When granting a new commercial lease, landlords often request a rent deposit from tenants to secure the payment of rent and the performance of tenant covenants. This precaution is particularly common with tenants who have weak financial status or minimal assets. However, determining landlords’ options following the insolvency of a tenant can be challenging. The specific structure of rent deposit arrangements, the particular insolvency process, and the applicability of the Financial Collateral Arrangements (No. 2) Regulations 2003 (FCAR) dictate the actions a landlord can take. This article explores the various structures of rent deposits and the implications for landlords in the event of a corporate tenant’s insolvency, offering essential guidance on navigating these situations.
The parties to the lease (which can include any guarantor to the lease) can enter into a formal rent deposit deed which will set out the circumstances in which the landlord can draw against the deposit and the basis on which the deposit is held.
There are a number of ways that a rent deposit can be structured, including, but not limited to:
- A landlord holding deposit monies either for itself, or on trust for the tenant;
- A tenant holding deposit monies and charging them to the landlord (or vice versa);
- A landlord holding deposit monies as part of its general funds or in a separate account; or
- An independent third party holding the deposit monies as stakeholder.
In the event of a corporate tenant’s insolvency, a landlord will want to be able to deduct unpaid rent and other payments from the rent deposit at no cost and without delay.
The rules governing the action that a landlord can take in such circumstances however can be complex. It is necessary to consider (a) whether the tenant is a company, or an individual, (b) which specific insolvency process is involved, and (c) whether the Financial Collateral Arrangements (No. 2) Regulations 2003 (“FCAR”) apply. This note focuses on company issues.
FCAR applies to ‘financial collateral arrangements’ entered into between two parties (who are not individuals) on or after 26th December 2003. Financial collateral is essentially cash (which could include rent deposit monies) or other financial instruments. A financial collateral arrangement must be evidenced in writing.
It is not clear that FCAR applies to rent deposits (whether they do or not is beyond the scope of this article) but there are benefits to a landlord if a rent deposit deed falls under its scope. Careful assessment of the terms of rent deposit deeds should be made on a case by case basis.
The Lundy Granite Principle
The Lundy Granite principle is a legal doctrine that allows a landlord to claim rent as an expense of the administration when the property is used for the benefit of the insolvent estate. In the case of Re Lundy Granite Co, it was established that if the administrator continues to use the leased property for the purposes of the administration, then the rent for that period (the company entering administration until beneficial occupation ends) can be treated as an expense of the administration. This principle ensures that landlords can recover rent as a priority claim, providing some protection against the financial impact of a tenant’s insolvency.
What options does a landlord have following insolvency of its corporate tenant?
This varies depending on how the rent deposit deed is structured (as set out above). It also depends upon the type of insolvency process (we will consider a company voluntary arrangement (“CVA”), administration and liquidation), and also whether the rent deposit is subject to the FCAR.
a) Where deposit monies clearly do not belong to the tenant
Most insolvency situations will not affect a landlord’s rights to make rent deposit deduction as permitted in the rent deposit deed. This includes deposits set up where a landlord holds deposit monies as part of general funds or in a separate account.
Where deposit monies are held by a 3rd party as a stakeholder there needs to be consideration on a case by case basis as to who has the beneficial interest in the sums.
b) Where deposit monies are held by a landlord as a trustee
Where trust arrangements provide that a tenant has sole beneficial rights to the deposit monies, the general view is that a landlord can make deductions from the deposit notwithstanding the tenant’s insolvency. However, the position should be checked carefully. Full deposit monies are likely to form part of the tenant’s wider insolvency estate even if a landlord has a claim against the tenant for arrears. Caselaw suggests that if a tenant’s insolvency practitioner brought a claim to recover the full rent deposit then a landlord can raise the apply set-off and be protected. Consideration needs to be given however to the Insolvency Act 1986.
c) Where rent deposit belongs to tenant but is charged to landlord
The position depends on which insolvency regime applies:
i) CVA
- Rights of secured creditors are not affected by the terms of a CVA unless they have expressly agreed to them.
- Where the deposit monies are charged and the landlord has not agreed to anything different in the arrangement, then its rights to enforce the charge should not be affected and the deposit can be used.
- If the FCAR applies to the rent deposit then any potential moratorium on enforcing security against small companies doesn’t apply.
- (NB – if the rent deposit is not charged, the landlord’s rights may be compromised under the terms of the CVA.)
ii.) Administration
- General position is that the statutory moratorium imposed on administration will apply, requiring administrator’s consent or court permission before enforcing security (which may cover withdrawal of deposit monies).
- Administrators usually will not withhold consent for withdrawal however.
- I the FCAR applies – again the moratorium will be disapplied however meaning landlords can draw down on the deposit without consent.
iii) Liquidation – voluntary and/ or compulsory
- Voluntary – no automatic moratorium is imposed, thus no restriction on landlord withdrawal of deposit monies apply, although if the rent deposit deed itself does not permit unilateral withdrawal of sums then court permission may be needed.
- Compulsory – secured creditors are not constrained and so a landlord can withdraw deposit monies. Consent would be required if the landlord wished to commence or continue legal proceedings, but merely withdrawing monies from the deposit account would not be caught by this.
The above is a brief snapshot of some of the issues to consider where there is a rent deposit and a corporate insolvency. Other considerations may apply, and a landlord may have other options available depending on the specific circumstances which apply at the time.
We can guide landlords and insolvency practitioners through the process, and can also provide guidance in structuring the initial terms of rent deposits at the outset of a leasehold transaction. Contact a member of the DTM Legal team by visiting our services page.
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