To guarantee or not to guarantee? An invalid question

After much deliberation the Court of Appeal has decided that a contractual requirement for an outgoing tenant’s guarantor to guarantee an assignee’s liability is invalid.  Phew, all clear on that now? Probably not, but what does this all mean for the property industry and its lawyers?

Gary Watson
Gary Watson

– Written by Gary Watson, head of Olswang’s Real Estate Group

For years now the issue of whether an outgoing tenant’s guarantor can be required to guarantee that tenant’s assignee has kept the property market on its proverbial toes and its lawyers wondering what to do. 

The decision in the 2010 “Good Harvest” case resulted in much anxiety and uncertainty, with landlords concerned about its impact on the value of their properties and tenants worrying about whether this could lead to greater restrictions on their ability to assign between group companies.

As Good Harvest was settled before going to the Court of Appeal, the recent emergence of a similar case almost a year later at the Court of Appeal was met with great expectation by those looking for clarity.

The July 2011 K/S Victoria Street v House of Fraser (Stores Management) case saw the Court of Appeal seek to tackle the difficult issues unearthed by Good Harvest.  Though not perfect, the decision does provide greater certainty on how to deal with a guarantor’s liability following the release of the tenant it guaranteed.

The case revolved around a sale and leaseback agreement, by which House of Fraser (Stores Management) Limited (“Management”) sold a store for £46 million to K/S Victoria Street (“Victoria”) and Victoria let the store back to Management for an annual rent of £2.25million for 35 years, with House of Fraser Limited (“HoF”) acting as guarantor. Management was HoF’s subsidiary and was chosen as the seller and initial tenant for tax reasons.

Victoria, however, did not view Management as financially suitable. Management was required by the agreement to assign to a financially healthier subsidiary with HoF guaranteeing that assignee’s liability.

So, what happened next? Victoria sought to enforce those requirements and HoF resisted claiming that they were unenforceable, mainly because the requirement for HoF to guarantee the assignee was in breach of the Landlord and Tenant (Covenants) Act 1995 (“Act”). At first instance, the High Court agreed that such requirement was unenforceable and Victoria appealed.

The Act applies to any new tenancies, essentially, completed on or after 1 January 1996 and states that if a tenant assigns its lease, it is released, but can be required by a landlord to guarantee its immediate assignee only, under an authorised guarantee agreement (“AGA”). The doubt is whether the tenant’s guarantor could also be required to guarantee the assignee. If this requirement is not allowed, it would be rendered void by the Act’s wide-ranging anti-avoidance provisions.

The Court of Appeal decided that the tenant’s guarantor cannot be required to guarantee the assignee, falling foul of the anti-avoidance provisions. So, HoF could not be required to guarantee the assignee, but Victoria could still require the assignment to the financially healthier company and the Court rejected HoF’s argument that the lease’s assignment provisions would in any event allow an assignment back to Management.

In its judgment, the Court tried to tackle a number of key issues for the property industry, which it did not need to decide but considered would be useful tp the industry. The Court’s comments in relation to those issues (including the efficacy of “sub-guarantees”) are not legally binding precedent, but they will be regarded as strongly persuasive, because of the judges’ expertise and seniority.

What does this all mean for the industry? While an outgoing tenant’s guarantor cannot be required to guarantee an assignee’s liability (even if the guarantor wishes to do so), it can validly be required to guarantee the assignor’s liability under the AGA (sometimes known as a “sub” or “parallel” guarantee).

That is a key statement as the landlord can be more confident that it can continue to look to the financially strong guarantor following the assignment. That makes commercial sense, since the guarantor is often the key element to the tenant’s covenant strength. Another important conclusion of the Court is that the guarantor can in any event validly guarantee the liability of an assignee on a further assignment.

Although this decision will likely reduce the practical difficulties around outgoing tenant’s guarantors, concerns still remain. For one, the property industry will be concerned about the decision’s impact on existing documentation that appears to be void in the light of the decision with potential impact on the valuation of properties. 

The judgment also raises some uncertainties, for example, is it permissible for a tenant to assign to its guarantor? If it is not, what impact, for example, does this have on assignments between partners in a partnership? Can a tenant’s guarantor who has sub-guaranteed the outgoing tenant’s obligations in an AGA go on to directly guarantee the assignee’s assignee? We could go on. 

While providing useful guidance on sub-guarantees, this case has, perhaps unnecessarily, opened a Pandora’s box of issues for the property market in relation to tenant’s guarantors.  We await further decisions and guidance from the courts, but the property industry will need to continue to take care when dealing with tenant’s guarantors.

Gary Watson, Head of Olswang’s Real Estate Group. This article was written in association with Warren Gordon, Head of the Real Estate Know How team.  Olswang’s Real Estate team has over 100 lawyers across Europe.