’s situation and may lead to a scarcity of affordable premises to let, especially where rents have still not reached late 1980s levels (some such areas do still exist). Tenants should also be concerned if rents fall significantly, particularly as downwards rent reviews remain rare.

Landlords’ remedies

If a landlord is aware of a proposed collateral agreement, it can seek an injunction to prevent completion. If the subletting has already occurred, a landlord can seek a mandatory injunction to restore the pre-sublet position. Although injunctions are discretionary, in Allied Dunbar the Court of Appeal highlighted a number of good reasons why a landlord may want to prevent such a breach. If a landlord can demonstrate loss, it may also have a damages claim. However, normally a landlord will continue to receive the full rent and the original tenant will remain obliged to perform the covenants. Ironically, the most obvious event to give rise to a substantive claim for damages is the tenant’s insolvency, when there will be no point claiming against the tenant.

Tactics

If the proposed sub-lease is yet to be completed, a landlord may seek an injunction preventing completion. Often landlords will not be told about a collateral agreement and, therefore, ought to be wary of any application to sublet where, on the face of it, the sub-tenant is to pay rent in excess of the market rent.

There are no easy answers for tenants and they should be very wary of entering into leases which forbid subletting at less than the passing rent, especially if the term is lengthy and there is an upwards-only rent review clause. One option is to request that the landlord waive strict compliance with the original alienation clause. However, usually landlords will not have to agree and the request will put the landlord on notice of the tenant’s possible intentions. The tenant may simply have to leave the premises empty or find another use in order to minimise losses.

Prospective sub-tenants will, naturally, be very wary of entering such agreements. If a sub-tenant is already party to one, it ought to make contingency plans. The best course is for the tenant and sub-tenant to co-operate and for the sub-tenant to be ready to move premises at short notice (which is likely to be costly and disruptive).

Conclusion

A serious downturn in the commercial rental market may lead to a significant reduction in the amount of property available at market levels. After all, a landlord with a good covenant in its tenant will have little incentive to waive compliance. It will be interesting to see how tenants with over-rented surplus property deal with this problem, the impact of the decision upon the rental market and how prospective tenants negotiate new leases.