Lease incentives and defaulting tenants

August 2019

Just as incentives are a fact of life for commercial lease transactions in Australia, so are defaulting tenants. A major issue for landlords is what happens to the incentive when the tenant vacates the premises part way through the agreed lease term? As partner Kristy Dorney explains, there are measures a landlord can take to offset this risk.

Background

While lease documentation displays the agreed rent or 'face rent', inevitably the landlord will give the tenant an incentive to enter into the lease, usually documented in a separate agreement for lease or incentive deed.

Incentives take many shapes and forms. Most common are the offer of a rent-free period from commencement of the lease, an abatement of the rent for the term of the lease, a cash payment, a contribution to the cost of the tenant's fit out, or sometimes the supply of fit out at no cost to the tenant.

All in all, the value of the commercial deal you receive as the landlord is the right to be paid the face rent and contribution to the building's operating cost less the cost of the incentive.

In a perfect world, the tenant will meet its financial obligations for the life of the lease and the landlord will receive the commercial value bargained for. However, when a tenant vacates early, a landlord loses both its rental income and the incentive given. This is a particular concern for a landlord who has given the benefit of its incentives upfront by supplying rent free periods or cash contributions to the fit out.

Claw back provisions void as penalties

Many leases seek to address this concern by including 'claw back' provisions requiring the tenant to pay back in full or on a pro-rata basis cash incentives paid to it or rent that would have been paid but for the agreed rent free periods.

However, these claw back provisions are regularly found by the courts to be a penalty and unenforceable. The law of penalties in Australia prevents one party to a contract from charging the other party a penalty if that party breaches the contract. You can sue a defaulting party for damages suffered due to their breach but, you can't recover more than you bargained for because that is effectively charging a penalty.

If a tenant stops paying rent, the damage suffered by the landlord is the loss of rent. If the tenant vacates the premises and the lease is terminated then, again, the damage suffered is the loss of rent. In addition to loss of rent, the landlord may have to incur additional costs such as the cost of disposing of property, making good the premises, agent fees for a new tenant and incentives to a new tenant. Each of those costs may be recoverable from the tenant.

Having a contractual right to claw back the benefit the tenant has received for incentives will provide an income stream to the landlord which could be set off against the damages outlined above. However, the landlord already has a right under the lease and at law to recover those damages from the tenant. So, on the face of it, a claw back provision will result in the landlord having a right to recover from the tenant more than it would have received if the tenant had remained in occupation for the term of the lease. This is the basis upon which the courts in Australia have frequently found that claw back provisions are a penalty and therefore not enforceable against the tenant.

Security

Careful structuring of incentive agreements and drafting may take a claw back arrangement outside of the realm of unenforceable penalties and. including a claw back clause is a good starting point for a landlord faced with a defaulting tenant.

However, a more valuable exercise for landlords to secure their right to receive the full benefit of the commercial deal bargained for is probably to look at what property of value it can access to set off against damages owed by a defaulting tenant.

Bank guarantees, bonds, personal and parent company guarantees are common and should be taken as standard.

Taking security over assets of a business or real property is less frequently seen but may be options depending upon the tenant and its willingness to agree.

Taking security over a tenant's property in the premises is an important and often valuable option for landlords. However, there are numerous ways this can be achieved and each alternative has specific drafting requirements in the lease documentation, due diligence searches and Personal Properties Securities Act (PPSA) registration if it is to be enforceable and effective as security.

The strongest form of security over a tenant's property is for the landlord to own the property outright and lease it to the tenant with the premises. Although not technically a security agreement, the arrangement does require registration on the PPSA register within very strict timeframes. Failure to register can see ownership of the property pass if the company appoints an external administrator.

Alternative to ownership, landlords should consider including clauses which allow them to withhold property pending payment of arrears (both before and after the lease is determined) and, on termination of the lease, to sell property to apply the proceeds against monies owed. Another option is advancing a loan to the tenant for the purchase of specific property over which security is taken. Again, each of these arrangements require specific drafting and registration on the PPSA register to be effective.

In practice, most landlords opt for a combination of the above.

PPSA registration

The importance of PPSA registration when, and sometimes before, the tenant takes possession of the property cannot be overstated. Whatever the arrangement, if the landlord leases property it owns or has a right to use the tenant's property to set off against money the tenant owes it, then this is a security interest which may be lost or rendered unenforceable if it is not registered. The type of security interest registered, description of collateral over which it is registered, and timing of registration in each case are different. Also, an incorrect registration is as good as no registration at all.

In a recent case, a landlord loaned a tenant $460,000 to purchase the plant and equipment of the outgoing tenant. The tenant granted the landlord a security interest over the plant and equipment. However, the landlord failed to register this security interest on the PPSA register.

An unregistered security interest will be trumped by a later registered security interest and is extinguished completely on the appointment of an external administrator, liquidator or trustee in bankruptcy.

In this case, the tenant went into liquidation whilst still occupying the premises. The appointment of the liquidator extinguished the unregistered security interest and the liquidator took the plant and equipment free of the landlord's charge.

What steps should you take?

Landlords looking to secure their incentive investment should take the following steps:

  • Speak to your tax adviser to understand the tax implications of the alternatives between owning fit out paid for by the landlord and simply making a cash contribution which will require another security arrangement.
  • Speak to your lawyer about the options and importantly, documenting security arrangements correctly in the lease agreements and registering the security interests on the PPSA register.
  • Get early legal advice, preferably before terminating a lease and re-entering, about enforcement of security interests and disposal or use of abandoned property.