Good Harvest upheld and clarified by Court of Appeal

29/07/11

The Court of Appeal in K/S Victoria Street v House of Fraser has upheld the Good Harvest decision that when a "new" lease is assigned the tenant's guarantor cannot give a valid guarantee of the assignee's obligations. This applies even where the guarantor offers the guarantee voluntarily, for example to facilitate the assignment of the lease from one group company to another. However, the Court of Appeal has more helpfully confirmed that sub-guarantees are valid and that a tenant's guarantor can act as guarantor for subsequent (rather than immediate) assignees. This note summarises the background law and considers the commercial implications of the decision.

Background law: Landlord and Tenant (Covenants) Act 1995

The original tenant and guarantor under a lease which was granted before 1996 will remain liable throughout the term of the lease for payment of rent and compliance with other lease obligations, even if the lease is assigned many times. However, for "new" leases (granted since 1 January 1996), when a tenant assigns his lease he and his guarantor are automatically released from all future liability under it. This is subject to the landlord being permitted to require, as a condition of assignment, that the tenant provides an authorised guarantee agreement ("AGA"), guaranteeing the obligations of the assignee. If the assignee assigns again the tenant will be fully released at this point. The Act contains anti-avoidance provisions so that any attempt by the landlord to require any additional or greater guarantee from the tenant will be unenforceable, but the drafting relating to guarantors is unclear.

Implications of the Court of Appeal decision

Although the Court of Appeal in the K/S Victoria Street case only had to give a decision on the validity of a requirement that an existing guarantor must provide a further guarantee in respect of an assignee's obligations, it helpfully provided some additional analysis of the other issues arising from the Good Harvest case. We now have clearer guidance on three points:

(1) A direct guarantee offered by the tenant's guarantor for the proposed assignee will always be unenforceable

Any direct guarantee given by the tenant's guarantor in respect of the assignee's obligations, whether required by the landlord or given voluntarily, will be void. So the tenant's guarantor cannot, for example, freely offer itself as guarantor for the assignee on an intra-group assignment and a bank cannot act as guarantor to both the tenant and assignee where the parties are unrelated but use the same bank. The court acknowledges that this decision limits the commercial freedom of the parties and is commercially unrealistic but considers it to be the only interpretation of the legislation which brings sufficient certainty.

This means that where the capital value of a property currently depends on such a guarantee it is likely that buyers will discount the price they are willing to pay and lenders may lend less on the security of the property. It also means that no account should be taken of any offer by a tenant's guarantor to stand as direct guarantor for the proposed assignee as such a guarantee will not be enforceable. It does not mean that such guarantee should not be accepted if offered as the guarantor may be unaware of the decision and may even pay up under such a guarantee, but as it cannot be relied upon it should not form any part of a landlord's decision to give consent to an assignment.

Where a lease restricts assignments generally but contains a provision allowing intra-group assignments on the condition that the existing guarantor guarantees the obligations of the assignee the practical implications will depend on the exact wording of the lease. Where the only condition of assignment is that the further guarantee is given, the landlord may be in difficulties. The part of the clause requiring the guarantee is void but if it is severable from the rest of the clause, the tenant will be free to assign to a group company without consent, even if that group company is of bad covenant strength (with adverse consequences for the landlord). On the other hand, if that part is not severable then it may be possible to argue that the tenant simply cannot assign without consent (with adverse consequences for the tenant).

If a landlord wishes to offer more relaxed intra-group assignment provision for tenants in the future these will need to be drafted to include alternative preconditions such as a minimum financial test for the assignee together with the assignee's alternative guarantor.

(2) A guarantor's "sub-guarantee" of a tenant's AGA is enforceable

A "sub-guarantee" exists where the guarantor guarantees the tenant's obligations in the AGA, either in its original guarantee or in the AGA itself. This point was not clear from the Good Harvest decision and is welcome news for anyone who has made use of this form of guarantee in the past.

It may also provide something of a solution where the tenant wishes to assign to a group company. Even though the guarantor cannot provide a direct guarantee of the assignee's obligations the tenant can offer an AGA which the guarantor guarantees at this point, thereby achieving the same effect as if the guarantor had directly guaranteed the assignee. It does not assist on any subsequent assignment, though in light of point (3) below, the guarantor could arguably provide a direct guarantor for a subsequent assignee any way.

There is no answer to the question of whether the guarantor could act as a co-guarantor to the tenant, rather than guaranteeing the tenant's obligations under the AGA. The practical effect would be much the same but arguably this will fall foul of the restriction on the guarantor giving a direct guarantee.

(3) A guarantor may act as guarantor for subsequent assignees, just not for the immediate assignee

This point did not arise in Good Harvest and it remains to be seen how much practical use it will be. It is arguable that where the guarantor is happy to offer a fresh guarantee for the assignee the restriction preventing the guarantor from giving this can be circumvented by structuring the deal as a two stage assignment: the tenant would assign to A1 who would immediately assign on to A2. There would be no guarantee of A1's liability but the tenant's guarantor would guarantee A2's liability.

However, caution is needed as this approach will have cost implications, will mean that the tenant will not be liable under any AGA given in respect of A1 (as it will be released on the assignment to A2) and the deal may well be held to fall foul of the anti-avoidance provisions because of its overall effect.

Where there are two possible guarantor companies within a group this may be a good way to allow more relaxed intra-group assignments, with the two companies guaranteeing alternate assignees.

What should you be doing now?

Landlords, tenants and those who act for them should all be aware of the implications of this decision.

• Review existing lease arrangements: any direct guarantee given by a guarantor in respect of an assignee's obligations is unenforceable. Guarantors cannot be required to perform such guarantees. Landlords should be aware of what effect this has on the value of their reversion.
• Review clauses allowing intra-group assignments: if the only condition is that the guarantor provides a further guarantee of the obligations of the assignee be aware that this condition may be severable in which case the tenant will be able to assign intra-group to a company with a weak covenant and no guarantor. Consider amending the conditions for intra-group assignments (by eg introducing financial strength tests, requiring an AGA from the tenant guaranteed by the guarantor, or requiring alternate guarantors).
• Look at existing guarantee drafting: the guarantor can validly guarantee the performance of the tenant's obligations under an AGA - if your standard guarantees are not currently drafted in this way consider amending them. Where this obligation is not contained in the guarantee itself it may be reasonable to require that the guarantor guarantees the AGA on assignment.
• Where a tenant wishes to assign and the guarantor is willing to remain bound consider using a two-step assignment but be aware that this is untested and may still be unenforceable.

If you have questions about any of the matters raised in this note we would be happy to discuss these with you. Please speak to your usual contact at BrookStreet des Roches.