Disclaimer of a lease by the landlord’s liquidator – part 2

The Court of Appeal last week ruled that a liquidator appointed to a land owning company could use the disclaimer power in s 568 of the Corporations Act to extinguish leases granted by that company.

This decision may have significant consequences for tenants and their financiers if their landlords are placed into liquidation.

The case also represents the next decision in the line of cases that includes Shevill v Builders Licensing Board [1982] HCA 47, Progressive Mailing House Pty Ltd v Tabali Pty Ltd [1985] HCA 14 and Apriaden Pty Ltd v Seacrest Pty Ltd & Anor [2005] VSCA 139, that discuss the ‘contractualisation’ of leases.

The decision overturns a decision by Davies J, discussed in an earlier post here.  That post also sets out some of the background to the decision.

Set out below are a number of material paragraphs from the decision.

Warren CJ and Sifris J held that (emphasis added):

[25]           By disclaiming the contract, WFL no longer has any contractual rights or liabilities under the contract. It is no longer required to perform its part of the contractual bargain. It does not have to provide the lessee with possession and quiet enjoyment. It follows that the lessee, as the other contracting party, loses its rights and is no longer required to fulfil its obligations. This is because the rights and duties of WFL as lessor and the lessee are reciprocal and interdependent. However, there is a qualification to the extent to which the other parties’ interests or property is affected. It is only affected to the extent necessary to release the company [WFL] from liability.

[26]          It is clear from the words used that third party rights and interests can be affected and indeed they may affect the most innocent of parties. The remedy is provided in s 568D(2). This section provides for such person ‘to be a creditor of the company to the extent of any loss suffered by the person because of the disclaimer and may prove such a loss as a debt in the winding up’. Accordingly, the Growers can prove for the amount they have been deprived of because of non-performance of the contract by WFL. Further, ss 568B and 568E provide a further remedy to parties aggrieved by any disclaimer. They can apply to the Court to set aside the disclaimer. They need to establish that the prejudice they will suffer is ‘grossly out of proportion’ to the prejudice to the company’s creditors. These factual matters were not before the trial judge or this court.

[27]          The critical question therefore, is how far it is necessary to go (in relation to the lease of the lessee grower) in order to release WFL from liability. This begs the question of what the liability of the lessor is?

[28]          The ongoing requirement to provide the lessee with possession and quiet enjoyment is clearly an obligation of WFL. It continues for the duration of the lease. It is self evident that the obligation to provide such tenure is a liability of WFL. The liability of WFL arises directly out of the tenure of the lessee. Put another way, the lessee’s right to possession (a right derived from the disclaimed contract) will only terminate if is has the effect of releasing WFL from liability. In our opinion, termination of the contract would relieve WFL from its ongoing liability to provide quiet enjoyment.

…

[32]           In our opinion, the continuing and prospective obligation to provide possession and quiet enjoyment is not a fully accrued obligation or liability that cannot be terminated.

…

[37]           The context of the word ‘liability’ in s 568D(1) suggests that it should be given the widest possible meaning and include the obligation to provide possession and quiet enjoyment. The section is specifically designed to enable a liquidator ‘to cease performing obligations…[and] to achieve a release of the company in liquidation from its obligations’. If WFL is to be relieved of its obligation to provide quiet enjoyment, clearly and in context a liability, the interest of the lessee so far as tenure is concerned is directly related to and underpins such liability. The tenure must go. It is necessary to affect the Growers’ rights (tenure) in order to release WFL from its liability (possession and quiet enjoyment). The cases where rights have been preserved usually involve claims against third parties unrelated to any liability of the company in liquidation.

[38]          The remaining question is whether, notwithstanding the termination of the interests of the lessee under the disclaimed contract – because the termination of such interest is necessary to relive WFL from liability – the asserted leasehold interest remains. The trial judge held that it did, essentially because it was not necessary to terminate such interest in order to relieve WFL of liability. We disagree.

[39]          For reasons that follow we are of the opinion that if the contract is disclaimed, the leasehold interest is also extinguished. In our opinion, any leasehold interest is governed by the contract of lease. It is the contract that regulates the substance and termination of the leasehold interest.

[40]          The authorities support the proposition that any leasehold interest is governed by the law of contract. …

[41]          It is clear that in a change from the previous position, the doctrines of frustration and repudiation apply to leases. This represented a clear change in judicial thinking. Instead of viewing leases essentially or exclusively in terms of their proprietary character, a development associated with the feudal origin of leases, leases have been considered from a contractual perspective. This involved a recognition that modern commercial leases, with extensive contractual provisions, stand in stark contrast to a long term lease of agricultural land at Blackacre at minimal or no rent. This contrast was recognized by Deane J in Progressive Mailing.

