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Partnerships: Imperfect leasing partners

It is not uncommon for a partnership to want to hold a lease of property, especially in the professional sector, where firms of solicitors, architects, accountants and GP practices are often formed as general partnerships. However, a landlord who is considering granting a lease to a partnership or, alternatively, considering granting consent to the assignment of an existing lease to a partnership, should carefully consider how to best protect its position by choosing the right tenant and guarantor arrangement at the outset.

Background

A general partnership (as distinct from a Limited Partnership or a Limited Liability Partnership) cannot enter into a lease in its own name as it is not a legal entity in itself. Therefore, individual partners must be named as tenants. However, as a matter of law, legal title may only vest in a maximum of 4 partners. The usual way of granting a lease to a general partnership is to grant a lease to 4 of the partners, who execute the lease as tenants, with the remaining partners acting as guarantors.

Problems arise when there are changes in the partnership, especially if one of the partners named as a tenant in the lease wishes to retire from the partnership. Legislation and case law means it is very difficult or, in some circumstances, impossible to deal with the lease to reflect the change in the partnership.

The Law

Section 5 of the Landlord and Tenant (Covenants) Act 1995 (1995 Act) releases any assigning tenant and its guarantor from all future liability under a lease granted after 1 January 1996. This is unless the lease permits the landlord to request an Authorised Guarantee Agreement (AGA) which requires the outgoing tenant to guarantee the incoming tenant. Case law has subsequently established that the landlord can also require the outgoing tenant’s guarantor to guarantee the tenant’s obligations in the AGA (often known as a GAGA or a sub-guarantee). Section 25 of the 1995 Act contains very stringent anti-avoidance provisions, which render void any dealings with a lease which seek to frustrate the purpose of the 1995 Act.

There has been a mass of case law on the effects of the 1995 Act over recent years which has analysed in particular the anti-avoidance provisions of the 1995 Act on various dealings, with the following outcomes:

  •  A tenant cannot assign a tenancy to its guarantor (EMI Group Limited v O&H [2016])

    The purpose of the 1995 Act is to ensure there is no renewal or re-assumption of liabilities, whether that is on the part of the tenant or the guarantor. As a tenant’s guarantor is ultimately liable for the same covenants in the lease as the tenant, the guarantor cannot, as a result of an assignment to it, reassume the same liabilities (in its capacity as a tenant rather than guarantor) as the effect of this would mean that there is no release of the guarantor’s liability. This would frustrate the operation of the 1995 Act and is rendered void by the strong anti-avoidance provisions of section 25 of the 1995 Act.
  • An existing guarantor cannot guarantee a new incoming tenant (Good Harvest Partnership LLP v Centaur Services Ltd [2010] and K/S Victoria Street v House of Fraser (Stores Management) Ltd and others [2011])

    If the guarantor of an outgoing tenant guarantees an incoming tenant, the guarantor will have identical obligations following the assignment as it had before the assignment - there is no release of the guarantor’s liability on the assignment. Therefore, under the 1995 Act, such a repeat guarantee is void.

  • A tenant cannot assign a lease to itself

    Although this was not specifically mentioned in any of the cases, it would be reasonable to apply the same logic as was applied in the Good Harvest, House of Fraser and EMI cases to say that a tenant cannot assign a lease to itself. As the assignment would impose on the tenant in its new capacity as the assignee, the same tenant obligations which the 1995 Act sought to release the tenant from on the assignment, the assignment would be void under the anti-avoidance provisions of the 1995 Act.

Practical Implications for Partnerships

The following example illustrates the problem which the 1995 Act and case law has created for partnerships holding leases.

Partners A, B, C and D hold the lease and Partners E, F and G act as guarantors. Partner A wishes to retire from the partnership and relieve himself of all liabilities under the lease.

The “traditional” way of dealing with this would be for Partners A B C and D to assign the lease to Partners B C D and E, with Partners F and G acting as guarantors. However, pursuant to the 1995 Act and the subsequent case law this is likely to void at every level:

a) Partners B, C and D cannot assign the lease to themselves;

b) Partner E, as a former guarantor, cannot become a tenant; and

c) Partners F and G cannot provide a repeat guarantee.

What are the Solutions for Landlords?

It is important for a landlord to plan ahead. When granting a new lease or granting consent to assign a lease to a partnership, the most practical solution for a landlord is that the partnership sets up a company which then enters into or takes an assignment of the lease. Each partner is allocated a share in the company and each partner (or a significant number of partners) provides a collective guarantee to the landlord. The collective guarantee is essential as the company set up to hold the lease will have no covenant strength. On any restructure of the partnership there does not need to be an assignment of the lease because the corporate vehicle continues to be the tenant - there would just need to be a transfer of the shares in the service company. The collective guarantee could allow retiring partners to be released from the guarantee without the landlord’s consent, so long as any new partners are also added to the guarantee and there is a lower limit on how many guarantors there must be at any one time.

In a large partnership, as an alternative to setting up a company, there may be a sufficient number of partners to ensure that any proposed dealing with the lease to enable partners to retire with no further liability takes place as an assignment to 4 new partners, who have not previously been tenants or guarantors under the lease. If a landlord considers the partnership is large enough to permit this then it should ensure that the alienation provisions in the lease specifically provide for this. However, even the very largest of partnerships may run out of replacement tenants and guarantors if there are frequent changes to the partnership.

For a landlord of a partnership who receives an application for consent to assign to reflect changes in that partnership, the establishment of a corporate vehicle to assign the lease to is only part of the solution. Existing partner guarantors will still not be able to guarantee the corporate vehicle holding the lease as that would be a repeat guarantee and, therefore, void under the 1995 Act’s anti avoidance provisions. Landlords could, therefore, find themselves with a substantially weaker “overall package” of tenant and guarantors following the assignment. It is important to consider whether a landlord is permitted to refuse consent to the assignment based upon the watering down of the overall package of covenants, but of course this does not help the partnership transition the lease so that it reflects changes in the partnership.

The final solution may well be for the landlord to accept a surrender of the existing lease and grant a new lease to the corporate vehicle with the partners acting as guarantors. A landlord must be careful to ensure that any dilapidations liability is rolled forward into the new lease and the tenant’s obligation extends to removing alterations made during the term of the previous lease as well as the new lease. Tenants will also need to consider the SDLT implications of a surrender and re-grant in these circumstances.

Published: 25 March 2017


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Spring 2017

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Jennifer Ayris