UK: Problems Ahead for Sub-letting

Article by Derek Ching

As previously reported in our Property Update, a case that may signal the end, in many circumstances, of side deeds, ‘Allied Dunbar v Homebase’, was then before the Court of Appeal.

Side deeds arise where a sublease is negotiated between a tenant and prospective subtenant but upon terms that are not permitted by the restrictions on sub-letting in the headlease. This may be because market rents have fallen below those payable under the head-lease or because the short duration of the proposed sublease makes a full repairing obligation unacceptable to the proposed sub-tenant. Where a landlord is expected to block any deal which fails to meet the numerous pre-conditions set out in the headlease, the tenant and prospective subtenant are tempted to solve the dilemma by creating a sublease which satisfies the landlord, but also entering into a side deed under which they privately regulate certain liabilities in a manner which departs from the permitted terms without troubling the landlord.

The Court of Appeal have now decided that the landlord (Allied Dunbar) was correct to oppose the tenant's (Homebase) request to sublet. As a result, the appeal judges have made life considerable harder for those tenants wishing to offload unsuitable or difficult to market premises.

It is worth briefly revisiting these. Homebase held a 25 year, full repairing lease of a retail warehouse from Allied Dunbar and the rent was subject to 5-yearly upwards only reviews. The subletting provisions included covenants that the tenant was not to sublet without landlord's prior written consent (such consent not to be unreasonably withheld); that the sublease should not reserve a rent less that the full market rent reasonably obtainable without taking a premium, that the sublease should contain covenants by the sub-tenant in the same form as those provided by the head tenant; and that the rent payable by the subtenant would be reviewed on an upwards only basis concurrently with the headlease rent reviews.

Homebase sought consent to sublet and produced a sublease that on the face of it complied with the alienation provisions. However Homebase also provided their subtenant with a side deed by which Homebase would indemnify the subtenant for part of the rent; agree to pay for certain repairs; and fix a rent irrespective of the rent review dates in the headlease and sublease. Allied Dunbar refused to grant consent to sublet and sought an order to prevent the sublease from being granted. Allied Dunbar contended that, when the sublease and side deed were read together, the transaction, when taken as a whole, did not comply with the headlease alienation provisions. Homebase counterclaimed, seeking damages for unreasonableness of withholding consent pursuant to the Landlord and Tenant Act 1988.

At first instance, the judge held that Allied Dunbar had acted reasonably to withhold consent and that the side deed and sublease were interdependent. Homebase appealed, but lost again.

The Court of Appeal went further than the High Court in their findings, holding that the overall transaction failed to comply with the provisions as to rent review and the requirement for the sublease to be "in the same form" as the headlease (due to the side agreement as to repairing obligations). Additionally they confirmed that the side deed and the sublease were to be viewed as interdependent and accordingly should be read together.

A number of implications arise:

1. Damage to reversionary interest

The sublease, in this case, would have attracted security of tenure, and Allied Dunbar were successful in arguing that, at the end of the contractual term of the headlease, Homebase would not enjoy statutory rights of renewal (no longer occupying business premises for a business purpose) and that the statutory right to renew would lie with the subtenant. The subtenant could then argue that any new lease was to be the sublease as amended by the side deed and as such, Allied Dunbar's reversionary interest may be harmed by having to renew on the less attractive terms imposed by the side deed. It did not matter that the side deed was expressed to be personal as between Homebase and its subtenant.

Can this case be distinguished where security of tenure would be excluded from the proposed sublease? Will the overriding principle remain - that the sublease and side deed must be read together to see if, irrespective of statutory renewal rights, the documents either do or do not comply with the headlease alienation provisions? It is difficult to see any basis for a different approach. Neither do we think it would help if the side deed contained an acknowledgment that the head tenant will not use the presence of the side deed rental as evidence of the market rent on any headlease rent review. The issue is whether the sublease deal is in an acceptable form not the impact of such a deal on later negotiations.

2. Professional Conduct

Upon receiving a tenant's application to sublet, landlords should certainly now enquire if a side deed or side letter, or some other form of financial adjustment, is proposed. If a tenant’s solicitor answers in the negative, is that solicitor guilty of professional misconduct in dealings with fellow solicitors and further, has the tenant's solicitor fallen into the muddy waters of fraud?

3. Landlord's Premium?

If the tenant's application for consent is deemed (due to the presence of a side deed) to fall outside of the parameters contained within the headlease sub-letting provisions, the landlord may be able to demand a ransom payment for the granting of consent.

4. Tactics during lease negotiations

Should tenants attempt to oppose, upon the taking of a new lease, provisions preventing subletting at less than the passing rent or similar traditional institutional style restrictions. If they continue to sign up to these provisions, in a difficult market, the only way for sub-leases to be negotiated in a form which satisfies the stringent requirements of the headlease is to offer a significant rent free period or reverse premium to the incoming sub-tenant to make it worthwhile taking on what are onerous obligations. On renewal under the 1954 Act a landlord will be in a strong position to resist any watering down of the subletting clauses. Otherwise it is simply a matter of making the best of the parties negotiating position.

5. Impact on rental levels

What are the rent review arguments for the future? The significance of the decision is that there is a danger that the property may only be sublet in a difficult market or near the end of the lease period (if at all) at the price of a significant payment in cash or kind to the incoming subtenant or alternatively upon payment of a ransom to the head landlord.This may lead tenants to argue for a reduced rent for such leases. Equally landlords may be well placed to turn the argument on its head and say that, as most institutional leases will impose such pre-conditions, the normal market rent remains appropriate for such leases and that tenants ought to pay a premium rent for leases that are free from such restrictions.

6. Increased void periods

Those negotiating subleases have to do so with knowledge of the terms of the headlease. A deal which will clearly not get past the landlord may not be worth the paper it is written on, with the result that the prospective subtenant walks away and the tenant is left with a surplus property for many more months. A deal that goes through may run the risk of operating in the absence of "real" headlandlord consent with attendant problems of enforcement, actions for breach of covenant and possible estoppel arguments.

7. Further advice

The Court of Appeal's decision has huge practical and financial implications for tenants looking to offload surplus premises and poses professional conduct and tactical issues for professional advisers generally.