This is Part 2 in our series on REFlections from the Riverbank examining issues faced by mortgagees in the context of commercial lease forfeiture.
In Part 1, we looked at lease forfeiture on the basis of a tenant's breach of covenant. We also considered the importance of including mortgagee protection wording in forfeiture clauses and, in appropriate situations, mitigating measures which may be taken to lower a mortgagee's level of exposure where a lease does not contain such protective wording.
In this Part 2, we will venture into the anxiety-inducing realm of forfeiture for tenant insolvency, and will consider the different forms of relief from forfeiture which can be sought from the Court. This article will again focus on forfeiture in the context of commercial capital value long leases, as opposed to rack rent leases under which a market rent is paid and which are generally of lower value.
Forfeiture for Tenant Insolvency
Whilst it is common for rack rent leases to grant a right for the landlord to forfeit upon the tenant becoming subject to an insolvency-related event (that is, an event which triggers insolvency proceedings under the Insolvency Act 1986, as amended), it is not market-standard for modern commercial capital value long leases to grant such rights. However, some older long leases (particularly those granted by Local Authorities) may contain insolvency related forfeiture rights.
The scope of this forfeiture limb may extend quite widely, going beyond the commencement of formal insolvency proceedings. For instance, some commercial leases will allow the landlord to forfeit upon the tenant becoming insolvent (i.e. unable to pay its debts when due). Thus there may also be some overlap where a lease stipulates non-payment of rent as a separate ground of forfeiture.
However, in the event of administration or liquidation, for instance, insolvency legislation intervenes and prohibits a landlord taking action to enforce its right to forfeit (either by legal proceedings or peaceable re-entry of the premises) without first obtaining a Court order permitting such action or consent of the insolvency practitioner. Even where the lease also permits forfeiture for non-payment of rent, the legislative bar will apply. These legislative restrictions provide limited comfort for mortgagees, as enforcement action can still be taken with the Court's permission or the lease may allow the landlord to forfeit for other insolvency-related events which fall outside the restrictions.
Where a commercial lease grants a right to forfeit for an insolvency-related event, the inclusion of mortgagee protection wording (examined in Part 1 of this series) will not necessarily assist. Moreover, where a mortgagee has taken security over a commercial lease and wishes to enforce its security, the inclusion in that lease of a right to forfeit for tenant insolvency will effectively fetter the mortgagee's enforcement options. Accordingly, whilst many mortgagees will accept as security a lease which permits forfeiture for breach of covenant by a tenant, one would be hard-pressed to find a well-advised mortgagee who would take the same approach towards forfeiture for tenant insolvency.
Once a landlord exercises its right to forfeit (whether for tenant breach, insolvency or otherwise), the lease and any security taken over it at that point come to an end. It is then open to the tenant, the mortgagee and anyone else with an interest deriving out of the lease to apply to the Court for relief from forfeiture. Here matters become slightly more complicated, however, as not all forms of relief are equal.
Applying for Relief from Forfeiture
The best form of relief is that which may be granted to a tenant, whereby the lease and any interests deriving out of it will be reinstated as if there had never been any forfeiture. The Court has a wide discretion in deciding whether to grant relief from forfeiture. However, generally speaking, for a tenant to obtain relief where a lease has been forfeited for breach of covenant:
(a) it must remedy the breach or, in respect of a breach which is irremediable, pay compensation (if an adequate remedy); and
(b) the Court must be convinced that, going forward, the tenant will comply with its obligations under the lease.
If the lease has been forfeited for non-payment of rent, it will be a condition of relief that the tenant must pay all rental arrears, interest and costs ordered by the Court. Although relief from forfeiture is a discretionary remedy, in practice, provided these conditions are met, relief will generally be granted to a tenant (albeit subject to such conditions as the Court sees fit). If the lease has been forfeited for an insolvency event, in most cases the tenant may still apply for relief (and, depending on the circumstances, the insolvency practitioner may be under a duty to apply for relief).
In exercising its discretion to grant relief to a tenant, the Court will undertake a balancing exercise, considering the proportionality between the hardship to the landlord if relief is granted to the tenant, and the hardship to the tenant if relief is refused. In the case of a commercial lease of significant capital value, where the refusal to grant relief from forfeiture would result in a substantial windfall to the landlord, it is far more likely that the Court will grant the relief sought by the tenant.
Where a lease has been forfeited, a legal mortgagee who has taken security over the lease (or an equitable mortgagee with the right to call for a legal mortgage) may also apply to the Court for relief, regardless of the grounds of forfeiture (section 146(4) of the Law of Property Act 1925). However, where relief is granted to a mortgagee, the outcome is not quite so ideal. The relief will consist of a brand new lease being granted to the mortgagee (without retrospective effect) on terms decided by the Court in its discretion. Further, any inferior interests deriving out of the forfeited lease will fall away and will not be reinstated by the Court. This is far from an ideal outcome for a mortgagee, particularly where value is derived from the income stream of subordinate leasehold interests.
The ideal position for a mortgagee in a forfeiture scenario is clearly for the borrower to apply for relief as tenant. However, the problem arises as to how the borrower could be compelled to apply for relief. In any event, even if an application is made by the tenant, since the grant of relief is at the discretion of the Court, each case will turn on its own facts and the positions of the respective parties. A mortgagee should therefore seek to protect its position as much as possible.
Where a mortgagee is looking to take security over a commercial capital value head lease which does not contain mortgagee protection wording and/or grants the landlord a right to forfeit for tenant insolvency, the forfeiture risks are clear. However, in certain "low-risk" cases (for instance, where the lease is at a peppercorn rent and part of a large portfolio to be taken as security) a mortgagee may nevertheless wish to proceed if there is a way it can ensure greater control over any potential forfeiture proceedings. What a mortgagee requires in this situation is: (a) to ensure it will be notified of a potential forfeiture event, thereby having an opportunity to step in and remedy any breach of the lease by the tenant/borrower, and (b) in the event the lease is forfeited (whether for breach of covenant, insolvency or otherwise), the ability to compel the tenant to apply to the Court for full relief from forfeiture.
It is, of course, imperative when looking to take security over a lease containing forfeiture provisions that a mortgagee obtains specific legal advice in order to properly assess the situation and level of risk involved. In appropriate cases, the mortgagee's solicitors may draft into the security documents specific obligations on the borrower in contemplation of a potential forfeiture scenario. Such terms should:
(a) require the borrower to notify the mortgagee immediately upon becoming aware of any actual or attempted exercise by the landlord of its right to forfeit the lease; and
(b) grant a power of attorney which allows the mortgagee and its agents to apply directly to the Court for relief from forfeiture on the borrower's behalf (i.e. to apply to the Court for full relief as tenant).
In addition, where the lease in question does not contain mortgagee protection provisions, indemnity insurance should be obtained to cover losses to the mortgagee arising from a landlord exercising or attempting to exercise its right to forfeit without first having notified and given the mortgagee the opportunity to remedy the relevant breach (this option is considered in more detail in Part 1 of this series).
The above protective measures should not in any way cause mortgagees to become complacent about lease forfeiture clauses. The appropriate position in each case is a matter of fact and degree, and suitable legal advice must be sought. In particular cases, however, the measures suggested above may help lower the level of risk to a mortgagee and pave the way forward to completion.
The next article (Part 3) will be the final instalment in this series. Part 3 will consider the complexities of taking security over an underlease where the superior lease contains forfeiture provisions and the consequences for a mortgagee where the superior lease is forfeited.
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