Commercial tenants should seek bank guarantee from landlords before moving in

The recent decision of the Victorian Court of Appeal in "Re Willmott Forests Limited (Receivers and Managers appointed) (in liquidation) [2012] VSCA 202" brings into question the security of a lessee’s tenure.  

It suggests the existence of a category or “class” of lease, which can be unilaterally brought to an end if the landlord goes into liquidation. 

This has broad-reaching implications, particularly for tenants proposing to invest significantly in businesses that require security of tenure and/or fit-outs that are only feasible if they can be amortised over the period of a long lease.

Will tenants now be asking landlords to provide security deposits or bank guarantees securing the value of their investment in the leased premises?

The Willmott Forests Case

The liquidators of Willmott Forests Ltd (receivers and managers appointed, in liquidation) intended to sell land on which a forestry scheme had been established.  As part of a set of project documents, the growers of the forestry scheme had rights to grow and harvest trees on the land.  Those rights included leases and licences for the occupation of the land. The liquidators wished to sell the freehold land unencumbered by the leases and licences by disclaiming the contract documents as onerous pursuant to section 568 of the Act and they asked the Court to clarify whether they could.

The Supreme Court decision

In the Supreme Court her honour Jennifer Davies held that the answer to the question above was "no" on the basis that:

• a lease grants both contractual and proprietary rights;
• a leasehold interest is the property of the lessee and a disclaimer by a liquidator only terminates the lessor’s rights, interest and liabilities under the lease;
• it is not apt to describe a leasehold estate as a liability or an encumbrance on the lessor’s property; and
• such a disclaimer would not bring the lessee’s proprietary interest in the land to an end as the proprietary interest has already vested in the lessee. 

The decision of the Court of Appeal of the Supreme Court

On appeal, this decision was overturned, with the Court of Appeal finding that a leasehold estate cannot continue if the lessor has been released from its obligations under the lease agreement. This meant that a liquidator was empowered to end a lease and dispossess the tenant of its leasehold interest and tenure.

In terms of the competing interests of the landlord’s creditors and the lessees’, the Court of Appeal said:

Section 568D(1) allows the liquidator to terminate this obligation or liability despite its intrusion into the property rights of an innocent party.  The evident policy is to permit the loss of these rights in order to enable the company in liquidation to be free of obligations so that it can be wound up without delay for the benefit of its creditors.  To compensate, the rights of the affected parties are transmuted into various statutory rights and claims.

Of course in order for the “compensation” to be available, the liquidators must recover enough out of the liquidation to satisfy both its secured and unsecured creditors.  In the Willmott case this simply will not happen, so the idea that the loss of the innocent parties' rights will be compensated for in other ways will not be realised.

By prioritising the rights of the creditor over those of the tenant, risk is shifted from the lender (generally a sophisticated party who had an opportunity to consider its risks on the way in and who may have profited from the arrangement) to an innocent party who had no ability to mitigate the risk.

Tenants who intend to invest significantly in fit-out or in acquiring new premises from which to run their businesses should beware.  If your landlord is on shaky ground, so potentially is your tenure. Tenants may want to consider seeking some form of security from their landlords at the commencement of a lease to ensure that their investment takes priority over a potential creditor’s interest.  It is conventional for landlords to seek a bank guarantee or security deposit from tenants to protect their income stream, but I predict that it will become increasingly common for tenants to seek reciprocal protection, particularly where:

• the location of business is often a key strategic asset;
• significant amounts of capital fit-out is required;
• the lease is for a term exceeding five years; or
• the lease is only one component of the commercial arrangement between the lessor and lessee.

Without that protection, a lessee will be left with the following less than satisfactory options:

• prove its loss as an unsecured creditor; or
• apply to the court to have the disclaimer set aside (under section 568E of the Act); or
• attempt to negotiate a new lease with the liquidator.

We understand that the Willmott Growers have applied to the High Court of Australia for special leave to appeal this decision.