[47]           Although the event bringing about the termination of the contract of lease (and as a consequence, any leasehold interest) was a repudiation accepted by the non-defaulting party, it is the consequences of such termination, (namely termination of the leasehold interest) however brought about, that are relevant. There is no reason in principle or policy that should treat the consequences of disclaiming a contract of lease in a different way. In both cases, the lease agreement is at an end and what follows is a matter of law, namely termination of the leasehold interest that does not depend in any way on the reason for such termination. …

[51]          Finally, in assessing where the leases fit on the continuum referred to by Deane J in Progressive Mailing (Blackacre v complex contractual covenants), it is important to place the lease agreements of the kind in evidence in their proper commercial context. It is but one document in a suite of inter-related documents that regulate the rights and liabilities of various parties in a managed investment scheme that may fairly be regarded as tax driven. The scheme is underpinned by a constitution and the existence of numerous growers or investors who pool their resources and permit a manager to attend to all the necessary work. In this context, as with shopping centre leases, it is difficult to regard the grower or investor (they are not called lessees) as holding a leasehold interest or estate. The better view is that there is no demise of the kind that would survive any termination of the very contract that created the tenure.

[52]          The notion that a commercial lease is a demise that confers an interest in land and survives the termination of the contract creating the demise is to ignore recent, significant developments in the law that clearly suggest otherwise.

Similarly, Redlich JA held that:

[72]           The lease creates rights in rem being an estate or interest in the land demised. The right to possession which gives rise to the interest in the land is an essential part of the lease. The demise of an estate for a term of years is so intertwined with the covenant and contractual provisions relating to it that they must be viewed as constituting one legal transaction. Where the estate in land is one which has come into existence by virtue of a lease contract the disclaimer of the contract involves a direct repudiation of the relation of landlord and tenant which, once accepted, brings the estate to an end.

This decision has potentially far-reaching consequences for tenants of insolvent landlords and their financiers.

Firstly, it suggests that the tenant of a shopping centre can have its lease extinguished by a liquidator appointed to the landlord company.  If that were to occur, the tenant has three options:

1. prove as an unsecured creditor in the landlord’s winding up;
2. apply to Court to set aside the disclaimer under s 568B(1) of the Corporations Act;  or
3. try to negotiate a new lease with the Liquidator;

Proving in a winding up rarely produces a satisfactory result for creditors.

An application to set aside the disclaimer faces significant hurdles, including:

1. the application ordinarily needs to be made within 14 days of the liquidator’s notice of disclaimer (see s 568B(1)).  This may prove challenging, particularly for small business tenants;
2. the tenant would need to fund the application and risk significant legal costs being awarded against it if unsuccessful;  and
3. the tenant needs to show that the prejudice to it is ‘grossly out of proportion to the prejudice that setting aside the disclaimer would cause to the company’s creditors’.  This appears at first blush to present a higher barrier to relief for a tenant than, say, an application for relief from forfeiture.  It may prove difficult to satisfy if, for example, the liquidator is required to incur significant costs to comply with its obligations under the lease or the rent was significantly below market.

The person making the application to set aside the disclaimer needs to have, or claim to have, an interest in the disclaimed property (see s 568B(1)).  This means that:

1. if a head lease is disclaimed, a sub-tenant might face an argument that it does not have a sufficient interest in the disclaimed property;
2. similarly, a licensee (such as a franchisee with an outlet licence but no sub-lease), may also have difficulty establishing that it has a sufficient interest in the disclaimed property;  and
3. a tenant’s or licensee’s financier may also face additional hurdles.

Also, a sub-tenant trying to set aside a disclaimer of the head lease from which it obtains its interest will need to deal with obligations under the head lease.  In an application by a tenant for relief from forfeiture of a head lease, the sub-tenant is ordinarily required to satisfy the obligations under the head lease.  However, this presents difficulties when the head lease contains onerous obligations above those required of the sub-tenant.

For example, the freehold of a shopping centre may be owned by a land owning entity which grants a head lease of all the land (including common areas) to a management company.  The management company may then grant a series of sub-leases to shop owners.  If a liquidator is appointed to the land owning company and then disclaims the head lease, the shop owners will need to apply to the Court to set aside the disclaimer.  However, complying with the head lease may well be beyond the means of the small business sub-tenant.  It is not clear how the Court would resolve an application in those circumstances.

Consequently, the reality may well be that the tenant has no real alternative but to try to negotiate a new lease with the liquidator (which would, in all probability, be less favourable to it than the old lease) or risk the loss of its business and goodwill with limited recourse as an unsecured creditor.

It follows, of course, that the tenant’s or licenceee/franchisee’s funders may also be concerned about this risk.

Also, paragraphs 51 and 52 of Warren CJ and Sifris J’s reasons (set out above) seem to be open to two readings, being tenants of complex commercial leases:

1. do not have an interest in land at all;  or
2. have an interest in land, but not one that can survive the disclaimer of the contract that created it.

If the first interpretation is correct, then this represents a significant development in the law and has wide-reaching implications.  However, the second interpretation is consistent with paragraph 72 of Redlich JA’s reasons (the text of which is set out above).

The Court of Appeal’s decision has not yet made its way onto AustLii.  A copy is available here.