Introduction
Ask a lender to name their top three red flag issues when it comes to commercial property due diligence and, more likely than not, "lease forfeiture clauses" will feature in that list.
Forfeiture is a classic mortgagee red flag issue for good reason; most leases contain a clause which grants to the landlord the right to forfeit the lease (by re-entering the demised premises to terminate the lease) on one or both of the following grounds:
(a) the tenant has breached a covenant under the lease
(b) the tenant is subject to an insolvency related event
If a landlord forfeits a lease, relief from forfeiture can be sought; but if denied by the Court, the outcome is bleak for a mortgagee – the security for its loan will be lost. A mortgagee will therefore be justifiably nervous about a forfeiture clause in a lease when looking to charge that lease as security for its loan.
This is Part 1 in a series of three posts on REFlections from the Riverbank examining issues faced by mortgagees in the context of lease forfeiture. Along the way, we will also consider certain mitigating measures that can be taken by mortgagees who wish to take security over such leases in lower risk scenarios.
Parts 1 and 2 will be based on the more straight-forward scenario of taking security over a commercial capital value head lease at a peppercorn rent. Part 1 will examine forfeiture by the landlord (the freeholder) for breach by the tenant of a lease covenant or condition, and the importance of mortgagee protection wording; Part 2 will consider forfeiture for tenant insolvency and the different forms of relief from forfeiture which can be sought from the Court.
Part 3 will examine the more complex scenario of taking security over an underlease where the superior lease contains forfeiture provisions, and will consider the consequences for a mortgagee of a subordinate lease where the superior lease is forfeited.
Forfeiture for Breach of Covenant or Condition
There are very limited circumstances in which a landlord is entitled to forfeit a lease in the absence of an express forfeiture clause. A landlord has an implied right to forfeit only where: (i) the tenant breaches a condition of the lease (as opposed to a covenant); or (ii) the tenant denies the landlord's title. An example of breach of condition is where a tenant fails to make payment of rent, and payment of rent is expressed to be a condition of the lease. Accordingly, and to avoid doubt as to the circumstances in which a landlord may forfeit the lease, forfeiture clauses are a standard inclusion. In light of the above legal principle, the clause will generally be worded to grant to the landlord the express right to forfeit for (amongst other things) breach of a tenant covenant.
Mortgagee Protection Wording in Commercial Leases
Where the lease in question has been taken as security by a lender, forfeiture is clearly problematic. If a landlord exercises its right to forfeit the lease (whether rightfully or not), at that point in time the lease, and any interests deriving from it, come to an end. Thus, the mortgagee has lost its security. Setting aside the matter of applying for relief from forfeiture (which will be examined in Part 2 of this series), what a mortgagee requires here is the ability to step in before the lease is forfeited, to have the opportunity to remedy the breach. (Note that in this context we are only considering commercial leases, as there are specific statutory limitations which apply to a landlord's right to forfeit a long residential lease).
Any commercial lease to be taken as security should therefore contain a mortgagee protection clause, which qualifies the landlord's right to forfeit to give the tenant's mortgagee this opportunity. Mortgagee protection provisions should require the landlord to notify the tenant's mortgagee in the event of breach of tenant covenant, giving the mortgagee a period within which to remedy the breach prior to the landlord re-entering the premises or commencing forfeiture proceedings.
Whilst this is the ideal scenario (and any modern capital value lease should contain such wording, in contemplation of the lease being taken as security), we do not, of course, live in an ideal world. A mortgagee may find itself in a position where it was not properly advised at the time of taking security, and now has on its hands a leasehold security interest which could be forfeited at any time without warning. Alternatively, a mortgagee may be looking to take security over a capital value head lease in a scenario which is inherently "lower risk" – this would be where the relevant lease is at a peppercorn rent and forms part of a large portfolio of properties to be taken as security, which is otherwise acceptable to the mortgagee. A mortgagee in this context may understandably be reluctant to simply walk away from the deal.
Potential Solutions
In all cases, a mortgagee should seek specific legal advice on the forfeiture point. A suitably experienced legal advisor should be able to advise the mortgagee on the nature and level of the risks involved, and whether there are any measures which could be taken to reduce its level of exposure in an appropriate situation.
As is increasingly becoming a first-resort solution to a host of property "defect" issues, indemnity insurance is one such protective measure. Many underwriters today will offer terms for mortgagee-only insurance policies, to cover losses arising from a landlord exercising or attempting to exercise its right to forfeit a lease without having first notified the mortgagee and given it the opportunity to remedy the breach. Depending on the level of risk assessed by the underwriter, the premium payable under such a policy may be lower than expected. This can be a convenient way for a mortgagee to lower its level of exposure.
Another solution is for the lease to be varied before security is taken over the lease, in order to rectify the forfeiture clause to include suitable mortgagee protection wording. This may seem like the best possible solution for any lease with unsatisfactory forfeiture provisions; however, one must proceed with caution. If an approach is made to the landlord to rectify the forfeiture clause, but rectification is denied or not achieved for whatever reason, this may in itself disqualify the mortgagee from obtaining indemnity insurance, in circumstances where insurance may otherwise have been available.
Conclusion
As the saying goes, prevention is better than cure, and this is certainly true in the context of lease forfeiture. However, in many cases, prevention is simply not an available option. The law surrounding lease forfeiture is complex, and a well-advised mortgagee must proceed with caution. It is crucial that any mortgagee looking to take security over a leasehold interest obtains suitable legal advice, in order to assess the risks involved and the best way forward.
In the next two parts of this series, we will delve into some of the more problematic forfeiture scenarios and consider how mortgagees can best navigate these often treacherous waters.